The growth of private credit has fueled an expansion of investment vehicles offering a range of investment objectives with different liquidity and risk profiles. While the underlying assets may be similar in some cases across investment vehicles, the issuer's structural features and level of flexibility of the fund manager can influence our credit rating analysis.
For example, common vehicles investing in middle-market loans include collateralized loan obligations (CLOs), business development companies (BDCs), and open- or closed-ended private credit funds, each of which S&P Global Ratings considers through a different analytical approach. Our sector-specific methodologies describe our analytical framework for assessing the creditworthiness of each of these investment vehicles. Here, S&P Global Ratings presents frequently asked questions from investors about the differences in how we rate common types of private credit investment vehicles.
Frequently Asked Questions
What are the structures--and their influence on credit profiles--of private credit investment vehicles?
Structured finance vehicles like CLOs seek to mitigate certain risks by establishing an insolvency remote special purpose entity (SPE) where the roles and responsibilities of each transaction party, portfolio eligibility criteria, and allocation of cash flows are contractually defined. The senior-most tranche of a CLO can be (and often is) consistent with our 'AAA' rating because of its structural protection.
BDCs typically choose to be treated as registered investment companies (RICs) and must adhere to certain rules under the Investment Company Act of 1940, including leverage restrictions, but may invest in the debt and equity of the same or different companies. While leverage (measured as debt to adjusted total equity) of a BDC is lower than the total leverage of a CLO, we think the investment portfolio risks are higher. We also see more reliance on the fund manager to manage certain risks when compared to the structural mitigants we commonly observe in CLOs. Thus, we typically rate senior unsecured bonds issued by BDCs in the 'BBB' category.
Compared to CLOs and BDCs, private credit funds' managers generally have more flexibility in determining both the portfolio composition and capital structure. While credit-focused funds may invest in similar assets as CLOs and BDCs, they generally aren't restricted in the way they are funded or capped on the types of risks they can take. Instead, we see a wide range of structures and risks, which leads to a broader range of rating outcomes.
There are also hybrid private credit funds that don't meet all of our criteria for us to rate them as CLOs, but that do seek to mimic some features of CLOs (such as funding with permanent or long-term equity capital to reduce the risk of forced liquidation, including interest and principal coverage tests, or including strict portfolio investment rules). We may rate hybrid structures at higher levels than typical private credit funds if they're successful at mitigating risks, but we may not rate them as high as the senior-most tranche in a CLO.
What does S&P Global Ratings consider the key differences among CLOs, BDCs, and alternative investment funds (AIFs)?
BDCs. BDCs have leverage constraints informed by regulation. BDCs, by regulation, were initially set up to encourage investment in small and midsize companies in the U.S. They typically also choose to be treated as RICs, like REITs, which are more tax-efficient investments for investors by eliminating corporate taxation as long as they distribute at least 90% of their profits every year as dividends. BDCs may also be publicly traded, like some AIFs but unlike CLOs.
Given that BDCs can invest in both debt and equity, BDCs may serve as a warehouse where investments are collected before being refinanced. In addition, given their ability to invest in equity, BDCs may also be used to finance the equity portion of structured financings or other funds, including the equity tranche of a CLO, although we would deduct the equity invested in another vehicle if the vehicle is leveraged (so that the equity isn't leveraged twice). These are asset risks typically not seen in CLOs or private credit funds. While some assets may be similar between the vehicle types, BDCs can take meaningfully greater asset risk than CLOs. Notably, BDCs typically do not have asset–liability management guidelines about whether investments mature before liability payments are due to be paid.
We apply our financial institutions framework to BDCs in part because they are less structured (meaning they have more flexibility) compared to CLOs, but are subject to some constraints, including on their portfolio mix and leverage. Like our approach to other nonbank financial institutions in the scope of our "Financial Institutions Rating Methodology," published Dec. 9, 2021, we start with an anchor to reflect BDCs' exposure to common economic features, but greater competitive and funding risks compared with banks, among other differentiators.
CLOs. We calibrate our CLO ratings methodology to reflect our experience rating corporate loans through our default and transition studies, which measure the likelihood of corporate defaults at various rating levels, as well as our credit model that addresses the potential correlation of defaults. In order to use our credit model, we require a rating input for each obligation, which is typically an S&P Global Ratings' credit rating or S&P Global Ratings' credit estimate for CLOs. Our recovery studies inform our forward-looking view of recovery assumptions at various stress levels.
