Some private credit funds have been incorporating securitization technology in their capital structures through credit tranching, defining associated payment waterfalls and coverage tests, and mitigating asset-liability mismatches. These features may provide structural protections and more predictable cash flows for secured creditors of an AIF, but generally result in less flexibility for the fund manager/general partner (GP). However, in return, the structural protections may lower the dependence of the creditworthiness of secured financial obligations on the ICR on the AIF. Nevertheless, relative to CLOs, we believe private credit funds generally have higher exposure to legal, operational, and counterparty risks, and the ability of the GP to manage these risks may continue to influence creditworthiness.

Private Credit Funds And Middle Market CLOs: A Comparison Of Typical Characteristics

Table 1 summarizes the typical characteristics of open-ended private credit funds employing direct lending strategies compared to middle market CLOs, and characteristics that hybrid structures may feature. The table provides general classifications; we acknowledge that individual issuers may have characteristics that differ.

We typically rate private credit funds by applying our alternative investment funds methodology, and middle market CLOs by applying our global CLOs and CDOs criteria (see "Related Criteria"). For hybrid structures which possess a combination of private credit fund and CLO characteristics, we may determine the applicable analytical approach on a case-by-case basis depending on the structure's risks and mitigants.

Table 1

Credit Tranching In Private Credit Funds

We've discussed several proposals with market participants seeking to implement credit tranching in private credit funds, with two examples highlighted below. The first structure utilizes a feeder fund to issue the rated debt (see chart 1), while the second structure issues direct financial obligations from the main fund (see chart 2).

Chart 1

In a feeder fund structure, a limited partner (LP) equity interest in the main fund collateralizes the rated notes. Accordingly, the rated notes are indirectly backed by the investment portfolio of the master fund and rely on distributions to the LP interests of the main fund which in turn are applied according to the feeder fund's priority of payments. The rated notes may be subordinated to any senior ranking debt obligations of the main fund, such as subscription line or net asset value (NAV) facilities. The strength of the GP's commitment to make timely distributions of collections on the investment portfolio to LP interests may be a key differentiating risk factor for the creditworthiness of the tranched notes issued by the feeder fund.

Chart 2

Stand-alone structures bear a closer resemblance to CLOs than feeder funds, with noteholders being direct creditors of the main fund. However, funds may not contain the same degree of structural protections which are common in CLOs, including investment portfolio eligibility criteria, contractual mitigants to counterparty risk, and insolvency remoteness considerations of the main fund.

Key Differentiators Of Credit Risk Between Private Credit Funds And CLOs

Funding and liquidity

CLO transactions are structured to mitigate asset-liability mismatch by ensuring that repayments of principal and interest on the underlying investment portfolio will be sufficient to meet contractual payment obligations on the rated notes. Accordingly, there generally isn't any refinancing risk in CLOs and an assessment of the issuer's funding and liquidity profile is not required in our credit analysis as the portfolio is self-liquidating.

On the other hand, private credit funds generally have more diverse and flexible capital structures which requires active asset-liability management by the GP. Funds may be structured as open- or closed-ended and may utilize permanent or nonpermanent capital (e.g., funds which have substantive restriction on redemptions or more flexible gates governing redemptions), in addition to LP provided equity. In our view, closed-end credit funds with no early redemption rights for LP interests (or evergreen funds with permanent capital) and which do not utilize nonpermanent funding may mitigate the exposure to market value risk arising through liquidation of the investment portfolio to meet redemption requests or financial obligations maturing before the investment portfolio.

With respect to timely interest payments, in both funds and CLOs the rated notes may contain payment-in-kind (PIK) features which permit interest capitalization if cash flows are insufficient to make periodic interest payments. Under our rating definitions, so long as noteholders are in an economically equivalent position to when interest is paid timely (for example, if interest is paid on any deferred or capitalized interest), we can generally rate the notes on a deferrable basis (i.e., our issue credit ratings address the ultimate payment of interest, including any accrued amounts). This structural feature can mitigate any impact on our credit ratings due to temporary cash flow timing mismatches.

Market value risk

The legal maturity date of rated notes in CLO transactions is generally set so that assets mature before the contractual payment obligations coming due on the notes, or in other words, the portfolio is self-liquidating. As a result, CLO transactions generally are not directly exposed to market value risk given our analysis considers whether note acceleration events before legal maturity are deemed as ratings remote.

Given the presence of refinancing or early redemption risk in AIFs, asset-liability mismatch may result in forced asset realizations to satisfy the payment obligations, exposing the fund to the investment portfolio's market value risk. Our rating analysis reflects that the investment portfolio may need to be liquidated under stressed conditions to meet equity redemption requests, repay notes maturing before the underlying investment portfolio, or any other financial obligation due (see "Related Criteria").

If market value risk in a fund is structurally mitigated such that we believe it is likely the portfolio will be self-liquidating, the risk profile of the tranched debt may be more similar to CLOs than to traditional AIFs.

Additional Risks In Private Credit Funds Compared To CLOs

Counterparty risk

CLO transactions typically mitigate the exposure to financial counterparties, such as bank account and hedge providers, through ratings-based downgrade triggers which require replacement of the counterparty if downgraded below a minimum eligible rating or collateralization of the issuer's exposure to the counterparty. Given the remedies available if the counterparty's credit quality deteriorates, we may conclude that counterparty risk does not constrain the maximum supported ratings in a transaction (see "Related Criteria").

