Speaking in Sydney, Pimco president Christian Stracke said some investors are shortchanging themselves on returns when they step into complicated, increasingly popular deals such as collateralized fund obligations, or CFOs. The broader wave of engineered structures may be innovative, he added, but parts of it look too relaxed about risk.
He pointed to significant risk transfers, or SRTs, as a place to be cautious. "In an SRT, your writing credit protection on a mezzanine piece of paper is very similar to what we saw before the GFC," he said. "These are examples of things that we're watching, they're examples of complacency, they're examples of people under-pricing the risk to get leverage."
These structures often let asset managers and banks move slices of their exposure to insurance companies. In fund finance, managers raise cash by turning fund ownership interests, which are equity, into debt-like obligations. In a related setup, banks deploy significant risk transfers to offload portions of loan risk to outside investors.
Insurers, flush with cash and typically constrained to higher quality bonds, often end up as the end buyers. That is why many of these deals are structured to earn strong credit ratings. Among the prominent firms that have set up CFO deals are Blackstone Inc., Carlyle Group Inc., and Vista Equity Partners.
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Fund finance has swelled past $1 trillion, and CFOs now rank among its fastest climbers. Adoption is spreading in Asia too. In July, Churchill Asset Management and Seviora Holdings Pte Ltd - an asset manager owned by Temasek Holdings - completed a CFO totaling $400 million.
Pimco has been outspoken on the pitfalls of financial engineering. In a July note, it said it sees "evidence of excess" across markets, while stopping short of calling for a crisis. Stracke emphasized the firm does not expect a new global financial meltdown and said today's overall borrowing in the system is relatively restrained. "The very important difference of today versus pre-GFC was the amount of leverage-on-leverage that we saw before the financial crisis," he said.
Stracke said "some collateralized fund obligations and synthetic risk transfers are where we see pockets of risk," pointing to investors accepting too little compensation because the structures can build in extra leverage. That pushback is already showing up in the market: at times, private equity firms have struggled to close CFOs when investors judged the leverage too heavy. The takeaway for anyone allocating capital is simple enough to say out loud: the mechanics are getting more complex, the coupons can look tempting, but the true cost of the risk is the part worth reading twice.
