(Editor's Note: Private Markets Monthly is a research offering from S&P Global Ratings, providing insightful interviews with subject matter experts on what matters most across private markets. Subscribe to receive a new edition every month: https://www.linkedin.com/newsletters/private-markets-monthly-7119712776024928256/)

Alternative investment funds (AIFs) are increasingly turning to credit markets through net asset value (NAV) facilities, capital call facilities (or subscription lines), and hybrid forms of these (which are often called dual-pledge facilities) to diversify and optimize their funding. Innovation is also emerging in the rapidly growing credit investment strategies market. At inception, funds use short-term subscription lines to fund their investments prior to capital calls from limited partners (LP)—secured against the uncalled capital from these same partners, with the lines' capacity diminishing as capital is called and extinguishing as the fund becomes fully deployed.

At S&P Global Ratings, our independent opinions on creditworthiness take a holistic view to provide greater transparency for the totality of private markets participants. Credit is credit—whether public or private, rated or unrated. In this edition of Private Markets Monthly, Global Head of Private Markets Analytics Ruth Yang interviews our analytical and methodologies leaders about S&P Global Ratings' recently released criteria for rating subscription lines and how we're adapting our ratings as fund finance evolves.

How are alternative investment funds utilizing subscription-line facilities?

Matthew Albrecht, Managing Director and Chief Analytical Officer for Financial Services:  At S&P Global Ratings, we're focusing more intensely on alternative investment funds—with a rapidly growing cohort of around 40 funds globally that are mainly confidentially-rated and investment-grade. These funds are investing in alternative assets across venture capital, private equity buyouts, unlisted illiquid debt, complex hedge fund strategies, and more.

Rated AIFs are typically structured with a master fund holding capital that's invested into a series of alternative assets, on which the fund relies to generate net return for its investors. Equity from general and limited partners alongside fund finance (meaning subscription lines, NAV facilities, bonds, and more) are providing sources of capital to these funds. Regardless of whether the capital is coming from traditional sources like banks or alternative capital providers, fund finance is most often secured by the assets, unfunded commitments of investors, or accounts of the fund.

At the incorporation or inception of the fund, subscription lines (which are also known as subscription facilities, or just sub-lines) are used to support asset purchases. Tranches under the facility are on a short-term basis of less than a year, secured by uncalled capital commitments. After the fund draws on a sub-line to invest, it pays down the liability by calling on LP commitments.

What is S&P Global Ratings' approach to rating subscription-line facilities within the umbrella of our alternative investment fund framework?

Russell Bryce, Managing Director for Financial Services Methodologies: 

Our subscription line criteria primarily addresses the likelihood that committed limited partners provide called capital when requested to allow for repayment of a subscription line on time and in full. We can rate a subscription line of credit at the fund's inception, even when some of the limited partners aren't yet confirmed and the fund hasn't yet invested in any assets.

To assign a rating to a subscription-line facility, we need the fund's investor letters, term sheet, facility agreement, all LP agreements and side letters, and any other relevant documents. We also expect to receive information about the general partner (GP) that manages the fund; details on the LP pool with the names of institutional investors and the amount they've committed to invest; and the fund's guidelines, financial reports, information about its strategy, and data on its historical performance or the performance of previous vintages.

While we don't need direct interaction with the GP to rate subscription lines—which is in contrast to our information requirement for assigning issuer credit ratings to funds—our view of the GP is likely to be neutral, at best, to the assessment without that interaction or other direct knowledge. Our assessment addresses the creditworthiness of LPs and considers the economic and reputational costs to LPs if they don't perform.

Nik Khakee, Managing Director for Cross-Practice Methodologies:  We use our CDO Evaluator to assess the capacity of funding available from diversified pools of LPs through their capital commitments. As LPs' invested capital increases over time, our assessment of willingness and structure could improve—which may result in higher rating outcomes if the increase isn't offset by deterioration in other relevant areas, like the fund's performance; the GP's reputation, track record, and size; or the experience and depth of the investment team.

