Global AIFs Have Filled An Important Niche

Alternate investment funds have performed as a novel, niche product with greater returns over the past decade, owing to their more diverse investment appetite, at a time when returns for more traditional investment vehicles have stagnated. They typically launch theme-led vehicles with clear product distinctions. Even in the face of elevated volatility this year, the volume of alternative assets under management is set to grow further, to $23 trillion by 2026 from around $10 trillion in 2019, according to Preqin data.

Our global publicly rated universe comprises a dozen peers. Although this report focuses on European AIF ratings, understanding their global peers is essential. Some rated AIFs include traditional listed funds investing in public equities, but most have exposure to alternative assets--a broad term that includes private equity and debt, real estate, venture and growth capital, infrastructure, and natural resources. In general, ratings on AIFs are robust and tend to be investment grade, mainly because of generally contained fund level leverage, stable funding, and good medium-term track records.

The small number of AIFs that we rate means that their ratings strengths do not necessarily read across to the entire global sector of unrated peers. For instance, even though we see asset-level leverage as a manageable source of incremental risk for rated AIFs, this may not be the case for all funds with private-equity exposure. Average purchase price multiples for leveraged buyouts in the U.S. rose above 11x for the first nine months of 2022, underpinned by debt-to-EBITDA ratios touching on 6x, according to Morningstar's Leveraged Commentary & Data. This compares to 4.1x average debt to EBITDA for European private equity fund 3i Group at midyear 2022 (excluding the material investment in Action, which has a lower loan-to-value ratio and if included pulls the average to 2.7x) (see chart 1 below).

Greater leverage and multiples create not only incremental default risk, and put pressure on asset recovery in the event of default, but also creates risk in the event a fund is unable to achieve a similarly high exit multiple as paid on entry. Features like contained asset leverage partly explain why we see rated European AIFs as resilient to mounting macroeconomic and market pressures, which cannot necessarily be said of their unrated peers.

Chart 1

Table 1

After A Long Run Of Favorable Conditions, Pressure Is Mounting On European AIFs

Until recently, our rated European AIFs benefited from a decade-long period of low interest rates, low market volatility, and growing alterative asset valuations. However, the broad sell-off in global financial assets and tightening of funding markets over the past two quarters of 2022 represents a reversal. This broad-based pressure is affecting a host of rating factors. Weakening valuations are worsening leverage metrics, and tighter funding markets are pressuring prospective funding and liquidity.

Chart 2

Chart 3

The tightening in public markets reflects familiar themes. Sharp inflation, sparked by a combination of post-pandemic supply chain restrictions and spiraling commodities prices following Russia's invasion of Ukraine, has prompted central banks to raise interest rates. These hikes have led to a wide re-pricing of financial assets, and volatility has returned to global markets. Remarkably, credit spreads have widened to levels last seen at the height of the pandemic, and European equity indices are down by an average of 19% over the first nine months of 2022.

In private asset markets, we expect pressure to rise as well. However, the lack of a liquid reference price for many private-equity and venture capital funds means that asset price pressure will probably lag behind public markets. Indeed, while very early-stage private investment appears to have preserved some value for now, large pre-IPO companies have already seen their valuations fall precipitously. This recalibration of late-stage valuations has stalled the stream of planned exits, as founders and management teams wait for volatility to subside and benchmarks to recover. Furthermore, as the broad market sell-off in nascent technology firms indicates, the demand for certain pre-IPO assets has contracted materially as well.

Chart 4

A period of sustained pressure on asset valuations looks likely to persist. However, the existence of private, bilateral markets for AIFs to divest their stakes in private companies has preserved volumes to some extent in 2022. Falling valuations not only pose risks to funds' leverage levels, the pause in divestment also traps capital in illiquid assets and stifles fund level liquidity. This lack of liquidity is one of the key risks facing Europe's alternative investment funds in the near term.

