Fund financing is a hot topic of conversation across capital markets and is raising additional scrutiny from a range of stakeholders. The recent webinar “Exploring Credit Risk in Fund Financing” hosted by S&P Global Market Intelligence looked at some of the complexities when evaluating credit exposure to Alternative Investment Funds (AIFs). This article summarizes the Q&A from the session.

Presenters:

James Mansfield, Director of Credit & Risk Solutions, S&P Global Market Intelligence (Moderator)

Suming Xue, Director of Credit & Risk Solutions, S&P Global Market Intelligence

Q&A Summary:

What are Fund Financing Vehicles?

Two vehicles discussed during the webinar include: Subscription line (Subline) financing and Net Asset Value (NAV) financing.

Subline Financing: A subline is a loan taken out mostly by closed-end private market funds where the loan is secured against a fund's investors' commitments, generally without recourse to the actual underlying investments in the fund.

NAV Financing: Once a closed-end private fund has matured beyond its commitment or investment period, it has typically called and deployed nearly all its capital commitments to make investments. As such, these funds often have little to no borrowing availability under any subscription credit facility and turn to NAV financing. Here, one or more bank(s) or alternative lender(s) provide a fund or holding companies with a term loan, with borrowing availability based on the NAV of the fund’s investment portfolio.

What is the purpose of a subline from the perspective of a borrower?

Subline facilities have traditionally been used for short-term bridge financing as a senior-secured Revolving Credit Facility (RCF), typically with 30-90 days as the loan term. It is secured against the uncalled capital commitment of fund investors. One of the innovations is that the size of the facilities is becoming larger, and the tenor longer. 

The benefit/purpose of sublines are to:

• Improve liquidity (evidenced during COVID).
• Enhance operating efficiency and competitiveness in investment bidding.
• Provide assistant to cash flow management.

What are the key risk drivers to lenders with subline?

An important consideration is the quality and granularity of Limited Partners (LPs), given the facility is secured against a fund’s uncalled capital commitments. Creditworthy LPs (i.e., investment grade) will likely be able to meet their capital commitments when called by the investment manager. At the same time, a high concentration of LPs by geography or by type can be a negative. Commonly, a lender would also investigate a fund manager’s track record, expertise, and knowledge, plus coverage for such things as key-man risk.

Banks have been active in this space given relatively healthy returns and backing by highly rated counterparties. Relative to NAV strategies, however, the growth among non-bank lenders has been much slower. Why?

This trend can be attributed to the consolidation in the banking sector, tighter banking regulations, and significant economic growth in the middle market. While the subline facilities have been an established feature of this market for some time, they also have weaknesses as the facility is usually for short-term financing. When most of the capital commitment is used, it would be difficult for borrowers to raise subline, so they may not be suitable for matured funds.

The increasing demand for NAV could also be due to its scalability and flexibility. Unlike an “upwards-looking” subline, NAV financings are on the value of the nominated fund’s underlying investments as “downwards-looking” financing. NAV financing would be much more suitable for the mid-life of a fund when significant amounts (or all) of its capital have been deployed and undrawn commitments are low. NAV can provide liquidity and flexibility without taking any additional impact on underlying portfolios. 

What are some of the key credit factors to consider with NAVs?

Typically, we would look at several credit risk factors:

• Stressed leverage on qualified assets to understand the value of qualified assets in the event of adverse economic situations since the value could be reduced due to unfavorable market conditions.
• Concentration of the portfolio/qualified assets since the more diverse a portfolio is by geography/industries the lower the probability that the fund will take a severe hit if a single geography or industry is under stress.
• Liquidity risk assessment (including asset liquidity) for the next 12 months since an AIF with mixed assets that are strong and marketable and of different maturities should be able to quickly dispose of the assets in times of stress without a significant discount.
• The track record of the fund performance, manager experience, and knowledge depth since strong credentials would reduce risk.

How does this manifest itself currently within S&P Global Market Intelligence’s AIF Scorecard that is designed to evaluate risks with AIFs?      

Scorecards provide a consistent framework for calculating credit risk, drawing on a mixture of quantitative and qualitative questions in a check-box style. They are fully transparent, providing underlying logic and weights, and generate numerical scores that are broadly aligned with S&P Global Ratings’ criteria.^[1] Scorecards are especially useful for low-default portfolios that, by definition, lack the internal default data necessary for the construction of statistical models that can be robustly calibrated and validated.               

The AIF Scorecard can assess the creditworthiness of a wide range of AIF types, such as a private equity fund, hedge fund, credit fund, infrastructure fund, and any firm that is not established as a fund but operates like one.

The key risk factors for assessing subline or NAV facilities, mentioned previously, are included in the AIF Scorecard. There are seven key credit risk factors. Apart from a quantitative measure on the stressed leverage, users can also refine their stressed leverage assessment by considering qualitative risk factors, such as

• Market risk, risk of the strategy, and concentration risks.
• Quality and diversity of the funding source and permanence of the capital.
• If there is robust liquidity to service debt and meet any other obligations. (The fund’s liquidity is measured quantitatively by its liquidity needs versus the potential sources of liquidity.)
• Does the AIF’s performance support or deplete its overall creditworthiness?

