An Introduction to Certificated Products and AMCs - Part 2

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As you’ve probably guessed from the title, there is a Part 1 to this series, and it focuses on the history of what Certificated Products are, how they came to be and most importantly why they were developed in the first place.

If you haven’t read Part 1, I recommend you do so.

In this part we are going to dive deeper, but to do so we are also going to focus on a specific subset of Certificated Products. The market for Certificated Products is huge, and generally not very unified, which makes talking about the category of Certificated Products as a whole quite a challenging task; and in all honesty, talking in high-level general terms will have very little benefit or meaning to you, my reader.

So in Part 2 we will focus on the sub-categories of: Actively Managed Certificates (AMC), Tracker Certificates (Trackers) and Credit Linked Notes (CLN).

In Part 1 I also introduced the concept of using a segregated assets approach to issue these products; this is the structure I will be carrying through into Part 2.

Again, If you haven’t read Part 1, I highly recommend you do so.

There is a lot of ground to cover here and I will try to keep it as concise as possible, but be aware that by doing so I will omit details that, while important, their omission will not detract from the value of this discussion; and I will likely cover these omitted details in standalone articles in the future.

What are AMCs, Trackers and CLNs?

I’ve prepared a quick reference table that summarizes each of these sub-categories; feel free to keep this on hand to use when needed. Throughout the remainder of this discussion I am going to reference these sub-categories as Products.

	AMC	Tracker	CLN
What it’s Used For	Build a dynamic and actively-managed portfolio of assets	Build a rules-based strategy that invests into a single pre-defined asset	Setup and securitise a private loan between the Issuer and a borrowing entity
Discretion	Manager actively adjusts the portfolio on an ongoing basis	Fully rules-based — predefined at issuance, no ongoing discretion	Typically static exposure to a defined reference (borrower/credit), not actively traded
Best Use Cases	Delivering an actively managed strategy in bankable, transferable form	Giving bankable/ISIN access to an otherwise hard-to-hold asset (illiquid fund, alt asset, private equity, etc.)	Structuring a private lending or project-finance-style exposure as a tradeable note
Primary Audience	Portfolio managers, asset managers running discretionary strategies, or capital raisers that want to blend different capital types into one offering	Capital raisers wrapping a specific fund/asset for distribution (think feeder fund capability); asset managers offering index-style access; capital raisers looking to convert their equity raise into a financial product	Capital raisers structuring a lending/credit deal; asset managers building credit exposure products
Ongoing Management	High — manager must actively steer the strategy	Low to none — set-and-monitor after launch	Low to Moderate — mostly a one-time structuring exercise per reference credit, however ongoing management of the underlying loan is still required
Valuation Complexity	Higher — calculation agent must value a basket of assets each constantly changing	Lower — valuation usually mirrors almost one-to-one the value of the underlying asset	Moderate to Higher — driven by the underlying credit's performance/default status, but must also take into account interest coupons and their accrual and payout mechanisms

You have probably noticed that in this table there is no reference to “repackaging of assets” or “bundling” or “de-risking” in relation to these three Products, and this is a very important feature. Unlike other Certificated Products which do focus on repackaging assets, like Collateralized Debt Obligation (CDO), the three Products we are focused on are used to build a financial product from scratch; which is what makes them so popular to use for building things like Reference Portfolio’s, or for Capital Raising.

These Products also range in their flexibility for use.

An AMC is a highly flexible product, able to reference a dynamic portfolio of assets and it is for this reason that it is usually compared to a fund, or sometimes called a “fund-light”.

A Tracker has little flexibility but its simplicity makes it the perfect Product when you are focused on only one underlying asset. One example of their use case has been to build cost effective Feeder products for large private market funds as it is able to aggregate thousands of investors for a fund that would otherwise be too expensive for a single investor to enter.

A CLN sits between the AMC and Tracker in terms of flexibility and is a popular Product for investment sponsors who deal with real assets like Real Estate, or rely heavily on trade finance or working capital finance. The idea is to securitise, or wrap, a private loan agreement, into a CLN Product that structures interest and capital payouts in either simple or complex mechanisms to best suit the cash flow needs of the company or project that is borrowing this money.

