Leverage on Leverage: The Hidden Risk in Rated CFO and CLO Structures

TL;DR: Rated collateralized fund obligations (CFOs) now let insurers and other buyers hold a AAA-rated slice of a private credit fund that is already borrowing against its own portfolio through subscription lines and NAV facilities. That is leverage stacked on leverage, and the Financial Stability Board said in May 2026 that this multi-layered structure is "opaque" and complicates monitoring of the roughly $1.5 to $2.0 trillion private credit market. I'm not telling you these are the CDOs-squared that helped blow up the financial system in 2008. I'm telling you the mechanism that made those structures dangerous, leverage compounding on top of leverage and dressed up by a rating, is present here too, and it has never been tested through a full credit cycle.

Here's the setup. A private credit fund lends money to mid-size companies, the kind too small for a syndicated loan and too illiquid for public bonds. To juice returns, the fund borrows against its own assets. Then a separate vehicle, the CFO, buys a stake in that fund, slices the cash flows into tranches, and gets a rating agency to stamp the senior tranche investment-grade. An insurer buys that senior tranche because it carries a good rating and a NAIC capital charge that looks cheap relative to the yield. Two layers of borrowed money sit underneath the rating an insurer's risk model treats as safe. Let me walk through both layers, because the mechanics matter more than the label.

Layer One: The Fund Is Already Levered

Before a CFO ever gets structured, the underlying private credit fund is typically borrowing on two fronts. The first is a subscription line, a short-term loan the fund draws against investor capital commitments rather than against the loans it has already made. The second, more consequential type is a NAV facility, where the fund borrows against the net asset value of its existing loan portfolio.

NAV facility loan-to-value ratios typically run 5% to 30%, and often land in the 15% to 30% range, according to Oaktree's NAV Finance 101 primer and a Travers Smith note on NAV facility terms. That sounds conservative next to traditional middle-market direct lending deals, where LTVs commonly run 35% to 60%. But that comparison understates the point: NAV leverage sits on top of a portfolio that is itself financing borrowers running 5x to 6x debt-to-EBITDA, and the FSB's May 2026 report notes that ratio can effectively run closer to 7x once you strip out the EBITDA add-backs private equity sponsors like to include. So the base collateral is already levered corporate debt, and the fund adds a second turn of borrowing against it. That's layer one, and it exists before any tranching happens.

Layer Two: Tranching the Fund Stake Itself

A CFO takes an ownership interest in a private credit fund (or a basket of funds) and carves the cash flows into tranches, senior, mezzanine, equity, the same waterfall structure used in a traditional CLO equity tranche structure, where the bottom slice absorbs losses first so the top slice can carry an investment-grade rating. The senior tranche gets paid first and rated highest. The equity tranche absorbs losses first and gets no rating at all, just leveraged upside if everything performs. This is structural leverage layered directly on top of the financial leverage already inside the fund. The senior CFO noteholder isn't just exposed to loan defaults. They're exposed to loan defaults after the fund's own NAV facility lender gets paid first, and after the equity tranche below them gets wiped out. Two layers of leverage sit between "a company misses a payment" and "the senior tranche takes a loss." KBRA's own data shows how fast this has scaled: the agency rated 152 tranches across 67 CFOs between 2018 and 2024, covering roughly $37.7 billion in issuance and $28.5 billion in rated debt. By September 2025, CFO issuance had already hit a record $16 billion year-to-date, and KBRA rated the first-ever four-tranche fund-investment deals: more slicing, more layers, less history behind any of it. Star Mountain Capital's CFO I, closed in August 2026, is one of those newer deals.

What the FSB Actually Said

I want to be precise here rather than dramatic. The FSB's May 2026 report on vulnerabilities in private credit doesn't say these structures will fail. It says leverage in private credit "exists at multiple layers," naming fund-level leverage, back-leverage, and CLO/CFO tranching, and that this layering is "opaque" and "multi-layered," which complicates monitoring by regulators and, by extension, by the investors and rating agencies relying on that monitoring. The report puts total private credit assets at roughly $1.5 to $2.0 trillion as of end-2024, and sizes the private credit CLO market, often called middle-market CLOs, at approximately $155 billion outstanding as of October 2025, about 16% of the total $977 billion U.S. CLO market. That 16% share matters because it shows this isn't a niche curiosity anymore. It's a meaningful and fast-growing slice of a market that regulators are on record saying they can't fully see through. The FSB's language is careful, institutional, and exactly the kind of statement that gets ignored until it doesn't.

What Rating Agencies Say About Their Own Models

KBRA has been the most active rater in this space and deserves credit for publishing detailed data on CFO growth. But look at what the growth curve actually shows: from a base of 67 rated CFOs built up over six years (2018-2024), the market added enough new issuance to hit $16 billion in nine months of 2025, and did so while introducing four-tranche structures that hadn't existed before. Every time a rating agency approves a more complex tranche structure, it is extending a methodology built on a shorter track record to a more complicated instrument. That's not an accusation of bad faith. It's an acknowledgment that the models rating this senior CFO paper have limited data on how four-tranche, fund-of-fund-leverage structures behave when a real chunk of the underlying borrowers default at once, in a rising-rate or recessionary environment, with NAV facility lenders also trying to get paid. No downgrades have hit this market yet. That is a fact, and I won't pretend otherwise. It is also exactly what everyone said about rated tranches of subprime-backed CDOs in 2006.

