Collateralized Fund Obligations

Abstract

Collateralized fund obligations (CFOs) are structured finance products linked to the performance of underlying funds of hedge funds. The capital structure of the CFO entails repackaging fund assets into a special purpose entity (SPE), which then issues debt and equity securities with different risk- return trade-offs. To date, three public CFO deals have been brought to market. Placing the CFO equity tranche, in which equity investors agree to absorb the first losses among underlying fund shares in return for the most upside potential, has proven to be challenging. Nonetheless, the authors demonstrate that investing in the equity tranche provides real value to investors, as it outperforms funds of hedge funds in 80% of the observations.