In this report, S&P Global Ratings explains its approach and data requirements for rating alternative investment funds (AIFs). This Credit FAQ should be read in conjunction with our criteria article "Alternative Investment Funds Methodology," published on Dec. 9, 2021.

Frequently Asked Questions

How does S&P Global Ratings define and rate an alternative investment fund?

The AIFs that we rate take various forms. Typically, but not necessarily, they are set up using a fund structure and can invest in a diverse range of public and private assets. These may include private equity investments, private debt, real estate, commodities, hedge fund strategies, and fund of funds investments. AIF raise a mix of permanent or nonpermanent capital as a source of financing.

We classify AIFs into two categories, by trading strategy:

• Buy-and-hold strategies: These funds focus on harvesting investments. Examples include private equity funds.
• Complex trading strategies: These funds finance themselves using capital that has varying degrees of permanence. The assets have meaningful turnover. Examples include hedge funds or high-frequency trading funds.

When assessing the creditworthiness of an AIF, we consider:

• The investments it makes;
• The trading strategies it employs; and
• The funding structures it maintains.

Our analysis reflects the fund's ability to repay its recourse liabilities when due, in a theoretical liquidation scenario following a 'BBB' stress. It generally does not factor in support from the ultimate parent of the fund--typically an asset manager or hedge fund, whose creditworthiness we assess separately. Key rating factors include the fund's risk-adjusted leverage, funding, and liquidity (see chart).

Our rated AIFs, globally, include buy-and-hold AIFs such as Mercantile Investment Trust, 3i Group PLC, Pershing Square Holdings Ltd., and Metrics Credit Partners Real Estate Debt Fund. Examples of funds that use more complex strategies include Citadel Wellington/Kensington Global Strategies Funds and The Currency Exchange Fund.

We distinguish AIFs from alternative asset managers, which generate revenue from management fees charged as a percentage of assets under management, performance fees, and investment income through their underlying general partner commitments in the funds they manage. AIFs depend on their absolute investment performance.

How would S&P Global Ratings treat an entity that has both investment and asset management activities?

If most of an entity's revenue comes from the management and performance fees it charges for managing third-party money or assets on behalf of retail or institutional investors, we would analyze it as an asset manager (see "Guidance: Corporate Methodology," published on July 1, 2019). Alternative asset managers operate a hybrid model that combines:

• Investing their own balance sheet in financial or real assets to generate returns;
• Investing in their funds, to align their interests with those of the limited partners (LPs); and
• Managing third-party assets that generate management and performance fees as well as investment income.

For these entities, their third-party asset management business typically exceeds their on-balance-sheet business. Where balance-sheet investments represent a sizable proportion of total income, we may incorporate the investments into our analysis by using S&P Global Ratings-adjusted debt to adjusted total equity as a core credit metric in our analysis of financial risk. This allows us to capture the impact of investment performance as well as the earnings from fee generation.

Conversely, if investment represents most of the firm's business and its risks, we would apply our AIF methodology. For example, in addition to its private equity investments, 3i Group has a stake in 3i Infrastructure (which, in turn, manages third-party funds). We include 3i Infrastructure as an asset in our stressed leverage analysis.

How does S&P Global Ratings differentiate between an investment holding company (IHC) and an AIF?

The equity funding structure and investment objectives of AIFs differ from those of IHCs, and this affects how we treat them. AIFs typically expect to hold assets for a limited period and their funding consists of both permanent and nonpermanent capital. IHCs, however, invest their own capital and have permanent equity with no redemption term. This allows for a medium- to long-term investment horizon as there is no pressure to liquidate investments to meet redemption demands.

That said, some AIFs can have features that resemble an IHC. For example, Mercantile Investment Trust and Pershing Square are both closed-ended, permanent capital vehicles. They still differ from IHCs in having a return target and anticipated holding period. In our experience, IHCs have a longer-term interest in their portfolio of invested companies, which generally leads to longer holding periods. Therefore, we rate Mercantile and Pershing under our AIF criteria, and not as IHCs.

Can a corporate entity that is not organized as a fund be analyzed under the AIF criteria?

As noted above, not all AIFs are set up using a fund structure. If an entity that is not organized as a fund has characteristics similar to those of a hedge fund or private equity fund, and it executes strategies that have common elements with private equity investment or hedge fund trading strategies, it would typically be in scope of our AIF criteria. For example, 3i Group is a listed U.K. investment trust but, in our view, it has implemented a strategy similar to a private equity fund and bears similar risks. That said, we would not apply our AIF criteria to special-purpose vehicle (SPV) structures that are part of an AIF.

What analytical challenges arise when insurance companies invest in AIFs through a combination of equity and debt issued out of a feeder fund?

Some insurance companies invest in AIFs through a combination of equity and debt issued out of specially created feeder funds, which, in turn, flow into the master fund. In these cases, we assign an issuer credit rating (ICR) to the feeder fund, and then derive a debt rating from the ICR.

The ICR on the feeder fund relies on a "look-through" approach--we consider the types of asset at the master fund level, and the leverage at the master fund and asset level. For example, a feeder fund may flow into a credit fund that has no leverage and invests mostly in 'B' rated corporate bonds with an average maturity of five to seven years. Under our criteria, in this case, the feeder's asset is the LP interest in the master fund and we would apply a 42% haircut to the value of this asset under a 'BBB' stress in our stressed leverage calculation. This is commensurate with the haircut we would apply if the fund were to hold 'B' rated corporate bonds directly.

