A little more than one-and-a-half year has passed since Astrea III Pte Ltd launched a series of bonds that are backed by cash flows from a portfolio of private equity funds. Sometime before the announcement of these first-of-its-kind notes—the Astrea III notes were the first listed collateralized fund obligations (CFO) in Singapore—we have published a couple of articles highlighting the key features of the bonds, and suggested that their risk of impairment is low-to-moderate, due to the relatively conservative structure of the deal. (Refer to What You Should Know About the Upcoming Astrea III Notes - Part 1 and Part 2)
With the Astrea III notes having recently reached their third distribution date on 8 Jan 18, we think it is a good time to update investors on their performance and refresh our memory of the bond structure. Also, word on the street is that the Temasek-subsidiary Azalea Asset Management Pte Ltd (Azalea) is preparing to launch the next Astrea CFO in the near future. Azalea is the parent of Astrea Capital Pte Ltd, which is the sponsor to Astrea III Pte Ltd, the issuer of the Astrea III bonds. Although both Temasek and Azalea have declined to comment on this matter, we think it is still beneficial for investors to get acquainted with CFOs, a niche segment of structured finance products which may present interesting investment opportunities.
A primer on collateralized fund obligations
Collateralized fund obligations: the basics
A collateralized fund obligation is a structured financial product backed by a diversified portfolio of hedge funds or private equity funds. The concept is similar to that of collateralized debt obligations (CDO), which are securities backed by a pool of one or more types of debt obligations, or any type of cash flow stream for that matter.
In a CFO, the issuer is set up as a distinct legal entity that is bankruptcy remote. This means that technically, the CFO cannot go into bankruptcy. Even if some holders of the CFO’s securities do not receive their full principal and/or interest, cash flows from the underlying assets are still distributed according to the priority of payments dictated by seniority. Therefore, it is imperative for investors to understand a CFO’s priority of payments in order to ascertain the cash-flow structure, and decide on which tranche of securities to invest in (based on the individual’s risk appetite and investment objectives).
The CFO issuer purchases and holds a diversified portfolio of investments. Using these assets as collateral, the entity issues tranches of securities. The typical capital structure includes senior debt, mezzanine debt, subordinated debt, and equity. They are commonly labeled in an offering as Class A, Class B, Class C, and so forth going from the highest to the lowest, in terms of priority of payments. This stipulation of strict seniority between the different tranches allows investors to determine his or her preferred risk-return investment, i.e. investors with higher risk tolerance may consider more junior CFO tranches for enhanced returns due to the leveraged structure of the CFO.
The underlying pool of assets is usually managed by an investment manager charged with managing important fund matters such as supervising the external service providers (e.g. the fund administrator) and deciding the fund allocations. The asset manager will invest the capital in accordance with the prescribed investment guidelines and methodology.
Collateralized fund obligations: the risks
As with any investment, there are risks associated with collateralized fund obligations. First of all, the performance of the underlying fund investments will determine whether noteholders receive their promised returns. If the value of these investments are impaired to the extent that they can no longer cover the CFO, the value of the notes would decline accordingly. Portfolio composition is thus the most important factor in determining the performance of a CFO.
Another risk with respect to CFOs is their secondary market liquidity. One of CFO’s major merits is that it provides greater liquidity for investors looking to get exposure to hedge funds and private equity funds, which typically have lower liquidity compared to the traditional asset classes. An investor can exit the investment as long as he or she is able to find a buyer for the notes. Nevertheless, given the lack of comparables in the bond marketplace, the higher complexity of CFOs (relative to plain vanilla bonds), and the resultant difficulties of pricing the bonds, liquidity for these assets may be limited at times.
Finally, CFO transactions typically involve external parties in important roles such as trustee for the CFO notes, investment manager, and bank account providers. The structure of the transaction will determine how much the CFO is reliant on these counterparties. Therefore, the financial health of the transaction’s counterparties may be an important factor in accessing the risks of a CFO.
The Astrea III bonds
It is important to emphasize again while Temasek Holdings play an eminent role in the deal—the equity investor, sponsor, issuer and manager are all wholly-owned indirect subsidiaries of Temasek—the Astrea III notes are not "Temasek-backed". Similar to other CFOs, the underlying pool of fund investments will be the source of cash flows for interest and principal payments. If Astrea III is unable to satisfy its obligations to bondholders, investors shall have recourse only to the asset pool. Therefore, the quality of Astrea III’s underlying collateral, its capital structure, and credit structure are the key attributes that we will review here.