Indirect Exposure

In Part 1, I briefly mentioned that Certificated Products are actually a form of debt note. This is a very important detail to keep in mind, and although I refer to the buyers of these Products as “Investors”, they are in fact creditors. However, I will keep the reference of “Investor” throughout this discussion as switching to the reference of “Creditor” may actually create more confusion and bring up ideas like a bank as a lender.

In this discussion I will not go into any more detail about this mechanic, even though it is important. I will prepare a standalone article discussing this mechanic, and I encourage you to read it.

Separation is Healthy

I mentioned earlier that we will focus on these Products as being issued using a segregated assets structure, and we need to go deeper into this, as it is one of the key features that makes these Products stand apart from other solutions on the market.

A segregated assets structure means that the basket of assets and liabilities of your investment opportunity are kept separate from other baskets of assets and liabilities.

In the context of our discussion, a segregated assets structure is generally used to refer to a Product that is issued by a legal entity that is either indirectly, or, not at all related to the investment sponsor or asset manager. One example could be a standalone entity setup by the investment sponsor, and controlled by the investment sponsor, but is not the investment sponsor’s main company. Another example is a Special Purpose Vehicle (SPV) setup using a corporate service provider, where the investment sponsor has no Director control or shareholding of this entity.

The choice of the type of entity that the investment sponsor uses will really come down to what the investment sponsor is trying to achieve (the level of asset segregation, the level of separation of control, the level of separation of substance, etc.)

There are several benefits, for both the investment sponsor and the investors, of using a segregated assets structure, but the most impactful benefit is: risk isolation. The balance sheet of the investment sponsor is separated from that of the investment asset, meaning the asset is ring-fenced away and no longer poses a risk to the investment sponsor, nor do the creditors of the investment sponsor have a claim on these ring-fenced assets, and investors no longer take the balance sheet risk of the investment sponsor; meaning if something should happen to the investment sponsor, this shouldn’t directly impact the investment asset.

(Note there are exceptions, especially in cases where guarantees are given, or claims are pledged, but I am deliberately ignoring these scenarios to simplify our discussion).

A segregated assets structure is not only relevant for cases where an investment sponsor wants to build a structure to better manage investor capital. There are many cases where families use a segregated assets structure to completely isolate specific assets away from their estates. This is not always done for tax reasons, rather it can help with earmarking certain assets for certain family members, or in other cases help families to unlock capital, which may otherwise have been impossible. The point is that I don’t want you to walk away from this discussion thinking that such a structure only benefits some, when it can be used creatively to achieve different goals.

Trading and Settlement

Even with a segregated assets structure, how does investor capital actually get raised?

Remember that an AMC, Tracker or CLN is actually a standalone financial instrument. Investors are not buying a share of the SPV. The SPV is the issuer of the Product, in other words, the SPV is offering investors to buy the Product.

With this in mind, issuers of these Products will work with an Issuing and Paying Agent (IPA), who will assist with obtaining an International Securities Identification Number (ISIN) for the Product.

For those that haven’t been exposed to ISINs; this is a 12-character alphanumeric code that is used to identify a specific financial instrument globally.

The key point here is that each Product is assigned a unique ISIN, it is not the Issuer that is given the ISIN; so a single Issuer can have several Products, each with their own unique ISIN codes.

With an ISIN code the Product can be booked into a standard brokerage or custody account, settled via Euroclear or Clearstream.

This becomes a key differentiator for you - where a private market fund will have a subscription agreement made up of around 100 pages, and the fund administrator will need endless KYC documents on the investor, before being accepted into the fund, the ISIN circumvents all of this. An investor will approach their own custodian bank’s trading desk and place an order to buy the Product, by giving the trading desk the relevant ISIN. The bank then initiates and settles the trade directly with the IPA, and the bank takes custody of the Product certificates. Neither the Issuer nor the IPA require KYC on the investor; this is fulfilled by the bank.

