Over the past couple of years, the private credit market has evolved from mostly direct lending (typically to highly leveraged corporates), to capture a larger universe of asset-based exposures. It continues to develop in terms of structure and customization to suit investor needs.

Chart 1

ABF and other exposures that use securitization technology have different risk profiles, compared with corporates (see table 1), and may provide benefits to investors, for example credit enhancement and diversification. This could partly explain the motivation underlying this trend.

Table 1

A fund invested in these exposure types will have its own unique risk characteristics. In the following, we compare and contrast these holdings.

Securitization Exposures

Public ABS, ABF, and SRT transactions have much in common, but they also exhibit significant differences. For example, in some cases they may depend on similar types of underlying assets, such as auto loans, credit card receivables, residential mortgages, and equipment leases. Yet credit risks can vary substantially deal-to-deal, based on the originator, structural features, and available credit enhancement, among others.

Private ABF, including warehouse lines, has tended to favor more esoteric collateral pools--such as royalties or digital infrastructure--or work with specialty finance originators. In comparison, public ABS tend to be a more commoditized market, with homogenous collateral pools and more established originators. Accordingly, ABF structures feature characteristics that are not common in public ABS.

For instance, originators funding via private credit may want a lot of flexibility on the eligibility criteria and concentration limits, while lenders may include terms that provide them with more control over the financing during the tenor. These terms can include enhanced structural protections related to the financial condition of the seller, even though the credit risk of the collateral backing the ABF has been segregated from the seller via a "true sale" to an insolvency-remote special-purpose entity.

In private warehouses, lenders also often protect themselves from duration risk by incentivizing the asset seller to refinance the transaction, for example terming out in a public ABS. This may be accomplished with coupon/margin step-ups, but can also be achieved by allowing the finance provider to purchase the collateral and sell it on the market to repay the liability.

ABF and warehouse facilities can also use simpler capital structures than public ABS as they are not as broadly syndicated. Lenders generally take the senior-most exposure and the seller maintains significant skin in the game through a comparatively thick first-loss position, compared with public ABS.

SRTs enable banks to offload part of an asset portfolio's credit risk to third-party investors, often synthetically through the issuance of credit-linked notes. Assessing the creditworthiness of synthetic transactions can differ from traditional cash securitizations, depending on how credit events and recoveries are defined, whether and how synthetic excess spread is determined, and depending on the transaction's legal and counterparty risk exposures. For SRT investors, these investments typically represent first-loss or mezzanine exposures and therefore have credit risks that we would generally associate with speculative-grade ratings.

Fund Finance Exposures

Subscription lines

These are typically used to support asset purchases in the early stage of a fund's life. Their primary source of repayment is from calls on the limited partners' (LPs') undrawn capital commitments (UCC). Subscription line facilities typically define the UCC borrowing base, advance rate, maximum draw amount, interest rate, and other terms and conditions. Lenders typically benefit from a first priority perfected lien on the fund's LP capital commitments and the accounts over which LP capital flows are made. Accordingly, the creditworthiness of subscription lines is generally less reliant on the overall creditworthiness of the fund than it is for other forms of fund finance.

NAV loans

They are typically used later in a fund's lifecycle as the fund reaches full deployment and can leverage its asset base for secured financing. The outstanding loan amount is subject to loan-to-value (LTV) covenants, and drawings may be repaid as funds harvest assets. Net asset value (NAV) loans can be used for liquidity, general risk management, and returning proceeds to LPs, among a plethora of additional purposes. In our view, given the typical structure and security package we have observed for NAV loans, their ratings are more closely aligned with the overall creditworthiness of a fund.

Corporate Exposures

Direct lending loans

They are typically held in direct lending funds, credit opportunities funds, business development companies, and the expanding mid-market collateralized loan obligations (CLO) sector. Loan proceeds may be used to finance corporate acquisitions by private equity firms (leveraged buyouts) or add-on acquisitions, to refinance or restructure outstanding debt, or for dividend recapitalizations whereby proceeds are used to upstream cash flows to private equity owners and related funds.

These are typically senior secured loans or unitranche facilities that combine first- and second-lien priorities. Most loans contain financial maintenance covenants and generally have better documentation provisions than those in the broadly syndicated loan (BSL) market. Based on the size of the entity, the market can be categorized into a lower-middle market, a core-middle market, and an upper-middle market.

Loans in the upper-middle market tend to compete with the BSL market, both on terms as well as pricing. Given the competitive dynamics between the two markets, we expect that issuers will seek flexible loan structures, including the payment-in-kind (PIK) toggle option and covenant-lite provisions in loan documentation at the higher end of the direct lending market.

