Azalea

The PE bond structure allows exposure to private equity, by reducing the traditional hurdles that investors face when trying to access this asset class:

• Allows for smaller minimum investment sums
  Private equity investments typically require large amounts of initial capital outlay. PE bonds require much smaller initial capital outlays
  
  
• Shorter holding periods
  Private equity investments typically have long holding periods of about 10 years. PE bonds have much shorter terms of 3 to 5 years
  
  
• No J-curve
  PE investors must be comfortable with the J-curve effect, which exposes them to negative cash flows in the initial years. PE Bonds behave like normal bonds and do not experience the J-curve effect
  
  
• Access to fund managers
  It is typically difficult to gain access to reputable fund managers. Astrea’s PE bonds are backed by portfolios of PE funds managed by reputable fund managers
  
  
• Liquidity
  Buying and selling PE interests take several months and require brokers to be involved. PE Bonds are listed, allowing trading of the investments to be done easily

For more information on private equity and the traditional barriers to entry of this asset class, please refer to our primer on private equity.

The information regarding private equity bonds has been derived from general information which is publicly available as well as generic structural information from previous issues of Astrea private equity bonds which is also publicly available. The information is included for information purposes only and has not been independently verified by Azalea and its affiliates and should not be regarded as an indication of the future performance or results of the fund investments, or private equity bonds or the private equity industry generally.

Constructing the asset base

A PE Bond issuer must first put together a portfolio of PE funds that will form the asset base to back the bonds issued. PE funds collect cash from their investments in companies, as they monetise or divest their companies.

An ideal PE Bonds asset base must be able to:

• Generate cash at a sufficiently high level to cover the bond obligations (interests and principal repayments) and,
  
  
• Sustain the cash generation over the life of the bonds

As such, the two most important criteria in constructing the ideal asset base for a PE Bond issuance are:

• Diversity across vintages, region, GPs and funds to minimize the impact of losses incurred in any one investment
  
  
• Issuer’s ability to access quality and reputable PE fund managers

The cash collected from this completed asset portfolio can only be used to service the structure of the asset-backed securities; it cannot be used for any other purposes.

Paying out cash through a pre-defined priority of payments

What the bond issuer does with the cash collected from its underlying assets is strictly dictated by a pre-defined set of rules called the priority of payments. This is commonly known as the ‘waterfall’, describing the way cash flows from the highest priority to the lowest priority. The diagram below illustrates how a typical waterfall may work:

Structuring the PE Bonds

A key feature of asset-backed securities is tranching – different tranches of fixed-income securities can be issued out of the same asset base. PE Bonds are no different. It is up to the bond issuer how many tranches of bonds to issue and the features to structure for each tranche of bond. In general, senior bonds enjoy greater credit protection than junior bonds.

PE Bonds are asset-backed securities, or bonds, backed by cash flows from private equity funds (“PE funds”).

Like any other bond, an investor owns a debt instrument. An investor pays a principal amount at the start of the investment and typically receive semi-annual interests until maturity, when the principal is repaid.

However, PE Bonds are unique in several ways, especially in the asset base from which cash is generated to service the bond obligations and how the cash is distributed.

Private markets complete an impressive decade of growth. Private market assets under management (AUM) grew by 10 percent in 2019, and $4 trillion in the past decade, an increase of 170 percent, while the number of active private equity (PE) firms has more than doubled and the number of US sponsor-backed companies has increased by 60 percent. Over that same period, global public market AUM has grown by roughly 100 percent, while the number of US publicly traded companies has stayed roughly flat (but is down nearly 40 percent since 2000).

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If 2018 was a year of divergence—acceleration in the US, deceleration in the eurozone and China—2019 saw economies slowing across the board. There is a growing expectation of a global recession in the near future. Beyond the trade wars and uncertainty around Brexit, a number of economic indicators are flashing red or yellow.

Some 57% of private equity fund general partners (GPs) surveyed by Preqin worldwide think the economy has reached a cyclical peak, while 14% think it has already entered a recession. They are also significantly more worried about geopolitical conditions than they were a year earlier. Overall, these concerns about market stability help explain why their No. 1 source of anxiety (70% of respondents) is overheated asset valuations.

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