Our criteria apply to issue credit ratings on a subscription line in four key circumstances: when it benefits from a first priority perfected lien on a closed-ended AIF's LP capital commitments; when we expect the primary source of repayment to be from calls on the LPs' undrawn capital commitments; when the lender has direct access to all LP capital flows; and considering that all LP capital must flow through cash accounts over which the lender has a first priority perfected lien or that are bankruptcy-remote from the fund.

When any of these conditions don't apply, we rate the facility based on our AIF methodology. The combination of the fund's structure, manager, asset base, capital sources, and leverage give us what we need to take a view of the creditworthiness of the fund and its liabilities through its lifecycle, and ultimately rate its fund finance obligations under our AIF framework.

How are our ratings adapting to meet the trends shaping fund finance in the private markets of today and tomorrow?

Will Edwards, Director of European Financial Institutions: 

We're watching the foundations of fund finance continue to shift with the rise of novel structures and changing security packages against a tough market backdrop, defined by a lack of exits squeezing liquidity. The sum of these trends is toward a greater amount of debt, with even more structural enhancement and diversity in the industry. We believe most rated funds can handle the additional leverage we're seeing in the market, and that our framework can incorporate conditions that are pushing funds toward debt.

While funds have never been larger, exits are at a multi-year low—and this weak deal environment increases the pressure on funds from investors to protect or return capital by taking on more debt. We see AIFs drawing on debt facilities secured by their investments to provide optionality in sending cash back to LPs, satiating investors' demand for returns in the absence of monetizations. More commonly, draws enable investment directly into existing assets without demanding more cash from equity providers.

Positively, we expect most rated AIFs will be able to handle rising leverage and maintain their investment-grade ratings because our framework already addresses concerns around leveraged asset valuation. The minority of funds with financial risk associated with potential ratings below investment-grade would not be able to turn to debt to unlock their liquidity without seeing weaker ratings outcomes. In our view, the private capital market is likely to be able to sustain more debt, given an unlevered start point and tentatively improving conditions for some funds—despite the pockets of the rated and unrated world that are already more levered.

Rising fund-level debt creates opportunities for innovation in how capital is structured for funds. We are observing that AIF structures are gradually introducing mechanisms from elsewhere in finance, like structured technologies, to enhance the position of their creditors as a way to attract new capital or preserve existing investment. Previously single-tranche secured funding is now in multiple tranches—where senior tranches take priority over asset cash flows and maturity is closely aligned with that of the fund's asset base. Put in simple terms, these features resemble collateralized loan obligations (albeit typically without the presence of a trust, indenture, or other structural components) despite still being in a credit strategy fund structure.

As fund finance structures are changing to enhance the standing of certain creditors, we're also seeing creditors begin to lend against increasingly broad security packages. In a traditional model, a fund will have distinct funding lines that are secured against different fund claims and assets. This is because the security available to lenders shifts across the fund lifecycle, and having these sources of capital as distinct lines makes sense as they meet different needs. The drawbacks to this approach can appear as administration for the fund (in having two subscription lines that they pay fees on simultaneously, which can drag on returns) and exclusion (where certain assets are left out of a security package).

Matthew Albrecht:  We're seeing a growing niche of funds intuitively moving toward a single facility, with a broader security package spread across uncalled capital and NAV facilities, to take advantage of the flexibility and simplicity across its lifecycle.

Our ratings can positively reflect the features that would make this funding attractive to lenders. We see a high amount of overcollateralization that is, importantly, overlaid with the potential to have a material amount of accessible and committed funding available to repay creditors at facility maturity. This is a strong enhancement that can uplift ratings more than our typical potential benefit to ratings from overcollateralization.

Nik Khakee: 

Our ratings are adapting to meet the evolution of the fund finance market foundationally, along with the greater amount and diversity of debt that we expect to see across private markets broadly.

Writer: Molly Mintz