NEW YORK – General partners have long bemoaned the tiny slice of the capital pie they are fighting for when it comes time to fund raise. After all, most pension funds allocate only minimal percentages of their available investment capital to alternative vehicles, while most insurance companies won’t touch private equity at all given NAIC regulations that demand investment-grade credit ratings.
That could change, however, based on news from Europe that a EURO150 million ($127.6 million) private equity fund-of-funds has been raised using an unique hybrid structure mixing traditional equity-backed limited partnerships with plain vanilla debentures. Moreover, the securitized fund, Prime Edge Capital, received from Standard & Poor’s what is believed to be the first ever announced stand-alone credit rating for a private equity vehicle, although an insurance wrap from Allianz Risk Transfer boosted the overall rating significantly.
“The typical bond investor invests in all sorts of transactions because they want diversified assets, but they had usually been prevented from participating in the private equity market,” said Jeffrey D’Souza, co-head of global credit derivatives with Deutsche Bank, which arranged and placed the Prime Edge bonds. “What this type of structure does is not only allow bond investors to further diversify, but also greatly expands the pool of available capital for private equity funds.”
Prime Edge is lead-managed by Capital Dynamics and sub-advised by Rainer Marc Frey (RMF) and Hamilton Lane Advisors. Investors on the equity portion of the deal will receive returns on Prime Edge’ investments, just like they would on any other private equity vehicle. Bondholders, on the other hand, will have to hang their hat on having enhanced their portfolio diversity, as they will only receive an annual coupon of approximately 7.5% without an additional equity upside.
A Secure History
The Prime Edge collateralized debt obligation (CDO) is really just the latest development in an evolutionary process that began in 1999 when Swiss investment bank Partners Group (which used to employ Capital Dynamics founder Thomas Kubr) sold $719.4 million worth of zero-coupon convertible bonds that, in 2007, can be exchanged for shares in a private equity offering called Princess Private Equity Holding Ltd. The bonds themselves received a private investment-grade rating from Fitch, and were additionally boosted by a wrap from Swiss Re.
Partners Group last year complemented Princess with an offering called Pearl Holding Ltd., which was recently reopened with a EURO500 million target and was expected to close at the end of last month.
The most intriguing step made prior to Prime Edge, was from global private equity behemoth J.P. Morgan Partners. Displeased with the markdowns it was receiving on its secondary partnership interest sales, Morgan Partners launched an $800 million securitized offering last August very similar in structure to Princess.
Named Porter Global Private Equity Ltd., the bonds featured a 2.5% sponsorship fee, were partially designed by Partners Group and marketed by Merrill Lynch & Co., the same firm currently selling the new Pearl Holding transaction.
However, unlike earlier Partners Group deals, private debt investors had significant enough reservations about Morgan Partners’ Porter bonds that the deal was recently pulled from the market so that its terms could be slightly restructured.
“There was an obvious appeal to the [Porter] deal because it offered the best of both worlds in that it’s fixed income as perceived by the rating agencies, but you’re still getting some of the upside of private equity,” said a private debt buyer from a West Coast insurance house. “The J.P. Morgan structure was a little rich for us, but we like the idea in general.”
Another problem was that the partnership interests offered were said by one buyside source to be of relatively young funds, therefore knocking out a number of the traditional private equity secondaries players who might have otherwise been interested in participating.
It is important to note that the Morgan Partners did not seek or receive a stand-alone credit rating on the bonds, although their accompanying insurance wrap from Swiss Re helped them get an unannounced triple-A mark from S&P. The deal will be put back into the market later this summer, and sources close to the transaction expressed confidence that it would get done by year-end.
While Prime Edge has held a formal close with undisclosed European investors, the fund-of-funds is still open until August and could wind up with as much as EURO250 million.
“We did want a bigger deal, yes, but we’re more than happy with what we raised given current market conditions and believe we may still add more,” Capital Dynamics’ Kubr said. “We offered a novel structure and received investments from people who had never before invested in private equity.”
The E150 million already raised will be invested into a diversified pool of 35 pre-approved European private equity fund managers. Six such infusions have already been made, Kubr said.
About EURO105 million of the Prime Edge vehicle was sold as 12-year senior notes, which were split into two tranches. Originally the E72 million of Class A bonds received a single-A stand-alone rating from S&P, while the E33 million Class B notes received a triple-B rating, which is the bottom of the investment-grade grid. After receiving the Allianz insurance wrap, all the senior notes ended up with a double-A rating.
“The private equity product is generally not capital guaranteed and investors carry the full risk, but Prime Edge is being wrapped, so Allianz is actually taking on the risk,” explained RMF’s Marc Dentand.
The E45 million worth of junior notes was sold to a separate group of investors than the senior notes.
While most buyside players on both the private equity and debt side have yet to participate in securitized private equity offerings, every investor contacted for this story said the potential upside of such a concept is staggering.
Indeed, the dual realities of an expanded private equity investor base and bond portfolio diversification will likely maintain a continuing flow of interesting offerings in the upcoming years. Not only is Kubr planning a stateside version of Prime Edge, but Soody Nelson, managing director and head of the structured finance market value group at S&P, said that the market may not have to wait that long.
“We’ve started to get a lot of inquiries about this sort of thing from insurance companies, pension funds and banks and other financial institutions,” she said. “We’re now working on several proposals, and by the end of the year will rate two or three.”
It is important to note that S&P was not the only credit rating agency the Kubr showed the Prime Edge deal to. In fact, a source familiar with the situation said that Kubr contacted Fitch eight or nine months ago, but that the credit rating agency declined to rate the deal on structural grounds. Prime Edge, did not, however, subsequently contact Fitch about the deal, instead settling on S&P.