AIF structures usually do not contain the same documented minimum required rating and collateralization requirements for financial counterparties, which in our view places more reliance on the GP to actively manage these exposures.

Legal risk

CLO issuers are established as insolvency remote special-purpose entities that effectively isolate the investment portfolio from the insolvency of third parties and restrict activities that are not necessary to affect the transaction. As such, our rating analysis can then consider whether the cash flows from the pool of securitized assets will be sufficient to meet timely payments on the debt.

AIF structures are governed by their limited partnership agreements (LPAs), and while usually bespoke to different situations and asset classes, they generally have more flexibility on the investment portfolio's composition, cash flow allocation (e.g., distributions to LP interests versus deleveraging or recycling into the portfolio), and liability management (e.g., potential for additional debt) compared with CLOs. AIFs are not bankruptcy remote, and as such, the GP plays a crucial role in managing the fund and certain risks, which are specifically mitigated in CLO transactions.

As part of our analysis of funds utilizing structured finance technology and determining the relative creditworthiness of the tranched debt versus the fund's, we would want to understand how the governing fund or facility documents address the following areas:

• Any limitations of the incurrence of additional indebtedness;
• Any restrictions on the fund or GP's objects and powers, including the ability to engage in any business or activities other than those necessary for, or incidental to, its role in the transaction;
• Any restrictions on mergers or reorganizations as it relates to the fund or GP;
• Any limitations on amendments to the fund, GP, or other organizational documents; and
• Any security interest over the fund's investment portfolio.

Operational risk

In CLOs we perform an operational risk overview of the collateral manager to determine whether it is capable of managing a securitization over its lifespan. To do so we review the assets under management, years of experience managing CLO transactions, internal controls, and staffing levels.

As most CLOs allow for reinvestments and asset trading, our operational risk assessment gives us comfort that the manager will be able to maintain the asset portfolio within certain boundaries through the asset eligibility criteria and contractual provisions that govern the type of trading allowed. The operational risk of the collateral manager typically does not constrain the maximum potential ratings we assign in CLOs.

On the other hand, AIFs generally have more flexibility than CLOs and the GP may play a more active role in managing certain risks. Accordingly, our view of the GP's influence over the creditworthiness of debt issued by funds may be more relevant to our rating analysis. The following factors may inform our opinion of the GP's ability to manage these risks:

• The GP's track record and investment performance;
• Their risk management practices, including trading and credit risk management, operational risk management, and management and governance; and
• The transparency and complexity of the fund's strategy.

Dependence On ICRs

Our ICRs on AIFs address their overall creditworthiness and consider the aggregate amount of leverage in a fund's capital structure. They do not apply to any specific financial obligation of the fund, as they do not reflect the nature of and provisions of the funds' obligations, their standing in bankruptcy or liquidation, statutory preferences, or the legality and enforceability of the obligations. However, the ICR is typically used as a starting point to assign an issue credit rating to the fund's financial obligations, where applicable. We typically rate all secured debt and senior unsecured debt at the same level as the ICR. However, we may rate first-lien senior secured debt higher than the ICR by one notch if there is sufficient overcollateralization under our rating stresses. Conversely, we rate a financial obligation lower than the ICR by one or two notches where we see additional risk from priority debt.

On the other hand, our issue credit ratings for CLOs consider the creditworthiness of each individual tranche and account for the available credit enhancement, transaction structure and priority of payments, and collateral security for noteholders. They do not depend on an assessment of the issuer's overall creditworthiness, or ICR, given our opinion that the issuer is structured to be insolvency remote.

Our issue credit ratings on senior tranches in CLOs are typically higher than our issue credit ratings on first-lien senior debt issued by AIFs given our view of differing degrees of linkage with the issuer's overall creditworthiness (ICR). We would generally view structural features in a fund that mitigate funding and liquidity, market value, counterparty, legal, and operational risks as characteristics that may materially differentiate the creditworthiness of the tranched debt from that of the GP or the overall creditworthiness of the fund (ICR). While we recognize that some of these risks may not be mitigated to the same extent we see in typical CLOs, structural features may be sufficient to lower the dependence of our issue credit ratings of tranched debt issued by AIFs on the ICR on the fund.

Related Criteria

• Alternative Investment Funds Methodology, Dec. 9, 2021
• Global Methodology And Assumptions For CLOs And Corporate CDOs, June 21, 2019

Related Research

• Private Credit And Middle-Market CLOs Navigate Growth And Economic Uncertainty, According To Q1 2024 Slide Deck, Jan. 26, 2024
• Private Markets Monthly, December 2023: The Outlook For 2024, According To Eight Experts On Private Markets, Dec. 18, 2023
• Private Markets: How Long Can The Golden Age Of Private Credit Last?, Dec. 4, 2023
• Credit FAQ: Is There A Middle Ground For European Middle Market CLOs?, Nov. 16, 2023
• Uneven Liquidity And Strained Valuations Are Pushing Some Funds Toward Debt, Sept. 28, 2023