For securities, our haircuts depend on:

• The rating: higher ratings get lower haircuts;
• The duration: longer durations get higher haircuts; and
• The type of security: collateralized loan obligations get higher haircuts than corporate bonds, for example.

We also consider the ratio of debt to equity in the financing of the feeder fund. The higher the debt component (or conversely the lower the equity component), the lower the ICR on the feeder fund is likely to be. Similarly, the lower the ratio of the fixed coupon on the feeder fund notes to the average yield at the master fund asset level, the higher the ICR will be.

In rating the feeder fund, we also take other factors into consideration, notably that feeder funds are generally only one of many limited partners that have invested in the master fund. They do not directly control or own the master fund's assets--to a large extent, feeder funds rely on the steady distribution of cash flows from the master fund to meet financial commitments such as paying ongoing interest expenses, or the principal at maturity. This could limit the rating for several reasons:

• Relying on a steady stream of distributions from the master fund may be hazardous because not all assets pay dividends or interest (for example, private equity holdings usually do not pay dividends). We would expect this to be a less relevant factor for a credit fund because most of its assets are likely to be interest-paying loans or bonds.
• Even when the master fund generates steady and strong cash flows, some fund managers may choose to reinvest the cash into additional or follow-on investments to maximize returns--and, potentially, performance fees--rather than distributing the cash to LPs.
• The fund manager for a master fund that is generating steady and strong cash flows but has high leverage may also choose not to make distributions in a stress scenario. The manager may prefer to retain cash at the master fund level to strengthen the fund's capacity to meet upcoming debt maturities or to maintain the fund's good standing with lenders.

We capture these risks in our liquidity score. They are part of the cash flow from the portfolio subscore, which is an important factor in our analysis.

We rate feeder fund debt at the level of the ICR on the feeder fund if we are rating the only debt at the feeder level. However, if the issuer is allowed to defer payment of the coupon on the feeder fund notes without triggering a default, we would typically rate the debt below the ICR, indicating that the investor is exposed to the risk of a coupon deferral. This is in line with our approach to rating hybrid instruments, in which we may assign ratings below the ICR, in part because of the deferral option. At the same time, having the flexibility to defer the coupon payment may be slightly credit positive for the ICR. It could give the issuer more flexibility in a stress scenario, when cash is scarce. Nevertheless, we would expect deferred interest to be paid--if it is not paid, we view it as a default.

In rating buy-and-hold AIFs, what information does S&P Global Ratings seek?

We require a meeting with the fund's management to discuss the key aspects of its investment strategy and risk management. We also seek information on the areas listed in table 1--these form the starting point for our ratings analysis.

Table 1

Can a fund that has a short or no track record be rated?

To rate a fund that has a short or no track record, we would need to compare it with a suitable "proxy" fund for which at least four years of historical data are available. We would also need clear portfolio guidelines and representation from management regarding its intentions for the new fund. To be comparable, a proxy fund would have to follow a similar strategy to the new fund, operate in the same sector, and have the same maturity. In many cases, a previous vintage of the fund can be used as a proxy fund.

Most importantly, the proxy fund should have been managed by the same group of investment professionals and utilize similar risk controls. We view this as core to our analysis--our assessment of management's record is a key ratings factor under our criteria (see chart above). A fund that has similar characteristics, but was run by a different management team, would not typically be considered a comparable proxy. We would also not rate an inaugural fund that employed a new strategy, even if the team running it were already managing rated funds using a different strategy.

In rating AIFs that have a short or no track record, what information does S&P Global Ratings seek?

If we consider that a comparable proxy fund is available to support our rating on a new AIF, or one with a short track record, we would need sufficient information to assess the predecessor fund (see table 1). We would also require information about the new fund's guidelines, so that we could account for any differences between the proxy and the new fund. Finally, we would require information about the proxy fund's existing holdings and the performance of its management team, to inform our quantitative and qualitative assessments.

Would S&P Global Ratings rate just one tranche of the debt issued by an AIF, without rating the fund itself?

No. Under our methodology, we always start by assigning an ICR to the fund; this serves as a basis for our ratings on particular debt instruments. In many cases, all secured debt is rated at the same level as the ICR. However, if a meaningful quantity of high-quality collateral supports the senior secured debt, we may rate first-lien senior secured debt one notch above the ICR.

Our ratings on senior unsecured obligations and junior secured debt may be at the same level as the ICR, or lower by one or two notches. This will depend on the amount of priority debt, S&P Global Ratings-adjusted assets, and unencumbered assets on the fund's balance sheet and is explained in more detail in paragraphs 39-45 of our AIF methodology. Adjusted assets are based on a fund's balance-sheet assets; we apply adjustments to account for the fund's intangible, netted, contingent, or complex exposures.

How does S&P Global Ratings treat different classes of shares?

Where a fund has different classes of shares, we determine if any of the instruments have debt-like features or if they can all be characterized solely as equity. We apply our hybrid methodology to assess the equity content of hybrid instruments (see "Hybrid Capital: Methodology And Assumptions," published March 2, 2022). For example, because we view preferred shares and subordinated debt as hybrid capital, they are less supportive for the credit quality of the fund. In our stressed leverage analysis, recourse liabilities include all debt obligations issued by a fund, including subordinated and hybrid debt, but we exclude the equity content of any hybrid instruments.

Related Criteria And Research

Related criteria

• Hybrid Capital: Methodology And Assumptions, March 2, 2022
• Alternative Investment Funds Methodology, Dec. 9, 2021

Related research

• Difficult Markets Will Test Europe's Rated Alternative Investment Funds, Dec. 5, 2022
• Guidance: Corporate Methodology, July 1, 2019