It takes money to make money, the adage goes, and this is no less true for the mutual fund industry. The sale of B shares requires up-front capital to compensate brokers, and at the same time generates an asset-based income stream that varies according to the fortunes of the market. To ease both of these pressures, fund companies have securitized 12b-1 fees, basically selling off that future income for a set period of time, in exchange for an up-front lump sum.
However, recent stock market performance has dramatically changed the landscape of B share financing, and up to 20% of outstanding bonds may be under water, said Bill Henson, managing director at Putnam Lovell NBF of New York, formerly a big name in 12b-1 financing.
"There will be a significant number of investors who will not receive their full principal and interest," Henson said, adding, "but I think there will be a net positive return."
Putnam Lovell, long rumored to have exited the 12b-1 business, is still "doing it on a selective basis," Henson explained, but the company is by no means the major player it once was. In part, he attributed the shift to irrational pricing resulting from competition.
"You had a situation where, up until a few years ago - this was part of the reason why we decided to take a step back - some of our competitors were pricing very aggressively relative to the risk being assumed," Henson said. The competitive field now appears to consist of Citibank and Constellation Financial Management, both of New York.
The securitization market has changed dramatically over the past several years, as this product, acquiring momentum in 2000, ran headlong into a recession. Immediately after Sept. 11, Fitch Ratings of New York put instruments issued by Putnam Lovell and Constellation on credit watch negative because of the potential effect of further declines in the equity market (see MFMN, 9/28/01).
By December 2001, Moody's Investors Service downgraded credit ratings of securitizations issued by Constellation and Citibank. By this past December, Fitch downgraded $246 million of 12b-1 securitizations from Putnam Lovell and Constellation.
"Last year, the market was pretty dry for this asset class," said Lily Cheung, director at Standard & Poor's in New York. However, securitization may be on the rise, in part because of new hedging structures, Cheung added.
Hedging Against Naked Risk'
Hedging schemes have changed the landscape of securitization; traditional bond structures allowed investors to carry "naked risk," said Joseph D'Anna, managing director at Constellation. After being mauled by the bear market, investors are interested in avoiding such risk.
"We developed a structure that develops puts on baskets or market indices that transfers the market-risk component of the mutual fund fees out to an investment bank and then leaves behind the more traditional bond type risk," D'Anna explained. "The market's been pretty receptive to that."
Citibank has adopted its own hedging strategy that makes its offering more palatable for investors. The new product incorporates index put options that act as a hedge against poor market performance. "With the new structure, which we're packaging for much broader complexes, it looks much more like a traditional fixed income security," said Paul Donlin, managing director, global head of securitization. Donlin estimated that his firm will help finance $25 billion in mutual fund sales in 2003.
All this repackaging is a good thing for mutual fund companies, which are facing growing concerns about risk management and the newfound vagaries of the stock market. "The demand has increased significantly from the mutual fund complexes," Donlin said.
Public flap about financial stress from B share sales has been conspicuously absent in the mutual fund world, with the exception of extreme cases such as Comerica of Detroit, which owns Munder Capital Management and took enormous B share write-downs in 2001 and 2002. In contrast, among carriers that sell variable annuities, write-downs from deferred acquisition costs have been rampant and often quite sizeable.
Even so, that does not mean that funds have not felt the pain - they just may not have to report it as quickly. "From an accounting and regulatory perspective, the mutual fund companies aren't forced to recognize it as soon as VAs are," D'Anna said.
Funds typically build some cushion into the earnings assumptions from 12b-1 and other asset-based fees, said Richard Grueter, partner in the audit and business advisory services practice at PricewaterhouseCoopers of New York. "The issue is, after three years of market declines in equity funds, some of that cushion is beginning to go away," although he has not seen many cases with balance sheet impact.
Contrasted against balance sheet shenanigans that served to conceal the true story, securitization has performed as advertised. "These particular deals in this particular asset class actually did what they were purported to do, which is to transfer the risk from the money managers and their related distribution arms into the capital markets," Henson said.
Fund fee securitizations were often used to help jumpstart smaller complexes that needed the cash to fuel sales, Henson said. "A lot of the early deals were done with the smaller, independent managers who didn't necessarily have the financial wherewithal for fund distribution, and it helped to level the playing field a little bit, as opposed to the players with deeper pockets."
For many fund complexes, even though few securitization deals have closed in the past two years, both Constellation and Citibank have been buying the 12b-1 fees and "warehousing" them to be later wrapped together in a bond package. It will offer diversification by including fees of different firms and different asset classes.
Securitization for the Masses
Most recently, Citibank sold a Rule 144-A transaction, which brings 12b-1 securitization out of the realm of private placements. This type of offering allows Citibank to "sell to a broader universe of investors and has more disclosure, salability, and tradability," than private placements, Donlin said.
Both Citibank and Constellation see securitization on the rise. "Only one-tenth of mutual fund B share sellers utilize an outside party for financing or risk transfer. We think that fraction is going to increase," D'Anna said.
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