The fund finance market continued to grow and flourish through the initial impact of the COVID19 pandemic.^[1] The desire of General Partners (GPs) to access all available sources of liquidity to capitalize on market dislocation has increased the demand for debt. In turn, instead of only using “vanilla” subscription-line facilities for fund financing, the net asset value (NAV) financing market (i.e., financing at the fund level based on the strength of the NAV of the fund’s underlying investments) has matured and materially grown. This is because of its flexibility, enabling a fund manager to deploy the borrowing where they deem best for the fund to preserve liquidity and support underlying portfolio companies. This innovation of fund financing widens the line of facilities an Alternative Investment Fund (AIF) can take. This also increases leverage within the AIF universe, posing potential credit risks to the lenders to the funds.

Members of the fund finance team at this bank are responsible for origination, measuring and managing credit risk of the funds and pricing for the underwritten loans. They were seeking a standardized framework for evaluating potential risks. Additionally, members of the credit risk management team responsible for modelling, validation and regulatory reporting were also interested in utilizing a comprehensive and transparent solution for determining the regulatory capital charge.

Pain Points

Europe is experiencing persistent inflation and energy shortages and, as the liquidity gap continues to expand, the alternative investment market is growing rapidly. Financing at all stages of a fund’s life, as well as the pricing a lender can obtain for the NAV facilities, is higher than for subline facilities, suggesting an increasing demand for the NAV facilities. The lenders of NAV facilities are “looking down” for recourse against the underlying investments, which can vary. As a result, this bank needed a comprehensive, standardized framework and stringent guidance for assessing the credit risk of the NAV facilities consistently across the board.

There are many challenges with this credit risk analysis:

• The AIF universe comprises mostly unrated entities and transactions, so there is not an assessment of credit risk readily available.
• The NAV facilities enable the sponsors to cherry-pick provisions from the underlying eligible portfolio of assets, as per leveraged credit agreements. This makes it difficult to have a consistent method/guidance on calculating the asset value at stress and the leverage (i.e., loan-to-value (LTV) ratio).
• An important factor for the LTV ratio is the diversification of the underlying loan portfolio. The more diversified the loan portfolio, the more favorable the LTV terms may be for the borrower. However, incorporating the portfolio concentration/diversification into credit assessments and/or pricing is not straightforward and transparent.
• There is the potential for regulators to begin to sharpen their focus on AIFs given concerns about how the use of leverage within the AIF sector may contribute to the build-up of systemic risk in the financial system.^[2]

With the increased demand for NAV facilities over the last few years, the bank’s credit risk and fund financing teams were looking to better understand their exposures. The teams began discussions with S&P Global Market Intelligence (“Market Intelligence”) to learn more about the type of solutions and support that was available.

Solution

Market Intelligence discussed its proprietary AIF Credit Assessment Scorecard that is an essential tool to identify and manage potential default risks with fund portfolios, as well as understand the various factors affecting a fund and the creditworthiness of NAV facilities.

The AIF Scorecard solution includes:

• An Excel®-based model that provides a consistent framework for calculating credit risk.
• The ability to identify default risk through quantitative and qualitative factors tailored for AIFs. Users can generate probability of default (PD) values for AIF portfolios and perform sensitivity analyses, scenario analyses and stress tests.
• Credit scores that are designed to broadly align with S&P Global Ratings credit ratings, supported by historical default data back to 1981.
• A comprehensive handbook and standardized framework providing guidance on the stressed leverage calculation to understand the LTVs for NAV facilities. Users can also refine their view of stressed leverage on specific risk factors, including concentration, market risk, risk of strategies and more.
• Technical documentation describing the analytical/statistical processes used to develop the underlying model, identifying the data used in construction and providing testing performance results.
• Scorecard implementation and application training workshops.
• Ongoing analytical and operational support.

Key Benefits

The fund financing and credit risk management teams felt that Market Intelligence offered a sound methodology and model to evaluate the credit risk of AIFs, as well as fund financing instrument-level credit risk. The teams subscribed to the offering and value having:

• An efficient and easy-to-use approach for scoring portfolios for a wide range of AIFs and fund financing transactions.
• Transparency with in-depth model development documentation that identifies how the Scorecard was created and its use of data.
• A rigorous annual review process that validates the model to maintain its performance and reflect updates in a User Guide.
• A due diligence tool for the fund financing team to use on various risk factors for a NAV transaction.
• Training and on-going support to understand the range of applications for the Scorecard and to receive on-going analytical support and updates.

The AIF Scorecard provides the bank with a comprehensive framework to better assess and manage potential risks incurred when offering leverage to fund vehicles. Alignment with the S&P Ratings’ methodology offers benefits when it comes to regulatory reporting and loan syndication. A sound methodology may provide the potential for regulatory capital relief, plus the opportunity for balance sheet management via loan distribution.