After the issue date, both the issuer (Astrea III Pte Ltd) and the manager (Fullerton Fund Management Company Ltd) do not have discretion over the acquisition or disposal of the fund investments in the transaction portfolio. Post-issuance, changes in the fund investment schedule will be mostly due to fund distributions, capital calls and fair value gains/losses. For a better prognosis of Astrea III’s performance, it is hence instructive to examine the composition of the transaction portfolio.
At the deal inception, the underlying collateral is a portfolio of private equity buyout and growth capital funds in the US, Europe and Asia. According to the bond documentation, factors affecting the selection of the fund investments (done by the sponsor Astrea Capital Pte Ltd) include the assumed quantum and timing of cash flows from the fund investments, the track record of the general partners (GP), the quality and stability of the fund management team, the investment strategy of the PE funds, and diversification (across vintages, GPs, funds). The outcome of these considerations was a well-diversified portfolio at inception, consisting of 34 PE funds invested in 592 investee companies.
The initial Astrea III portfolio’s largest exposure to a single fund was 6.7% (of NAV) in the Warburg Pincus Private Equity XI, L.P (21 Dec 17: 7.5% in Warburg Pincus Private Equity XI), while the largest GP exposure was 8.9% to KKR & Co. LP (21 Dec 17: 10.4% to EQT Partners). The majority of the portfolio (96.2% as of 31 Mar 16) comprised of mature funds in harvesting stages (vintage year of 2012 or earlier); the portfolio thus has a better likelihood of providing strong distribution cash flows.
We like that the majority of the portfolio comprised of equity buyout funds, on both the issue date (76.9%) and the most-recent distribution reference date (21 Dec 17: 77.2%). Buyout funds generally have more control over how the investee companies are run, including important decisions such as business strategies and choosing the senior executives. The numerous levers they have to implement changes increase the chances of survival in times of stress. The higher level of management control also provides buyout funds a greater say in the timing of monetizing their investments, allowing the funds to exit at any opportune time.
In terms of the capital structure, Astrea III is made up of five tranches—Class A-1, Class A-2, Class B, Class C, and equity (see Table 1), with the alphabetical order indicating the payment seniority. The Class A-1s (S$228m) and A-2s (USD170m) rank pari passu, and represent the most secured tranches with the greatest amount of subordination beneath them. The Class B notes (USD100m) are subordinated to the Class As, while the Class Cs (USD70m at launch) are the most subordinated tranche of the Astrea III notes, sitting just above the equity tranche.
The equity tranche is held in its entirety by the sponsor Astrea Capital Pte Ltd, an indirect wholly-owned subsidiary of Temasek Holdings. As highlighted in our previous articles, the Astrea III’s capital structure is conservative and provides a comfortable cushion against a valuation decline in the underlying portfolio. At its inception, Astrea III’s equity of USD631.6m made up a whopping 55% of total capital.
Table 1: Astrea III's tranche structure at launch (with credit ratings updated)
|Tranche||Principal/Amount||% of Capital Structure||Ratings (Fitch/S&P)||Coupon|
|Class A-1||S$228.0m||14.8%||A+sf / A+ (sf)||3.90%|
|Class A-2||USD170.0m||14.9%||Asf / Not Rated||4.65%|
|Class B||USD100.0m||8.8%||BBBsf / Not Rated||6.50%|
|Class C||USD70.0m||6.1%||Not Rated||9.25%PIK|
|Equity||USD631.6m||55.4%||Not Rated||Residual cash flow|
Source: Astrea III's Information Memorandum dated 21 Jun 16, iFAST estimates
Before we move on to discuss about Astrea III’s performance, we want to touch on a few points regarding its credit ratings. Fitch and S&P rated the A-1 notes at Asf and A (sf) respectively, when the transaction was launched in June 2016.
