The structure, the cash waterfall year by year, what a 30 per cent NAV fall does to each tranche, and why a full sweep leaves the equity barely levered.
A collateralised fund obligation (CFO, or collateralized fund obligation in US usage) puts a portfolio of fund interests into a vehicle that issues rated notes and equity, then pays the notes from the portfolio's distributions before the equity sees any cash. On an illustrative 1,000 portfolio with 400 of senior notes at 6.0 per cent and 150 of mezzanine at 9.0 per cent, a full cash sweep repays the senior notes in year 3 and the mezzanine in year 4, and the equity earns 10.9 per cent against 10.0 per cent unlevered. After a 30 per cent NAV fall, the senior notes are still repaid in full, by year 6.
Worked in full in The Fund Finance Professional by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The sponsor transfers limited partner interests, or a fund of funds, into a special purpose vehicle. The vehicle issues senior notes, which carry a rating, mezzanine notes, which may also be rated, and equity, usually kept by the sponsor. Distributions from the underlying funds pay, in order: senior interest, mezzanine interest, senior principal, mezzanine principal, and only then the equity. Unfunded commitments, if any, are covered by a liquidity facility or reserve, which this example leaves out by assuming the interests are fully funded.
The economics resemble a NAV loan with a cash sweep, but the debt is issued as securities, often to insurers, for whom rated notes can be more capital-efficient to hold than the fund interests themselves.
| Item | Amount | Coupon | Cumulative LTV |
|---|---|---|---|
| Portfolio NAV | 1,000 | ||
| Senior notes | 400 | 6.0% | 40% |
| Mezzanine notes | 150 | 9.0% | 55% |
| Equity | 450 |
The portfolio is mature: each year it distributes 20 per cent of opening NAV and the remaining value appreciates 10 per cent, so its unlevered return, valued at NAV, is exactly 10.0 per cent. All cash after interest goes to principal. The vehicle is wound up at NAV in year 10.
Distributions = 20% × 1,000 = 200; NAV at year end = 1,000 × 1.10 − 200 = 900
Interest = 400 × 6.0% + 150 × 9.0% = 24.0 + 13.5 = 37.5
Senior principal swept = 200 − 37.5 = 162.5; senior outstanding = 400 − 162.5 = 237.5
Senior LTV = 237.5 / 900 = 26.4%, down from 40%
| Year | Distributions | NAV | Senior | Mezzanine | Cash to equity |
|---|---|---|---|---|---|
| 1 | 200.0 | 900.0 | 237.5 | 150.0 | 0.0 |
| 2 | 180.0 | 810.0 | 85.2 | 150.0 | 0.0 |
| 3 | 162.0 | 729.0 | 0.0 | 91.9 | 0.0 |
| 4 | 145.8 | 656.1 | 0.0 | 0.0 | 45.7 |
| 5 | 131.2 | 590.5 | 0.0 | 0.0 | 131.2 |
| 10, with wind-up at NAV | 77.5 | 348.7 | 0.0 | 0.0 | 426.2 |
The equity receives nothing for three years, then everything. It turns 450 into a 2.24 multiple and a 10.9 per cent IRR, against 10.0 per cent for the portfolio without leverage.
Leverage at a blended 6.82 per cent on a 10 per cent asset should add more than 0.9 of a point. It does not, because the sweep repays the notes so fast that the equity is levered for less than four years and unlevered for the remaining six.
Stress the first year: NAV falls 30 per cent and distributions halve to 10 per cent of NAV for two years, then the base case resumes.
| Measure | Base | Stress |
|---|---|---|
| Unlevered portfolio IRR | 10.0% | 1.6% |
| Highest senior LTV | 40% | 56.2% |
| Highest total LTV | 55% | 81.2% |
| Senior notes repaid in full | year 3 | year 6 |
| Mezzanine repaid in full | year 4 | year 9 |
| First cash to equity | year 4 | year 9 |
| Equity IRR | 10.9% | −2.2% |
The senior notes see their LTV jump to 56.2 per cent and still collect every coupon and all principal: the 60 per cent cushion below them at closing absorbed the fall. The mezzanine is also paid, five years late. The equity carries the whole loss, ending at a 0.80 multiple while the portfolio itself still returned 1.6 per cent a year. This is the trade the rating rests on: the senior notes depend on distributions continuing, not on NAV holding.
| Appreciation | Unlevered IRR | Equity IRR | Equity multiple |
|---|---|---|---|
| 0% | 0.0% | −3.1% | 0.77 |
| 5% | 5.0% | 4.2% | 1.38 |
| 10% | 10.0% | 10.9% | 2.24 |
| 15% | 15.0% | 17.4% | 3.48 |
Below a portfolio return of 7.26 per cent, a little above the 6.82 per cent blended cost of the notes, the equity does worse than the unlevered portfolio. At 5 per cent it earns 4.2.
NAV-based lending, the LTV tests and the downside cases are worked in the free workbooks for this book.
A securitisation of private fund interests. A vehicle holds LP interests and issues senior notes, mezzanine notes and equity, paid in that order from the funds' distributions. In an illustrative CFO, 1,000 of NAV supports 400 of senior notes at a 40 per cent LTV and 150 of mezzanine to a 55 per cent LTV, with 450 of equity usually kept by the sponsor.
Both lend against fund NAV and are repaid from distributions, often through a cash sweep. A NAV facility is a bank or private credit loan to the fund; a CFO issues notes, usually rated and often bought by insurers, from a separate vehicle that owns the interests. In the worked example the sweep repays 162.5 of senior notes in year 1 out of 200 of distributions.
The notes depend on distributions more than on NAV. After an illustrative 30 per cent fall with distributions halved for two years, the senior LTV peaks at 56.2 per cent but the notes are still repaid in full by year 6, and the mezzanine by year 9. The equity absorbs the loss, ending at a 0.80 multiple.
This article is one calculation from The Fund Finance Professional. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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