Two Sigma Founders Turn Up Leverage for Private Equity Fund Bets
(Bloomberg) -- Billionaires David Siegel and John Overdeck are reviving a little known asset-backed security that boosts potential risks and rewards of investing in private equity funds.
Siegel and Overdeck, co-chairmen of the $52 billion hedge fund Two Sigma, are using a collateralized fund obligation at Sightway Capital, which invests part of their fortune. The CFO raised $216 million through a securitized note sale last month, according to the company. The notes will be repaid by the cash flows from stakes in 32 private equity funds.
The CFO adds leverage to Sightway’s private equity fund holdings, increasing the volatility while freeing up cash for other investments. Hedge funds and private equity firms have been increasingly using a similar technique to finance loans to leveraged corporations, packaging the debt into collateralized loan obligations.
“It’s the same thing that leverage has done since Egyptian times,” said Franklin Rudd, a partner at Compass Partners International, a private equity investor. “It takes an asset that people assume is low risk because it’s diversified and allows you to borrow against it. But when markets turn around, everything goes down.”
Using Data Science
Wray Thorn, Sightway’s chief investment officer, said his firm has anticipated the possibility of such a slump. Sightway relied on mathematical models and other technology developed at Two Sigma to better understand how the securitized bonds would perform in a market downturn. The results helped the notes earn an A rating from Fitch, lowering the cost of financing for Sightway.
“This is a really great example of how you can use data science and modeling techniques to innovate the way private equity is done,” Thorn said in an interview. “We believe in this instance, it resulted in a better outcome both for the issuer and the investors.”
Firms like Sightway that use CFOs for financing begin by pooling stakes in private equity funds. They then issue asset-backed bonds, whose interest rates are tied to their priority in being repaid.
Sightway, which had about $1.3 billion in assets under management in March, was formed to help Two Sigma’s founders and other employees diversify into private equity. The New York-based firm makes direct investments and also allocates capital to outside fund managers, primarily focusing on real assets such as agriculture, timber, energy and mining. Siegel and Overdeck aren’t involved in Sightway’s day-to-day management.
The firm, along with Temasek, Singapore’s sovereign wealth fund, is one of the few to issue CFOs in recent years. The nascent market for the debt offerings began to develop in the early 2000s, only to crater when the recession hit. Since then, demand for higher yielding assets, as well as those tied to private equity, has rekindled some interest in the market.
When Temasek put together its third CFO in 2016, investors submitted orders that were eight times the $510 million of bonds offered.
“The fixed-income people are getting an attractive yield driven by an asset class they don’t ordinarily have exposure to,” said Stephen Culhane, co-head of the investment management practice at law firm Arnold & Porter.
To create the CFO, Sightway bundled private equity stakes with a net asset value of $432 million, along with an additional $84 million of unfunded commitments, according to a credit report from Fitch. The CFO, SWC Funding, then issued the notes to outside investors and retained 50 percent as equity. The equity holder can reap the highest returns but also stands first in line to absorb losses.
The risk for CFO investors is indirectly tied to the strength of the markets in which its funds have invested. While the loans packaged into CLOs have scheduled repayment dates, private equity funds must typically wait for strong markets to sell holdings. Because the Sightway CFO primarily holds funds that invest in real assets, a prolonged slump in commodities could affect its ability to repay the notes.
In anticipation of a slump, Sightway built protections into the CFO that give it plenty of time to repay the notes. While the firm has 15 years to do so, its models show it will probably take about four-and-a-half years.
Thorn, the CIO, sees the possibility of an expanding market for the securities. “It’s something we hope to continue to do more of in the future,” he said.
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