In a report published in April 2017, Fitch said its rating criteria for the Astrea III bonds have applied “additional conservatism” due to “the volatility in NAV and distributions” observed in the securitization market during the global financial crisis. The rating agency added that the Class A’s notes would probably be rated triple-A if they were issued before the crisis. In July and September last year, Fitch and S&P upgraded their ratings on the A-1 notes one notch to A+sf and A+ (sf) respectively, citing Astrea III’s sufficient over-collateralization and decent performance, among other factors.
Solid performance since launch
2017 has been a great year for the global financial markets. The US economy grew 2.3%, as business sentiment was supported by President Trump’s pro-business agenda of deregulation and lower taxes. At the same time, the rest of the world’s economies have joined for the rare, synchronized global growth. These factors, together with the low level of market volatility, contributed to generous equity market valuations and a conducive environment for monetization in many private equity funds.
With most of its funds in the US (64% as of 21 Dec 17), Astrea III has benefited from the country’s healthy fundamentals and rich valuation parameters. In the third distribution period ended 7 Jan 18, the private equity funds portfolio value backing the Astrea III issuance generated USD225m in distributions. The underlying portfolio distributed USD588m over the three six-month distribution periods since 31 Mar 16. To put that last number in perspective, it is about 52% of the initial portfolio value (USD1.14 billion).
During the 18 months since launch, the portfolio has enjoyed USD266m of fair value gains. Combined with capital calls totaling USD144m over the same period, portfolio NAV stood at USD964m on 21 Dec 17. Meanwhile, payment to reserves accounts amounted to USD223.8m (out of the total USD588m of distributions). Just halfway through the A-1 notes’ scheduled maturity of three years, the total reserve amount already exceeds the S$228m (~USD168m) A-1 notes principal amount, and represents 66% of both the A-1 and A-2 notes (~USD338m).
Recall that the Astrea III bond documentation stipulates the maximum loan-to-value (LTV) ratio to be observed for each distribution dates. The purpose of the LTV test is to provide triggers to maintain sufficient equity in the structure to protect bondholders. If and when the maximum LTV is exceeded, Astrea III will have to divert cash flows from the underlying portfolio for its deleveraging. As of 21 Dec 17, Astrea III’s LTV ratio stood at 30.2% (see Table 2), comfortably below the 40.0% threshold.
Table 2: Astrea III's LTV ratio as of 21 Dec 17
|Total Portfolio Net Asset Value (A)||$963,956,129|
|Total Principal Amount of Notes and Liquidity Facility Loans Outstanding (B)||$514,855,778|
|Total Reserves Balance (C)||$223,821,931|
|Loan-to-Value Ratio (B-C)/A||30.2%|
|Maximum Loan-to-Value Ratio||40.0%|
Source: Astrea III
Lastly, Astrea III’s strong cash generation performance has allowed it to pay a handsome USD193.9m to the sponsor for its equity investment. In the event that the payouts to the sponsor exceeds USD326.6m (50% of the equity investments on 31 May 16) on or before 8 Jul 19, holders of the A-1 notes will receive a bonus payout of up to 0.30% of their principal. With three distribution periods remaining until the scheduled maturity, we think there is a decent chance for bondholders to receive this extra S$684k (in aggregate) bonus payout.
Strong alignment of interests
An important credit positive of the Astrea III transaction is the strong alignment of interest between the issuer, the sponsor, and bondholders. As mentioned earlier, the sponsor holds the entire equity tranche (USD778.9m as of 31 Mar 17), and it will retain the stake for the life of the transaction (as required by the sponsor share charge provisions in the transaction documents). Investors might also be happy to know that most of the directors of Astrea III are investing alongside them in the Astrea III bonds. Together, the directors held ~USD3.9m of the bonds (across Class A-1, A-2 and B) as of 31 Mar 17.
Furthermore, the sponsor has been outspoken about its mission to provide general investor education about private equity funds, and to broaden investor access to private equity, which has traditionally been hindered by high barriers to entry (e.g. prohibitive minimum investment requirement). We give high credence to this non-financial motivation of Azalea in launching the Astrea series of CFOs, due to a couple of reasons. First, the sponsor's linkages (through Temasek) with the government gives credibility to its professed commitment to make the private equity asset class more accessible to investors. Second, given that liquidity has been awash in the financial system for years, it is probably easier and cheaper for Azalea to go to the banks for funding instead, if the purpose of creating Astrea III is just to achieve cheaper funding costs.
For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.