Most loans are made to entities in the software, health care, professional, and commercial services sectors, predominantly to asset-light businesses. Direct lenders have traditionally avoided cyclical sectors, such as oil and gas and other commodities, direct-to-consumer businesses, and other old economy segments.

Real Assets

Project finance and infrastructure

Project finance is a financial engineering technique used to fund large projects and infrastructure assets by using the project's cash flows and assets as collateral. Creditors depend on the project's success for repayment, rather than the sponsors' creditworthiness.

Traditionally, project finance has been used for a variety of assets, including energy projects, such as conventional power, renewable energy, and pipelines. It also covers transportation infrastructure, such as roads, bridges, tunnels, ports, airports, and metro systems. Social infrastructure projects--for example hospitals, schools, prisons, and student accommodation--as well as telecommunications infrastructure, including towers and fiber, may also be financed this way. Environmental projects, such as desalination plants, and sports facilities, such as stadiums, have also used project finance. In recent years, digital infrastructure has emerged as a growing asset class using project finance structures.

The project finance market has long been supported primarily by bank loans and bonds. However, private markets are increasingly contributing to the supply of capital funding for future projects, including those related to energy transition and data centers that enable artificial intelligence and cloud computing services.

CRE investments

There is a broad spectrum of CRE collateral, but most investments will be against income-producing assets from certain "core" property types, such as office buildings, retail centers, industrial warehouses, multifamily and apartment buildings, and hotels. Some funds are dedicated to a particular property type or a specific region, while others will be more diversified by property type or geography.

Private funds will tend to be closed end, with longer investment horizons, given the inherent illiquidity of their investments, as opposed to REITS, for example, which are publicly traded. The loans (debt investments) themselves may be senior or subordinated in the capital structure, and can include bridge/gap financing, mezzanine interests, and other more specialized investments.

Securitized investments come in several flavors, including deals backed by diversified portfolios (conduits), individual properties or smaller portfolios (single asset single borrower), or against portfolios of non-stabilized assets (CRE CLOs), with various risk/reward opportunities in the capital stack.

Private credit investment vehicles

Recently, we have observed significant interest in investment vehicles that use securitization technology to tranche credit risk, representing another step in the evolution of this sector. An investment vehicle's structural features and the level of flexibility of the fund manager can influence our credit rating analysis. Our sector-specific methodologies describe our analytical framework for assessing the creditworthiness of each of these investment vehicles.

Chart 2

Credit Tranching In ABF Funds

For private credit investment vehicles with underlying securitization exposures--for example ABF--some market participants may question how they compare to collateralized debt obligations (CDOs) of pooled structured finance assets that were common in the lead-up to the global financial crisis (GFC). Some of the key differences we have observed in recent proposals that are meant to address certain risks include:

1 - Diversity across underlying asset classes

Unlike some CDOs with a single-industry exposure, such as subprime residential mortgages, diversity generally exists across a variety of asset classes. Accordingly, we expect performance to be less correlated across underlying exposures.

2 - Seniority of exposures and tranche thickness

ABF transactions typically represent the most senior tranche, with a relatively large investment position, for example 25%-100% of the capital structure. CDOs of structured finance pools often contain many mezzanine tranche exposures, for example 5%-10% lower in the capital structure. In practice, this implies that, for the same assets under management, ABF investment vehicles exhibit less diversification by the number of investments. Yet they benefit from significantly higher credit enhancements per investment.

In fact, we have observed in many cases that ABF assets held in private credit funds are structured to investment-grade-equivalent rating levels. Furthermore, even if credit enhancement for an exposure proves insufficient, the loss experienced as a percentage of the invested amount will be lower where thicker tranches are financed because each obligor represents a lower percentage of the investment.

3 - Market value risk

Some structured investment vehicles that were issued before the GFC had liabilities maturing prior to when cash flows would be realized from asset maturities. This created a risk that, if shorter-dated liabilities could not be refinanced, assets would need to be liquidated at current market values to repay the debt.

In recent ABF fund proposals we have received, many structures aim to isolate the rated liabilities from any market value risk of the assets. This means collateral pools are self-liquidating, such that cash flows from the assets can be relied upon as the primary repayment source.

Related Research

• The Opportunity Of Asset-Based Finance Draws In Private Credit, Nov. 20, 2024
• Private Credit Casts A Wider Net To Encompass Asset-Based Finance And Infrastructure, Nov. 20, 2024
• Credit FAQ: How We Rate Common Private Credit Investment Vehicles, Sept. 4, 2024
• ABS Frontiers: The Credit DNA Of Synthetic Risk Transfer Securitizations, Sept. 3, 2024
• ABS Frontiers: The Blurring Of Private Credit Funds And CLOs, Jan. 30, 2024