The Honest Historical Parallel, and Its Limits

Let's be exact about this, because sloppy comparisons discredit good arguments. A CDO-squared, the instrument that helped detonate the 2008 crisis, was a pool of tranches from other CDOs, which were themselves pools of tranches from mortgage-backed securities. It was leverage on leverage on leverage, built on correlated residential mortgage risk that rating agencies modeled as if it were diversified across geography when it wasn't. When home prices fell nationally, the correlation the models assumed away showed up all at once, and senior tranches that were supposedly bulletproof took losses. A CFO is not a CDO-squared. The underlying assets are cash-flowing loans to real operating companies, not mortgage-backed securities repackaged from already-repackaged mortgage risk. There's no evidence here of the kind of underwriting fraud that plagued subprime origination. The structures are smaller in aggregate and the buyer base, insurers and sophisticated institutional allocators, is not the same as the mix of money-market funds and retail-adjacent vehicles that touched CDO paper. What is genuinely parallel is the mechanism, not the instrument: two structural layers of leverage stacked on top of each other, rated by agencies extrapolating from a limited historical sample, sold to buyers who treat the rating as a proxy for "I don't need to underwrite what's underneath this." That mechanism is what makes compounded leverage dangerous regardless of the asset class wrapped inside it. It turns a moderate loss at the bottom of the stack into a much larger percentage loss for whoever holds the layer just above it, and it does that fastest exactly when everything is correlated and going wrong simultaneously. The lesson from 2008 isn't "private credit will collapse like subprime." It's "leverage compounds risk in ways ratings built on short cycles tend to underprice," and that lesson doesn't care what the collateral is.

Named Specifics: Who's Building These Structures

This isn't an abstract market. Churchill Asset Management and Oaktree Capital are among the active players building and lending against these structures. Oaktree's own educational material on NAV finance is one of the clearer public explanations of how the facilities work, which tells you the sophistication required to even evaluate the risk properly. Legal work on the structuring and NAV facility documentation comes from firms like Mayer Brown and Travers Smith, whose own notes lay out the LTV ranges cited above. On the regulatory side, Federal Reserve Vice Chair for Supervision Michelle Bowman and the Bank of England's Sarah Breeden have both been named in discussions of private credit interconnection risk, alongside the FSB and IMF at the international level. The NAIC is the body that actually sets the capital charges U.S. insurers hold against this paper, which is the concrete channel by which a "leverage on leverage" structure at the fund level becomes a solvency question for a life insurer's balance sheet. None of these organizations are saying the sky is falling. Every one of them is on record saying the layering makes the risk harder to see clearly, which is a different and more useful claim.

What This Means If You Hold Adjacent Exposure

You may not own a CFO tranche directly. Most accredited investors don't. But you may hold exposure one step removed, through a business development company (BDC) or an interval fund that allocates to private credit, or through an insurance company's general account if you own its equity or its annuity products. Here's the practical checklist I'd run before adding to any of that exposure right now. First, ask what leverage sits at the fund level, not just at the deal level. A BDC's regulatory leverage cap tells you one number. It doesn't tell you whether the underlying funds it invests alongside are also running subscription lines or NAV facilities that don't show up in the headline leverage ratio. Second, ask how much of your interval fund's private credit sleeve touches CFO or rated-note-feeder structures specifically, since that's the layer where tranching compounds fund-level leverage rather than just adding portfolio leverage. Third, remember that interval funds and non-traded BDCs already carry real liquidity constraints even without a leverage problem. That's the same structural mismatch behind the redemption pressure covered in our piece on the evergreen fund redemption crisis, and a leveraged, tranched credit portfolio is a worse asset to be stuck holding during a redemption queue than an unlevered one. Fourth, if you're evaluating a specific CFO deal, such as the kind of structure Star Mountain Capital has brought to market, read the tranche waterfall yourself and find out exactly what LTV the fund's NAV facility runs at and where your tranche sits relative to it, rather than relying on the letter grade. Our breakdown of the Star Mountain CFO I structure is a useful template for the kind of questions to ask on any deal like it. None of this means avoid private credit. It means underwrite the leverage stack yourself instead of outsourcing that judgment to a rating that has, at most, a few years of data behind structures this complex. A rating tells you what an agency's model predicts under the scenarios it tested. It doesn't tell you what happens in the scenario nobody has tested yet, which is a full credit cycle with real defaults hitting a market this layered. You're being paid extra yield for holding that untested risk. Make sure you know that's the trade you're making, and size the position accordingly.

Author Disclosure: Jeff Barnes, MBA has no personal position in any company, fund, or platform named in this article. Angel Investors Network has no current commercial relationship with any party mentioned. AIN provides marketing and education services, not investment advice. Past performance does not guarantee future results. All investments involve risk, including loss of principal.