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PE Panorama: US insurance regulator doesn’t like the parallels between CFOs and CDOs

insurance
By Paul Mackintosh   
January 26, 2023

Private equity in the US has just hit another regulatory roadblock - or speed bump - under the Biden administration. This time it’s regarding leverage provision, in an already tightening market. The regulatory body for US insurers, the National Association of Insurance Commissioners (NAIC), has taken a major step forward into assessing and regulating collateralised fund obligations (CFOs), securitised vehicles which package portions of various private equity funds into bond-issuing investable products.

According to a report in the Financial Times, they are alarmingly similar to the collateralised debt obligations (CDOs) which helped trigger the 2008 global financial crisis by mingling high-risk debt into apparently safe vehicles. The NAIC has stepped up to start assessing CFOs after its investigation concluded that ratings agencies could understate the risk that these vehicles posed to investing insurers.

This isn’t the first time the NAIC has tangled with private equity. The regulator has been running a review of private equity ownership of insurance companies since December 2021. This was over concerns that private equity-owned insurers were being driven more heavily into CFO investments, and that the owners might seek to extract money from insurance investees via fees. There were other general concerns over independence, alignment of interest and governance.

The NAIC’s move has put the brakes on the CFO market, according to the FT, by introducing a new and uncertain regulatory risk into the creation of these vehicles.

The regulator’s apparent motive should raise more concern that, as with CDOs, ratings agencies cannot be trusted to produce objective risk assessments on products where the issuer is paying for the assessment. And if CFO risks are so problematic as to require a new assessment and regulatory layer for insurers, what about the other existing investors, from pension funds to individual retail investors, already investing in such vehicles?

It’s worth remembering what is driving the issuing of potentially risky vehicles, making it all too similar to the disastrous CDO binge of the early 2000s. As Bloomberg reported recently, the ready supply of leverage to buyout funds in the US has choked off, with institutional loans and junk bond issuance in 2022 falling to levels last seen in 2011. Elon Musk’s Twitter takeover, backed by some US$12.5 billion of bonds and loans, has helped cool the market, but inflationary pressures look to have spelt the end for cheap leverage, driving buyout funds to look elsewhere for their debt.

And remember what buyouts are about. They don’t make money by convincing business owners to sell because they are so much better managers, or because public listing is too distracting. They do it by borrowing other people’s money to buy businesses. It’s no wonder that such a model comes unstuck when the tide turns.