Our collateralized debt obligation (CDO) Evaluator enables us to look into the distribution of simulated potential outcomes and apply stress scenarios (in the tail of the distribution) when considering ratings. This enables structuring of financing to different ratings levels for tranches with various levels of leverage--the financing capital structure. It is conceptually possible to apply our CDO Evaluator to a BDC portfolio, but equity investments, or any other unrated investments, would require separate analysis, and the BDC would need to eliminate risks that are mitigated by the structure that governs CLOs.
The tradeoff is that 'AAA' and 'AA' rated financing becomes possible in CLOs in exchange for specific documentation that ensures bankruptcy remoteness and establishes clear payment priority order to provide structural protection through subordination. These legal documents establish binding covenants and remedies triggered when covenants are breached, which we can capture and represent in our models.
CLOs have very clear asset-liability management guidelines to ensure investments mature before liability payments are due to be paid. As such, mark-to-market does not factor into our analysis, nor do market value stress assumptions since we don't expect assets to be liquidated to meet debt payments. The well-defined contractual rules of a CLO allow us to apply this credit modeling framework to assign ratings.
AIFs. AIFs were initially largely focused on equity investments, but more recently, private equity firms have recognized them as another financing platform that they can use to provide debt funding for their investments. AIFs do not typically have the level of legal guidelines that resemble CLOs. But they have guidelines--driven by investor preferences--that limit leverage and redirect earnings when applicable limits need to be addressed. As a result, an AIF can be as flexible as a BDC or as prescriptive as a CLO.
Our criteria and potential ratings outcomes reflect this range of possibilities. Where appropriate, we apply market value-driven stress assumptions to asset valuation--for equity as well as credit investments. When asset-liability management ensures that assets mature before debt payments, we may choose a CLO-informed approach to modeling risk for an AIF, and not market value analysis, because the mark-to-market and stress liquidation analysis is not relevant. When the AIF is more structured--such as funding with liabilities longer dated than asset maturities--we may apply tools we use when assessing CLOs, such as the CDO Evaluator. As a result, financing leverage of AIFs can look similar to CLOs. In a sense, this enables hybrid AIFs to be between BDCs and CLOs in terms of ratings.
AIFs can choose whether funding is through public or private placement. In addition, AIFs can choose to be subject to regulation, and we rate some that are subject to the Investment Company Act of 1940. Our analysis incorporates where on the spectrum each fund places itself in terms of investment vehicle guidelines and financing structure.
Table 2
| Common features of private credit investment vehicles | ||||
|---|---|---|---|---|
| Vehicle type | Funding and investment flexibility | Nature of S&P Ratings' risk assessment | Other considerations | General typical senior class rating levels (in order of prevalence) |
| BDCs | Driven by regulation - regulatory leverage limit (150% or 200%). Up to 30% can be nonqualifying investments (equity in joint ventures, structured vehicles, non-U.S. companies, etc.) | FI Framework, not asset specific, correlation is not measured. Ratings driven by an anchor-based starting place informed by country risk (of investments). Funding maturities are not assessed relative to asset maturities. | RIC tax exemption on dividends generated from interest income. | BBB |
| CLOs | Capital structure heavily informed by simulation models. Reinvestment limitations based on monitoring tests informed by model output and remedies triggered when covenants are breached. Legal requirements and guidelines related to asset isolation and bankruptcy remoteness. | A modeling approach to assess asset risk driven by corporate default and recovery studies as well as focus on the tail of simulated outcomes. Model-informed ratings that assess the ability of each tranche to sustain cash flow stresses caused by interest rate changes, currency movements, and the default timing of the portfolio. | SPEs to ensure bankruptcy-remoteness. | AAA, AA |
| AIFs | Investment guidelines specific to investor preferences. Investor-driven covenants inform leverage limits. Documentation specifies remedies upon covenant breaches. | Asset market value type haircuts to credit and equity investments when funding maturities do not exceed asset maturities. Credit loss simulation possible when funding maturities exceed asset maturities. Model-informed initial rating starting place, after which qualitative assessments adjust final rating. | Funds are not SPEs but are more limited in flexibility relative to a corporation. | BBB, BB, A |
Similar investments – such as middle-market loans – can appear in BDCs, CLOs, and AIFs. It is the nature of the financing (i.e., the choice of the investment vehicles themselves) that differentiates them. Our analytic approach reflects the differences in the financing platforms through which similar investments may be funded.
