Private Funds Are Turning to Complex Bonds to Tackle Cash Crunch

Private capital firms grappling with a moribund dealmaking climate are increasingly turning to a niche securitized product to raise cash.

Collateralized fund obligations, or CFOs, slice and dice private portfolios into bonds, many with top ratings, allowing their issuers to borrow cheaply against illiquid assets. A swathe of CFOs have come to the market recently, including deals this week from Ares Management Corp. and Carlyle Group Inc.’s private equity platform AlpInvest.

CFOs have taken off at least partly because private firms are getting creative about finding new sources of liquidity. An ongoing slump in dealmaking, exacerbated by this year’s tariff turmoil, has disrupted their normal business model. CFOs reliant on cashflow from highly-levered assets have become part of the workaround.

“Not a week goes by for me without getting a new CFO proposal, so I expect the market to continue to grow, said Greg Fayvilevich, global head of Fitch Ratings’ fund and asset management group, which assigns ratings to the collateralized debt.

Representatives for Ares and AlpInvest declined to comment.

NAIC All-Clear

The bonds have found eager buyers among insurers since the industry’s regulators paved the way for them to increase purchases of CFOs. The National Association of Insurance Commissioners’ rules went into effect from Jan. 1, and cleared up doubts about capital treatment for the securities.

That set the stage for private capital firms to tap into the deep-pocketed insurance industry. Proponents of the vehicles say that between scrutiny from regulators, ratings agencies and their professional investors, these products are a safe way to attract a new investor base.

“Many of these are carefully designed, they’re cash flow tested instruments to help insurers meet their obligations in ways that some low yield public markets can’t,” Jon Godfread, the current president of the NAIC, said in a recent interview.

But as CFOs get more popular, some are concerned about the bundling of unrated private funds into instruments with top ratings.

Some of the collateral used in these deals can be difficult to exit. The underlying stakes are still subject to economic headwinds whether they are packaged up or not. Restructuring advisors say they are spending more time sorting out problem loans for private funds as high rates, a consumer slowdown and tariff turmoil add to the stress.

In 2023, Fitch Ratings downgraded parts of a CFO managed by Nassau Alternative Investments, saying that the performance of the underlying fund investments was getting weaker due to the market environment and the portfolio’s exposures.

“You’re taking illiquid, opaque assets, slicing them up, and selling tranches with theoretical diversification and little transparency,” said Ludovic Phalippou, a Professor of Financial Economics at University of Oxford. “That’s exactly what we saw with CDOs,” he said, referring to the collateralized debt obligations that helped trigger the global financial crisis in 2008.

There are safeguards built into the CFO structure. Such deals generally include a first-loss equity portion which takes the first hit in the event of a default or decline in value, and this is typically held onto by the manager themselves. CFOs may also have less single-issuer risk than vehicles like collateralized loan obligations, where troubles for one big borrower can ripple through the market.

And to be sure, these CFOs are quite different to financial crisis-era CDOs. Those vehicles repackaged subprime mortgages, while many of the underlying companies in CFOs are private equity-backed firms with millions in earnings. Market participants also say that overall leverage was much higher in a 2008-era CDO than in a present day CFO.

Right now, the market is fairly small. Kroll Bond Rating Agency said in March that it has assigned ratings to $37.7 billion worth of CFOs since 2018, with the bulk of those coming since 2022. Many last year were backed by secondaries funds which are themselves bundles of stakes in private assets.

Other recent deals include a $2.4 billion CFO from Coller Capital last month, as well as products issued by Neuberger Berman Group. Representatives at both firms declined to comment.

Investors in private funds have also turned to CFOs as a way to exit their stakes. Limited partner Thrivent raised a CFO in the first quarter to rebalance its exposure to private equity “and stay active in the space,” according to a spokesperson for the firm.

According to Godfread, the NAIC president, it’s still important to take close heed of the risks of individual securities.

CFOs “may offer yield and diversification but we have to evaluate them carefully to make sure [customers’] policies aren’t exposed to hidden risks, and that’s going to be on a case-by-case basis.”