Although asset valuations appear to be under threat, AIFs tend to have permanent capital and to some extent can afford to delay asset sales until market conditions improve. In fact, when the maturity of an AIF is imminent, pressuring the fund to divest in the near term, many of them have the capacity to extend the fund's life, buying themselves time. Furthermore, many funds now sit on significant excess capital after years of record funding from 2019 to 2021 and through to a buoyant 2022. The excess capital means that AIFs retain a degree of financial flexibility, enhanced by their discretion to delay redemption, inject capital, move assets between funds, and begin to deploy capital into new funds. As it stands, the range of funds raising capital successfully in 2022 has shrunken, though.

Chart 5

Leverage Is Under Control And Should Remain So

One of the key ratios we use to assess the creditworthiness of AIFs is risk-adjusted leverage. For buy-and-hold AIFs, this is measured as stressed assets over recourse liabilities, where we employ very conservative haircuts to stress the assets (for example, 50% for equities or 60% for private equities) under a theoretical market downturn. In this respect, Europe's AIF ratings were generally resilient throughout the pandemic despite dramatic movements in asset prices. Indeed, historically stable leverage has been a key feature of ratings stability in the past three years. For example, after a difficult first half of 2020, AIFs benefitted from strong performance as economies recovered from pandemic restrictions, thanks to lower interest rates, easy monetary and fiscal policy, and moderating market volatility. Among globally rated AIFs, leverage is generally better than pandemic lows, despite nine months of market stress and volatility throughout this year.

3i Group, for instance, benefitted from solid valuations and strong cash generation from its private equity portfolio, supporting the upgrade to 'BBB+' in June 2021. More recently, even though Netherlands-incorporated Pershing Square has seen its net asset value (NAV) fall 4.8% in the year to November 2022, we expect the ratio of stressed assets to recourse liabilities to remain above 1.75x even in a stress scenario whereby its listed positions were to fall by 50%. In this context, Pershing has ample wiggle room under its current rating level to sustain prolonged distressed market conditions. In the hedge fund space, the currency Exchange Fund has demonstrated improving leverage over the past two years amid rising market volatility thanks to an increasing NAV.

Chart 6

For those issuers that added leverage at peak asset valuations seen in late 2021, the subsequent concerted decline in valuations has added rating pressure. Thus far in 2022, this led to the downgrade of Mercantile Investment Trust to 'AA-', which now carries a stable outlook, reflecting material headroom at this lower rating level. Indeed, Mercantile was among a number of funds that took advantage of generous market conditions in late 2021 to issue fresh debt and increase their leverage just as asset valuations approached their peak.

Long Investment Horizons, Stable Capital Bases, And Adequate Liquidity Support The Ratings

The long investment horizon and access to stable funding or permanent capital are important supports to the ratings on European and global AIFs. Our rated equity investment trust AIFs, such as Mercantile Investment Trust and Pershing Square Holdings, are closed-ended funds. Furthermore, most of our public and private equity AIFs, such as 3i Group, benefit from investors that have locked in their capital for a number of years, and where the fund has the right to extend its life. This is a significant defense against market uncertainty as it eliminates some of the typical short-term needs of funds to sell assets into an unfavorable environment to meet redemptions. This supports the financial stability of funds through periods of volatility, even as asset valuations come under stress, lending a degree of ratings stability.

Chart 7

Given generally stable medium-term funding for European and global AIFs, our analysis of short-term liquidity sources and uses takes on greater importance. High inflation and rising rates not only lower asset valuations, but also the earnings prospects of many underlying assets. As the macro environment worsens, some assets may need more capital to be invested or additional debt funding. By the same token, they may no longer be able to upstream predictable dividends or other cash payments to the AIF. This pressure on liquidity sources can result in acute pressure on ratings, especially where funds lack alternative liquidity sources given that underlying assets are illiquid and not easily marketable. On the other hand, where we believe assets may be more marketable, we reflect that in our valuation in a stressed liquidation.

