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As investors increasingly allocate capital across the private debt markets, evolving macro and financial conditions may require a need for greater transparency—especially as alternative investment funds (AIFs) accumulatively turn to credit markets through bond issuance, net asset value (NAV) facilities, capital call facilities, and subscription lines to diversify and optimize funding, as well as focus on credit investment strategies including private loans.

In this edition of Private Markets Monthly, Global Head of Private Markets Analytics Ruth Yang interviews five S&P Global Ratings subject matter experts on how we rate AIFs and analyze risks across fund financing.

How are alternative assets like AIFs adapting to evolving market dynamics?

Devi Aurora, Managing Director and Analytical Manager for Financial Institutions:  While the past decade of near-zero interest rates and relatively limited market volatility supported expansive fundraising growth for global AIFs, the uneven liquidity and strained valuations seen in today's challenging conditions are now changing the landscape. Fundraising for private equity and venture capital fell to a six-year low in 2023 in the face of higher-for-longer interest rates, persistent inflation, and sluggish economic growth. As such, newer funds have struggled to achieve the fundraising heights of their predecessors.

Andrey Nikolaev, Managing Director of Financial Institutions and Alternative Funds for Western Europe:  We see a number of AIFs making increasing use of NAV facilities to, among other objectives, return capital to their limited partners (LPs) in this environment of weaker deal activity. We also anticipate that private credit strategies—including direct lending, distressed debt, and secondaries—will continue to grow as choppy public markets globally and the tighter underwriting standards of banks in Europe provide new opportunities.

What is S&P Global Ratings' criteria for rating AIFs?

Nik Khakee, Managing Director, Methodologies:  While uneven liquidity and strained valuations have buoyed AIFs' latest push into private markets, S&P Global Ratings has provided transparency on this expanding market since 2006—and our coverage and criteria have evolved.

Thierry Grunspan, Director for Financial Institutions:  Across our publicly rated universe of global AIFs consisting of a dozen peers and our portfolio of AIFs with private ratings, AIFs are typically set up using fund structures with either buy-and-hold or complex trading strategies—the former of which are funds that focus on harvest investments, while the latter finance themselves with capital characterized by varying degrees of permanence and assets with considerable turnover. AIFs can invest in public markets (including listed equity, corporate bonds, and local and government bonds), private markets (most with exposure to alternative assets like private equity, direct lending or private debt, real estate, venture and growth capital, and infrastructure), and structured products (such as collateralized loan obligations, or CLOs).

Andrey Nikolaev:  We apply our global framework for rating AIFs (which we most recently updated in 2021) to various funds whose investment strategies span private and public equity, venture capital, and private debt, as well as hedge funds and other investment companies that share key characteristics of AIFs. Key rating factors include the fund's risk-adjusted leverage, funding, and liquidity. Our analysis calculates the stressed leverage for different types of funds, captures the risks relating to the funding and liquidity of different fund structures, and provides clarity on how we rate instruments issued by AIFs—and overall reflects funds' ability to repay recourse liabilities on time in a theoretical liquidation scenario following a 'BBB' or moderate stress.

Thierry Grunspan:  When assessing the creditworthiness of an AIF, we consider the investments it makes; the trading strategies it employs; the funding structures it maintains; asset liquidity, leverage (at the fund and asset level); and performance- and risk-management. We also run a quantitative cash flow analysis, comparing uses of liquidity in a stress scenario with liquidity sources. Types of transactions that we see within AIFs are senior unsecured debt raised in the markets; term loans, NAV facilities, and/or bank facilities; notes issued by feeder funds that flow into a master fund to facilitate investment by insurance companies; subscription lines of credit; and, although not as commonly, we can also rate junior debt or hybrids. Notably, we can only rate debt to the extent that we have an issuer credit rating (ICR), and debt is typically rated at the level of the ICR—but senior secured debt could be rated one notch higher with a sufficient level of over-collateralization , and junior debt could be rated one or two notches lower depending on the amount of priority debt and unencumbered assets.

Where does fund financing face the most risk moving forward, and what new products are emerging?

Andrew Watt, Head of Financial Services, Infrastructure, and Alternative Asset Ratings for the Americas:  Funding from certain sources will be more limited, as some established banks are reluctant to grow as a funding source and regulatory capital constraints are likely to further restrain funding options. However, this creates opportunities for a variety of alternative funding sources—the backdrop of higher interest rates, uncertain public capital markets, and pressure to realize returns for sponsors will ultimately lead to more funding and resourceful solutions providers in the private markets. The growth of various forms of NAV lending, as well as other related products, for general partners (GPs) and LPs seems likely. Still, complex solutions, rapid growth, and opacity can be ingredients for increased risk.

Devi Aurora:  Looking ahead through 2024, we expect that some AIFs will experience pressure and, in response to these market challenges, utilize debt as a means of investing in assets, returning capital to investors and limited partners, and supporting their squeezed portfolio companies. While decisions to assume more debt generally have negative implications for ratings, risks will vary according to each fund's strategy, strength, and reputation. We expect that most of the low-to-mid investment-grade ratings in the sector should be able to absorb AIFs' shift to long-term leverage, even as their foundations are tested by changing conditions, due to the flexibility that they'll have in maneuvering from the historically low levels of leverage seen in existing fund structures. Still, some will struggle and differences or divergences between funds will likely continue to grow.

Nik Khakee:  Fund ratings and the issue ratings we provide to NAV facilities and subscription lines continue to provide value to banks and insurers as they consider their capital allocations to this key area of their strategies. Market participants are focused on the growth in this sector: some came to the funds sector early (more than 10 years ago), and some are arriving to service funds now. This has naturally led to variation in lending documentation and structure, alongside triggers, and should make rating analysis even more useful as market participants seek to better understand benchmarks around which they set their particular financings. The different roles for banks and rating agencies are also evolving. The largest sponsors and GPs have been interacting with market participants for years now, and have some distribution capabilities of their own—but they also believe both banks and rating agencies remain important as they consider their distribution strategies. Finally, it appears that increasing complexity is likely, and this should be an area of analysis in which our experience may prove helpful.

Thierry Grunspan:  As a speaker at the Global Fund Finance Symposium in Miami this month, I shared our view that the lines between fund finance and CLOs/collateralized fund obligations are blurring, notably for funds of funds financing or credit funds. We see increasing interest for dual-pledge facilities (backed by the assets of the fund and uncalled LP capital commitments) as a way to manage the transition between the first years of the investment period to deep into the harvesting period (when most of the capital has been deployed). We also see a growing interest for rated feeder fund notes as a way for insurance companies to get the economic benefits of an LP interest in a fund while optimizing regulatory capital requirements.

Writer: Molly Mintz