(There are instances where a Certificated Product will have a Registered Investor Book (RIB). In these cases either the Issuer or the IPA will have a register of the investors who have purchased the Product, and KYC on the investors will be required).

Once an investor’s subscription to your Product has settled successfully, cash for Product certificates are exchanged simultaneously via Delivery-vs-Payment (DVP) settlement, meaning there is no delay between when the Issuer gets its cash and the investor gets their certificates.

At this stage the investment sponsor / asset manager is now able to use the cash raised to buy assets and start implementing their investment strategy.

The Tram Lines

The investment sponsor / asset manager does not have free rein to invest in anything they want, how they want, when they want. In a segregated assets structure they act as the agent of the Issuer (with a clear contract entered into between the parties). The Issuer will have prepared a term sheet for this particular Product (ISIN) and within this term sheet, elements such as the overall investment strategy, universe of instruments, how and when the investment strategy is implemented, as well as sections on the liquidity of the Product, when investors may subscribe into or redeem out of the Product, any lock-up periods, penalty fees, and all fees to be charged on the product that investors will have to pay.

The term sheet is a legally binding document; if a mechanism isn’t included in the term sheet, or a fee is not present on the term sheet, then they cannot be implemented / charged.

Changes to a term sheet are possible, and these changes will need to be communicated to all investors. Thankfully, because these Products have an ISIN code, communication can be done in the form of a corporate action, which is transmitted to all custodian banks, via the clearing system holding the certificates.

It is here that we now introduce the Calculation Agent; this is the party responsible for calculating the Net Asset Value (NAV) per certificate of the Product, as well as any coupon payments, fee deductions and other relevant financial matters.

The complexity behind their calculations really depends on how complex your Product is and the types of assets purchased by the Issuer.

How exactly that NAV gets calculated, and what happens when performance fees, hurdles, and crystallization dates all sit on top of it, is its own deep rabbit hole. I've already started down that rabbit hole in my “Performance Fees” series, which you may be interested in reading.

Does Not Compute

Before we close off, we do have to address an elephant in the room.

While these Products do have ISIN codes and can traded and settled DVP through Euroclear or Clearstream, it’s not always smooth sailing.

Every bank maintains its own internal “eligible securities” list, and depending on the jurisdiction where your investor banks, Certificated Products may simply just not be on this list.

This means even with all the infrastructure in place, you as the investment sponsor / asset manager may still not be able to raise capital for your Product.

It is here we get into a little “Distribution Engineering” and there are some solutions that you can make use of.

First, always have your investor base defined; not capital committed, but defined. Be clear about the jurisdiction of your investors and whether they are family offices or High Net Worth (HNW) individuals.

If your investor base are several multi-family offices, then chances are these offices will be able to to open several different bank accounts for their clients, and the possibility of finding a bank that will settle Certificated Products is relatively high.

Second, if the bank of an investor declines to settle a Certificated Product trade, it may be possible to open a custody-only account for this investor with another financial institution. I have actually been involved in this process a few times, and while I wasn’t responsible for opening the custody-only account, I was in the position to refer the investor to a global player that does offer these accounts. Many Neo-banks or competitor banks are quite sophisticated and competitive in this area.

As the protagonist from Layer Cake put it “The art of good business is being a good middleman. Putting people together”.

Finally, there are financial institutions that help to “bridge” trades, between two parties where settlement wouldn’t normally occur. These firms undertake intermediation trading, but they will charge a fee for their services.

Again, it’s always recommended to have all of these details figured out before building a Product, spending the money, only to fall short of actually being able to raise capital.

All of this should now give you a fairly good picture of how AMCs, Trackers and CLNs actually get built and funded.

This may not have been the most exciting read, but keep this as a reference if you’re planning on using Certificated Products for your next investment opportunity.

Out of the many times that I have seen great ideas and structures fail, it’s usually due to one of or more of these elements not having been thought out properly; a term sheet written with holes or in ambiguous language, or an ISIN that couldn’t be settled.

I hope that Part 2 will add value in your planning.