A key difference in our analysis is the modeling approach for assessing asset defaults and recoveries in a CLO versus our approach to BDCs and AIFs. The modeling approach is enabled by the well-defined scope of investments in a CLO, as well as our requirement that we have a view on the individual creditworthiness of every obligation. With those constraints and inputs, we can rely upon our default and transition studies to assess the level of defaults likely to affect the portfolio in a given stress scenario. Absent those constraints, which may mean a wider range of investments (potentially including equity), asset liquidation risk, or other risks not mitigated contractually, we use frameworks to rate BDCs and AIFs that capture those risks. These frameworks may make assumptions about the average risk across an investment type or the value of an asset in a liquidation scenario.
In our view, while the nature of assets matters--such as equity or debt securities--how assets are financed is also key to our analysis. The investment vehicle, and its lack of or presence of legally binding financing structure and portfolio management rules, is crucial to our analytic approach and the potential rating outcomes.
In general, we expect to view BDCs as riskier than banks and thus to rate BDCs lower. We expect to rate AIFs in a broad range of categories, given the wide variety of assets and structures we have observed. Our ratings on private credit vehicles are likely to be lower than our ratings on CLOs. However, by how much will be informed by the vehicle's investment portfolio guidelines and the vehicle and financing structure's level of flexibility.
How does S&P Global Ratings decide to assign issue-level or issuer credit ratings to an investment vehicle?
An investment vehicle's structure determines the types of ratings that we assign.
Structured finance vehicles including CLOs have predetermined capital structures, finite lives, and a defined asset mix. As such, at the initiation of the structure, we have all the information necessary to assign issue ratings to issued tranches. Structured issue ratings then move over time based on their likelihood of payment, considering senior and junior claims on cash flows or risks in a structure.
We follow a rating approach for BDCs and AIFs that is more like a traditional corporate issuer credit rating (ICR). The manager has the ability to modify the capital structure, asset mix, and other factors after the vehicle is launched. While BDCs are generally meant to be permanent capital vehicles, AIFs can be either permanent capital vehicles or have a limited life, like a CLO. Still, within that limited life, the fund managers typically have the flexibility to modify a range of factors within the parameters of the investment mandate, including a fund's capital structure.
Therefore, we assign an ICR to the BDC or AIF. The ICR acts as a reference point for all relevant issue ratings, which can be in line with the ICR or higher or lower, based on seniority in the capital structure and asset security, among other factors. The issue ratings can then move up or down in line with ICR movements or based on issue-specific risks. In some cases, where private credit funds mimic some features of a CLO and the structure supports tranches, we could use our CDO Evaluator to assess the creditworthiness of each funding tranche. In those instances, the ICR represents the senior class of creditors to the fund.
How does S&P Global Ratings rate a CLO?
We rate CLOs by applying our "Global Methodology And Assumptions For CLOs And Corporate CDOs," published June 21, 2019. CLOs typically issue multiple tranches of rated debt through a bankruptcy-remote SPE and pay interest and principal on a sequential basis, providing credit enhancement that can support high investment-grade ratings on senior liabilities.
The issuance proceeds from the liabilities are used to purchase a portfolio of publicly traded corporate loans and bonds or, in the case of middle-market CLOs, privately originated loans in the direct lending segment of the private credit market. Proceeds from asset maturities are the primary source of funds used to redeem the liabilities. In other words, the portfolio is self-liquidating, mitigating market value or refinancing risks that may be present in other private credit investment vehicles.
While CLOs are typically actively managed during a four- to five-year reinvestment period, the asset manager must maintain compliance with the eligibility criteria, portfolio profile tests, and reinvestment conditions outlined in the transaction documentation. Our analysis considers how the deal's risk profile is likely to evolve over time considering these requirements. In addition, transaction documents typically contain specific mitigants for certain credit, funding and liquidity, legal, operational, and counterparty risks, which may come at the expense of less flexibility for the asset manager but have a positive influence on creditworthiness, in our view.
Our methodology for rating CLOs relies on our assessment of the creditworthiness of each underlying borrower as a key input to derive scenario default rates (SDRs) on the portfolio using our CDO Evaluator model. Because the borrowers in a middle-market CLO are not typically publicly rated, we assign a credit estimate to each borrower. We calculate a weighted average recovery rate on the portfolio using our recovery ratings assigned to each loan or, in the absence of a recovery rating, based on the recovery assumptions outlined in our CLO criteria, which consider the type of asset, the jurisdiction, and the seniority as key determinants.