In a similar vein, for funds with more high-frequency or complex trading strategies, we assess liquidity reserves of highly liquid assets and compare this to their trading capital, which consists of their S&P Global Ratings-adjusted net asset value and long-term debt.

We also positively consider that, following record fund raising, liquidity and cash buffers are high in the system, supplementing AIFs' invested assets to meet short-term cash needs. All told, our rated AIFs tend to hold liquidity sources comfortably greater than their uses, with some unevenness in the liquidity backdrop.

Chart 8

Some Fund Types Can Actually Protect Against Inflation Or Rising Rates

Some AIFs, depending on their strategy, can offer upside potential as the market turns or the economy slows. Some types of AIFs perform better when rates rise, for example, those invested in the private debt markets, and more specifically, in floating-rate debt vehicles. We expect such investments to provide some protection in an environment of rising interest rates. Although we don't rate any credit funds in Europe, we do rate some globally. Drawbridge Special Opportunities Fund LP (a U.S.-domiciled fund) and Metrics Credit Partners (an Australia-domiciled fund), are some rated AIFs that invest in the private debt markets or specialty credit funds. Other AIFs may run strategies that provide further protection against inflation, for example, those with exposure to real assets such as commodities or infrastructure, which not only provide a hedge against inflation but could also provide cash flow.

Some investments and strategies will exhibit more granular and specific countercyclical qualities. 3i Group, for example, has a highly concentrated position in Action, which we account for in the rating. However, Action is also a discount retailer that has been growing steadily and should perform resiliently in a recession. By the same token, hedge funds such as the Citadel Kensington and Wellington funds tend to benefit from market volatility.

A Generally Positive View Of Management's Capacity To Navigate Stress

We also closely assess management teams, their strategies, track records, and relative performance to gauge their ability to navigate changing market conditions. In our view, even as the macro environment worsens around them, rated AIFs' management teams are generally of a high standard and relatively well equipped to navigate the new operating climate.

The Risks Are Stacked To The Downside

Europe's AIFs are diverse in scope, with exposures to a variety of asset classes and strategies. However, market turmoil and the deteriorating macro environment in our view stack the risks to the downside for nearly all rated AIFs--whether through their risk-adjusted leverage or funding and liquidity. Nevertheless, leverage headroom, high liquidity levels, and stable capital structures are some important mitigants to broad pressure on the rated European sector. Although the ratings are under pressure and may see some downward migration in the next 12 to 24 months, market and macroeconomic volatility should bend, but not break, the vast majority of Europe's rated AIFs.

Appendix: How We Define And Rate An Alternative Investment Fund

The AIFs that we rate take various forms. They are typically set up through a fund structure (see chart 9). Our analysis reflects the assets and liabilities of the fund itself. It generally does not consider a link to the ultimate parent of the fund--typically an asset manager or hedge fund, whose creditworthiness we assess separately. Although under these structures funds can invest in a diverse range of public and private assets, these assets are often private equity investment, hedge fund strategies, or fund of funds investments.

We classify AIFs into two categories:

• Those with buy-and-hold funds that focus on harvesting investments, for example, a private equity fund; and
• Those with complex trading strategies, where the assets have meaningful turnover and the AIF funds itself with capital with varying degrees of permanence, such as hedge funds or high-frequency trading funds.

When rating AIFs and assessing their creditworthiness, we look at the investments and trading strategies they employ as well as their leverage, funding, and liquidity as key rating factors (see chart 10). We treat AIFs differently from investment holding companies or securities firms due to their equity funding structure and different investment objectives. Typically, AIF funding consists of permanent or nonpermanent capital. We also distinguish AIFs from alternative asset managers, which generate revenue from management fees charged as a percentage of assets under management and performance fees, rather than absolute investment performance. Among the global rated peer set, some examples of a buy-and-hold AIFs are Mercantile Investment Trust, 3i Group, and Pershing Square Holdings. Examples of funds with more complex strategies are The Currency Exchange Fund and Citadel Kensington Global Strategies Funds.