US regulators are cracking down on investment vehicles used by private equity groups over fears that rating agencies are downplaying the products’ dangers, exposing insurers to undue risks.
The vehicles are known as “collateralised fund obligations”, a name that echoes the “collateralised debt obligations” that played a big role in the 2008 financial crisis. They parcel up stakes in hundreds of private equity-owned companies into products intended to diversify risk and so obtain better credit ratings.
A year-long investigation by the National Association of Insurance Commissioners, a US regulatory group, has found that rating agencies can understate the risk of CFOs to insurers, which are among the vehicles’ main investors, according to people familiar with the matter.
The NAIC, which coordinates US insurance regulators, has now decided to assess the risk of individual CFOs, supplanting credit rating agencies — a similar initiative to steps the regulator took to rein in mortgage-backed securities in the wake of the financial crisis.
The move has taken the industry by surprise. “The NAIC has introduced a lot of uncertainty into the market and it has frozen a lot of activity,” said one executive working on plans to launch a CFO.
Some of the biggest names in the private equity industry, such as KKR and Blackstone, have issued CFOs, but the size of the mostly private market is almost impossible to measure.
An adviser who has worked on several CFOs added that the regulator’s involvement was “a huge deal” that “could have a profoundly adverse impact on the development and the issuance of CFOs.”
The NAIC said it was not surprising “that entities that have benefited financially by exploiting gaps in the NAIC’s regulatory guidance would be distressed when those deficiencies are being remediated by state regulators whose objective is the financial solvency of US insurers.”
The ECB has previously looked at CFOs, a person familiar with EU regulatory discussions said. However, they added, European bank exposures to such vehicles are small and the products are not a live issue.
A CFO contains stakes in a range of different private equity funds and can also include private real estate, credit and infrastructure funds. Typically, a CFO issues equity and senior and junior bonds, which offer fixed interest payments funded by cash that the funds pay out to their investors.
In a November report, the NAIC said that CFOs’ complex structures denied “regulators, and possibly insurer investors, transparency into the true underlying risks, credit exposure and nature of the investment.”
The planned crackdown comes as several large financial institutions are considering setting up CFOs for the first time. Executives at JPMorgan Asset Management have held talks about potentially setting up a CFO, though no decision has been taken, according to a person with knowledge of the talks. JPMorgan declined to comment.
The private equity firms Eurazeo and Ardian have also discussed setting up CFOs, two people with knowledge of the matter said. Eurazeo and Ardian declined to comment.
One senior executive whose business stands to be hit by the reform said the move was “a huge land-grab” by the NAIC.
Under the current system, insurers can invest in CFOs’ debt at a low risk-based capital charge of less than 1 per cent. If the same insurer invested in the underlying private equity funds directly, it would face a much higher charge of as much as 30 per cent.
The NAIC report said it wanted to “eliminate this version of risk-based capital arbitrage”. Its new rules, which could be introduced this summer if US state-level insurance regulators agree them, would force insurers to share details of the product they were investing in with the NAIC, whose assessment would help determine the risk-based capital charge.
Fitch and KBRA rate CFOs and S&P Global has rated ones set up by a unit of the Singapore state-owned investor Temasek. Typically, the ratings are paid for either by the organisations that issue the CFOs or by the investors in them.
Greg Fayvilevich, a senior director in Fitch’s funds and asset management business, said that while “some of the riskier structures may fall out”, he thought “more diversified, traditional” deals were likely to continue.
KBRA said it was “aware of the NAIC’s efforts” and added: “We are always transparent and welcome the opportunity to discuss our rigorous analytical approach with the market.” S&P Global Ratings declined to comment.
Additional reporting by Laura Noonan