To assess the creditworthiness of each tranche in a CLO's liability structure, we apply cash flow stresses to generate a breakeven default rate (BDR) using the interest generated by the portfolio over time and our weighted average recovery rate assumption, and by modeling a series of interest rate curves and default timing patterns. In addition, if we view foreign exchange risk as material with no related structural mitigants, our analysis considers the resilience of each tranche to potential foreign currency movements.
We would typically assign a rating to a CLO tranche where the maximum amount of defaults it can withstand in our stressed cash flow analysis (i.e., the BDR) is higher than the corresponding SDR for a given rating level calculated in our CDO Evaluator.
How does S&P Global Ratings rate a BDC?
We rate BDCs by applying our "Financial Institutions Rating Methodology," published Dec. 9, 2021. We apply this framework to financial institutions (FIs), which we define as banks as well as nonbank financial institutions such as securities firms and finance companies (which include BDCs) when we consider that their greatest risks relate to asset quality, funding and liquidity, and tangible capital.
As discussed above, BDCs (and other finance companies) differ materially from AIFs and CLOs. BDCs elect to be subject to regulation under many of the provisions of the Investment Company Act of 1940. A BDC's failure to maintain an asset coverage ratio above regulatory limits can result in restrictions on new investment activity, and may lead to debt acceleration on its revolving facilities. Given the potential regulatory-driven intervention, we assess BDCs through our FI framework since, as for banks, regulation may play a role in future activity.
We set the preliminary anchor for finance companies--including BDCs--three notches below our bank anchor. We do this because we view these entities as subject to less regulatory oversight and likely to invest in assets with higher risk (lower asset quality) relative to banks. We may adjust the anchor positively to reflect a BDC's commitment to maintain significant cushion relative to regulatory leverage limits, for example when a BDC maintains a 200% asset coverage ratio.
Conversely, we may adjust our capital and earnings assessment negatively when BDCs approach regulatory leverage limits. Given that the anchor for BDCs already reflects heightened business risk, our view of capital and earnings reflects the relative strength of the BDC's capital and earnings when compared with other nonbank financial institutions.
For BDCs, we use leverage as our basis for the capital and earnings assessment because they mainly invest in leveraged loans, and in some cases second-lien loans and/or equity. Similar to other ratings to which we apply our FI framework, we consider strength and stability of earnings, sufficiency of earnings to support balance sheet growth, and the issuer's willingness and ability to build capital. This last point is typically less available to BDCs since the regulatory framework requires payout of the vast majority of earnings.
As noted above, we assess BDCs relative to banks, so we also consider their lending and underwriting standards relative to banks. This, in addition to investment concentrations and mark-to-market volatility, may affect our view of a BDC's risk position.
In our funding and liquidity assessment for BDCs, we make a qualitative assessment of how well the assumptions made in the stable funding ratio (SFR) represent the BDC's funding position, as well as BDC-specific funding strengths and weaknesses. We also consider the reliability of funding sources over time. To assess a BDC's liquidity, we use our liquidity coverage metric (LCM), but also consider qualitative factors when relevant. We may view a BDC's liquidity as weaker if it faces imminent debt payment acceleration or loss of access to its credit facilities when the acceleration could result in essentially all borrowings outstanding being immediately due and payable.
How does S&P Global Ratings rate an AIF?
We use our "Alternative Investment Funds Methodology," published July 26, 2024, to analyze the creditworthiness of AIFs, which are typically set up through a fund structure, with investments in private equity, venture capital, private debt/credit, structured finance, real estate, infrastructure, multi-strategy hedging, or other funds, among other strategies. In contrast with a CLO, AIFs rely heavily on the fund manager to actively manage the portfolio against its investment mandate and to manage risk, including those related to liquidity, investor redemptions, and counterparties.
Our global AIF framework describes how we calculate stressed leverage for different types of funds; how we holistically capture the risks related to the funding and liquidity of different fund structures; and how we incorporate qualitative assessments for our ratings on instruments issued by AIFs, including their net asset value facilities. Alongside the diversity and stability of a fund's funding and liquidity, our rating analysis reflects a fund's ability to repay its recourse liabilities in a hypothetical liquidation scenario following 'BBB' or moderate stress (informed by conditions observed during 2007-2009 financial crisis).
