US regulators crack down on private equity securitisation vehicles

US regulators are cracking down on a type of investment vehicle used by private equity groups over fears that rating agencies are downplaying the dangers of the products and exposing insurers to under-appreciated risks.

The vehicles are known as “collateralised fund obligations” and echo the “collateralised debt obligations” that played a central role in the 2008 financial crisis. They parcel up stakes in hundreds of private equity-owned companies into products that are meant to diversify risk and win stellar credit ratings as a result.

But the National Association of Insurance Commissioners is moving to take over assessment of the products for US insurers, some of the main investors in the vehicles.

The planned move by the NAIC, which represents US insurance regulators, comes after a year-long investigation found that rating agencies can understate the risk of CFOs to insurers, according to people familiar with the matter. It is similar to steps the regulator took to rein in mortgage-backed securities in the wake of the financial crisis.

The changes “could have a profoundly adverse impact on the development and the issuance of CFOs”, said one adviser who has worked on several CFOs. The regulator’s involvement is “a huge deal”, they added.

The plans have taken the industry by surprise, said one executive working on plans to launch a CFO. “The NAIC has introduced a lot of uncertainty into the market and it has frozen a lot of activity.”

“It is 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 NAIC told the Financial Times.

A CFO is, in effect, a box containing stakes in a range of different private equity funds, as well as private real estate, credit and infrastructure funds, in some cases. 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.

The NAIC has raised concerns about “the many . . . private layers” of CFOs. Its crackdown will also target similar structures.

The lack of disclosures of the assets underlying a CFO “den[ies] regulators, and possibly insurer investors, transparency into the true underlying risks, credit exposure and nature of the investment”, the NAIC said in a November report.

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.

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. “The regulator is being a market participant,” they said.

“The NAIC is not a ‘market participant’ but does respond when necessary to investment innovations . . . that are oftentimes used by market participants to circumvent regulatory guidance,” said the regulator, adding it is a non-profit organisation.

Under the current system, insurers can invest in CFOs 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.

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