The AIF Scorecard also has a detailed guidance book and transparent benchmarks to help users understand the creditworthiness of a fund and/or the credit quality of the fund financing transactions.

What is the key output of the AIF Scorecard?

The AIF Scorecard is the credit solution provided by S&P Global Market Intelligence for assessing the creditworthiness of an AIF, which is based on the S&P Global Ratings criteria “Alternative Investment Funds Methodology, Dec. 9, 2021”. The Scorecard provides the creditworthiness of the AIF as a small letter grade credit score,^[2] which can be mapped to relevant probabilities of default (PDs). The PD mapping is based on over 40+ years of default data from S&P Global Ratings.

How do you capture a fund’s diversification?

We capture a fund’s diversification with subfactor concentration within the risk position assessment.  As mentioned, the granularity of the fund is important. We look at the number of positions in the same asset class/sector/geography and if they are correlated.

What sort of innovation is expected to ensure that sufficient quantitative factors can be integrated in a consistent and repeatable way?

The AIF Scorecard is mainly used to assess a fund’s creditworthiness and obtain a good proxy for the credit quality of the NAV facility.  We collaborate with a good number of clients who are experienced in the NAV market. This provides the benefit of enhancing both the quantitative and qualitative risk factors based on their input, as well as the guidance book. In addition, we have been working with our global clients on customized solutions for subline facilities for potential regulatory requirements.  

How are clients using the AIF Scorecard as part of internal risk modelling, external stakeholder reporting, etc.?

Users include banks, insurance companies, export credit agencies, asset managers, and investment managers for a variety of different purposes, the most common being for credit risk assessment and risk-based pricing.

In relation to a stress leverage assessment, what are the key considerations on the asset’s haircut in the Scorecard?

Along with many other credit risk dimensions, stressed leverage is a very important dimension for assessing AIF creditworthiness. The haircut of the asset suggests how much value the asset would be reduced by under adverse economic conditions. The type, location, and potentially the rating of the asset would be taken into consideration to calculate the haircut to apply when computing stressed leverage.

The Scorecard guidance book highlights some of the haircuts on different asset types based on the S&P Global Rating criteria and research paper, drawn from historical data. When applying a haircut to the fund’s actual asset or portfolio, an analyst may also consider whether the value of the asset is representative of the market. An adjustment to the standard prescribed haircut may apply. The concentration of the asset within the fund portfolio should also be considered.

Additionally for corporate bonds, the haircuts would be based on the type of debt, rating of the issuer, and time to maturity. For real estate assets, the haircut would be based on the type of asset, loan-to-value (LTV) ratio, and whether it is real estate debt or equity.

Oftentimes, lenders get very scarce information around LPs to do proper assessments. How does the AIF Scorecard deal with the lack of information?

General information sought on LPs as part of the Scorecard includes: the types of LPs in the fund (e.g., insurance companies, pension funds, corporates, and high-net-worth individuals), diversity of the LPs, and uncalled LP capital commitments earmarked for liquidity purposes. If the fund is not closed-ended, notice periods for LP redemption, frequency of liquidity offered to investors, lock-up periods, and penalties for early redemptions are important, as well.  We would encourage lenders to seek information from the borrower.

Using a traditional private equity fund as an example, in general there is no possibility of redemptions for investors, so an “adequate” assessment may be considered.  Another important consideration is the quality and granularity of the LPs. Creditworthy LPs (i.e., investment grade) will be able to meet their capital commitments when called by the investment manager. Also, a very concentrated LP base would be considered as negative.

Where the fund has multiple LPs, some LP information may be lacking from the borrower side, so some public sources of information (e.g., Preqin or S&P Capital IQ Pro) is recommended, which may assist with a certain level of LP information in relation to the LPs’ credit quality and type.  Alternatively, the Scorecard can provide some level of “proxy” credit quality on the LPs by type and geographic location, based on historical data.

Does the sector or industry focus of the portfolio companies/investments of each fund factor into this, or is that built into the "Track Record & Investment Performance" driver?

The sector or industry concentration is considered in the risk position assessment within the risk-adjusted stressed leverage assessment to refine the quantitative evaluation of the stressed leverage results. A concentrated portfolio would be considered negative and potential downward adjustment may apply when assessing risk-adjusted stressed leverage. Additionally, an analyst may consider applying a harsh haircut on the assets due to concentration (e.g., single-market concentration).

Can the Scorecard be used to assess the credit quality of a capital call facility?

Following the S&P Global Ratings methodology, the Scorecard starts by assessing the creditworthiness of the fund. This serves as a basis for assessing certain debt instruments. In many cases, all secured debt is considered at the same level as the fund-level credit quality.  However, if a meaningful quantity of high-quality collateral supports the senior secured debt, an analyst may consider a notching uplift under the S&P Global Ratings AIF methodology.

Why is S&P Global Market Intelligence well placed to deliver such a solution? 

Apart from the solution being based on the reputable S&P Global Ratings criteria, Scorecards are also transparent and flexible. A “glass box” approach provides users with important information, such as global benchmarks, frequently updated country and industry risk scores, a comprehensive User Guide, and the support of subject matter experts for any technical and non-technical queriers.

For more information on the AIF Scorecard click here.