For funds that use more transparent, traditional strategies and have asset profiles that do not change significantly over a short time horizon, we typically determine the stressed leverage assessment by haircutting the assets to reflect the impact of a 'BBB', or moderate, stress scenario and compare the ability of stressed assets to cover total recourse liabilities. The haircuts vary depending on the nature of the assets, but typically reflect our view of the expected market value of those assets when we believe asset liquidation risk exists. Liquidation risk may exist because of the nature of the assets (e.g., equity investments), an open-ended funding structure that exposes the fund to the risk of investor redemptions (for which they may have to liquidate assets), or the presence of asset-liability mismatches (at the fund or at the asset level through repos).
Conversely, when the risk of liquidation is not present, we expect the fund to be able to hold assets to maturity and therefore use haircuts that approximate loss due to defaults that we determine using our CDO Evaluator, as opposed to haircuts that reflect the risk associated with the liquidation of portfolio assets. This may be the case for funds that invest in credit instruments such as private loans that have permanent capital, strong legal features governing the distribution of cash flow, and where the risk of asset liquidation has been mitigated.
How does S&P Global Ratings rate vehicles that have a combination of CLO and AIF characteristics?
For these hybrid structures, we may determine the applicable analytical approach on a case-by-case basis depending on the structure's risks and mitigants. For example, when we believe a fund has some characteristics of an AIF but the structure supports tranches, we could assess the creditworthiness of each funding tranche.
For example, we could use our CDO Evaluator model to assess the stressed leverage for each tranche to represent the potential rating level when the assets are rated; all creditors are secured; a creditor class subordination structure is established; intercreditor relationships are clearly defined, including nonpetition assurances; limitations on additional debt are legally defined; and all of this is included in legally binding documentation.
The other elements of our AIF framework, such as risk position, still apply and could result in tranche ratings lower than the preliminary indication based on model output. This is similar to how we incorporate stressed leverage based on market risk into our overall fund rating analysis for other AIFs.
Finally, when we believe a fund is bankruptcy-remote, we may choose to rate it by applying the CLO criteria or other structured finance methodologies, depending on the assets.
How does S&P Global Ratings expect evolving regulations to affect private credit investment vehicles?
We have observed rapid growth in private credit investment vehicles in the past few years as the echoes of the 2007-2009 global financial crisis continue to drive tighter bank capital regulations, often pushing risks away from the regulated institutions and directly to investors. For example, we think the latest Basel III proposals may reduce banks' ability to use internal models based on their own experience to optimize their risk-weighted assets versus the standardized approach (see "Credit FAQ: How The U.S. Proposes To Implement Basel III Capital Rules And The Impact On U.S. Bank Capital Ratios," published Jan. 11, 2024).
We also expect new bank regulation to drive the growth of synthetic risk transfers, in which banks transfer a portion of the credit risk, often the first-loss position on loans or securities, to third parties. These transfers may also be an attractive investment for some investment vehicles, though largely in the private credit fund space (see "ABS Frontiers: Looming Basel 3.1 Rules Could Incentivize More Bank Securitization," published June 3, 2024). While the specifics and implementation timelines of the capital rules vary by country, we expect private credit investment vehicles will continue to flourish as regulations evolve.
Related Criteria
- Alternative Investment Funds Methodology, Aug. 30, 2024
- Financial Institutions Rating Methodology, Dec. 9, 2021
- Global Methodology And Assumptions For CLOs And Corporate CDOs, June 21, 2019
Related Research
- ABS Frontiers: The Blurring Of Private Credit Funds And CLOs, Jan. 30, 2024
This report does not constitute a rating action.
| Primary Credit Analysts: | Matthew B Albrecht, CFA, Englewood + 1 (303) 721 4670; matthew.albrecht@spglobal.com |
| Cian Chandler, London + 44 20 7176 3752; ChandlerC@spglobal.com | |
| Secondary Contacts: | John Finn, Paris +33 144206767; john.finn@spglobal.com |
| Nik Khakee, New York + 1 (212) 438 2473; nik.khakee@spglobal.com | |
| Russell J Bryce, Charlottesville + 1 (214) 871 1419; russell.bryce@spglobal.com | |
| Matthew S Mitchell, CFA, Paris +33 (0)6 17 23 72 88; matthew.mitchell@spglobal.com |
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