What Is a Collateralised Fund Obligation?
A Collateralised Fund Obligation is a structured finance product linked to the performance of investment funds such as hedge funds and private equity funds. It mirrors the logic of a Collateralised Debt Obligation, but instead of mortgages, the underlying assets are fund interests.
A CFO involves:
- Repackaging fund assets into a special purpose vehicle
- Issuing tranches of debt and equity
- Using investor proceeds to finance the SPV’s investment into the funds
Private capital firms can also issue CFOs to raise money for their own deals.
Only a handful of CFOs have ever been publicly disclosed. Temasek Holdings’ $810 million securitisation of a private equity portfolio is one of the few examples. The lack of transparency makes it difficult to assess risk exposure.
Why Private Equity Creates Risk Inside CFOs
Leveraged buyouts
Private equity firms rely heavily on leveraged buyouts. LBOs use debt to acquire companies, with the target’s assets used as collateral. Elon Musk’s Twitter acquisition included $13 billion of LBO debt.
Deal volume surge
Private equity activity surged after the pandemic:
- 1,545 UK deals in 2021
- £159.2 billion total value
- Driven by depressed valuations and historically cheap borrowing
High leverage meets rising rates
LBOs typically use a 90% debt to 10% equity ratio. The resulting bonds are junk‑rated. Companies with large junk debt struggle to refinance. KKR‑owned Envision Healthcare was downgraded to a C rating, the lowest junk grade.
As interest rates rise, floating‑rate debt becomes more expensive. CFOs add another layer of leverage on top of an already leveraged industry.
CFO Ratings: A Transparency Problem
If private equity portfolio companies carry poor credit ratings, CFO tranches should reflect that risk. Yet senior bonds issued by Temasek’s CFO remain rated A+.
Without disclosure of underlying assets or tranche structure, the rating cannot be verified.
S&P recently warned that US and European corporate defaults may triple in 2023. If defaults rise, CFO performance could deteriorate.
For law firms, this means:
- More restructuring and insolvency work
- More litigation around structured products
- More CFO issuances as private equity firms seek alternative financing
The BIS Bombshell: $80 Trillion in Hidden Dollar Debt
The Bank for International Settlements has reported that pension funds and other non‑bank financial institutions hold more than $80 trillion in off‑balance sheet dollar debt through FX swaps.
How FX swaps work
An FX swap involves:
- Borrowing one currency and lending another at the spot rate
- Reversing the exchange at a predetermined forward rate
FX swaps allow borrowing without cross‑border loans and eliminate foreign exchange risk by locking in the forward rate.
Why the debt is hidden
FX swaps do not appear as liabilities on balance sheets. The obligation to repay borrowed dollars at the forward rate creates off‑balance sheet dollar debt.
Why $80 Trillion Matters
Risk to pension funds
Pension funds are typically risk‑averse. Their exposure to hidden dollar debt raises concerns about liquidity and counterparty risk. If they default, investor losses could be severe.
The scale problem
$80 trillion is roughly 4 times the total number of US dollars in existence. It is close to the size of the global economy.
If these debts must be repaid, institutions will need access to dollars. This may require the Federal Reserve to open swap lines, as it did:
- During the 2007 to 2009 financial crisis
- During the 2020 pandemic shock
Inflation and currency effects
Opening swap lines increases dollar supply. This could worsen inflation, currently around 7.7% in the US. A weaker dollar could make US companies cheaper for foreign buyers.
This creates opportunities for cross‑border M&A. Firms such as Freshfields, with strong corporate practices and major European clients, could benefit from increased acquisition activity.
Concluding Thoughts
Both CFOs and hidden FX‑swap debt carry a doomsday tone. Yet law firms thrive in both booms and busts. Countercyclical practice areas such as restructuring, insolvency and fraud litigation grow during downturns. Private equity and structured finance teams grow during periods of expansion.
The firms that balance both sides of the cycle will be best positioned to profit from whatever comes next.
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