More common in Europe, the prevalence of obtaining credit ratings for subscription credit facilities has increased in the United States. In this Legal Update, we explain the increasing use of credit ratings for a subscription credit facility, factors that impact the credit rating, the benefits of a subscription credit facility credit rating, and what to consider if pursuing a subscription credit facility credit rating.
Rating agencies typically provide credit ratings for most of the investors whose capital commitments serve as collateral for subscription credit facilities, but, until recently, it had been relatively uncommon for a US subscription credit facility itself to obtain a credit rating. While more familiar in the European market due to insurance companies participating in subscription credit facilities originated by European lenders, there has been a recent increase in rated subscription credit facilities in the United States as well. As noted by KBRA in its recent report on subscription credit facility credit ratings, the increased use of creditratings for subscription credit facilities is driven in part by an increase in alternative capital providers in the market, some of whom prefer to invest in rated investment products because of regulatory requirements and favorable capital reserve requirements, such as regulated insurance companies. As market forces have reduced the amount of available capital provided by traditional financial institutions, sponsor demand for funding from alternative sources such as insurance companies is expected to grow.
KBRA currently maintains active ratings on more than 40 subscription facilities, including traditional capital call and hybrid facilities, with credit ratings ranging from BBB to AA- for such facilities. In addition to KBRA, Fitch recently published an exposure draft of their rating criteria for subscription credit facilities and we understand Fitch will start rating subscription facilities soon.
Relevant Factors for Rating a Subscription Credit Facility
If a lender or a facility sponsor seeks a credit rating, several quantitative and qualitative factors impact that assessment.
- Credit quality. Facilities that have highly rated investors and high diversification levels will, in turn, have higher credit ratings. High-net-worth individuals or investors with little information will receive lower credit ratings than investors that are publicly rated, have available financial information, have long track records of investment performance, and establish relationships with the sponsor. The presence of unrated investors, however, does not automatically mean the facility will have a lower credit rating. Unrated investors will be classified and given an assumed credit rating. If a rated entity guarantees the unrated investor, the guarantor's credit rating will apply. An unrated investor that is a subsidiary of a rated entity will typically see the rated parent's credit rating assumed with a small reduction. The highest credit rating Fitch will assign to an unrated investor, according to its exposure draft, is BBB-.
- Projected capital call defaults and losses for various investor credit rating levels. Rating agencies project capital call defaults of the facility's limited partners via internal modeling using past performance and reputational or relationship considerations. A limited partner that fails to fund a capital call will likely be excluded from future fundraising with that particular sponsor in addition to potentially facing difficulties accessing private capital opportunities with other funds. The probability of the limited partners in a particular fund defaulting on their commitment is aggregated and weighted by the size of the respective commitments. If defaults are estimated to exceed a particular percentage for a given investor credit rating level, then ratings agencies may conclude there is no viable recovery if an investor defaults and the facility's overall credit rating will be limited.
- Quality of Commitments. A diverse investor pool mitigates potential non-performance of any one investor. The investor documentation also impacts a subscription credit facility's credit rating. Side letter provisions that potentially reduce an investor's obligation or incentive to fund capital calls, as well as provisions that reduce the manager's or lender's ability to enforce capital calls, will reduce that particular investor's underlying credit rating. For instance, a side letter that includes limitations or conditions on the fund's ability to enforce capital calls or remedy capital call defaults, will yield a reduced credit rating for the subscription credit facility.
- Fund manager's and fund's characteristics. When assessing the capabilities of the fund's manager, rating agencies will look at its resources, scale, franchise and fundraising, and historical performance. Rating agencies will also look at the structure of the fund, including its strategy, whether the manager's experience aligns with the fund's target market, prior performance, operational capabilities, and the percentage of remaining capital calls that are unfunded. A legal review of the fund's documents is conducted to ensure the fund has the ability to borrow, grant security interests in the capital commitments, pledge the right to call on the investors, pledge the right to enforce the capital commitments, and enforce related remedies against a defaulting partner. The jurisdiction of formation for the fund, the strength of the defaulting investor remedies, and the general partner's right to remedy defaults (e.g., overcalls, forfeiture of defaulting investor's interests, and legal recourse) in its partnership agreement all affect the overall credit rating.
- Structural terms of subscription credit facility. Rating agencies will consider the subscription credit facility's size, clean-down intervals, the lender's legal counsel, and facility tenor, as well as any covenants in the facility documentation that limit borrowing or any pre-approval requirements for certain amendments. The uncalled capital commitment coverage relative to the facility size and covenants requiring certain net asset value ratios and indebtedness thresholds collectively measure a fund's ability to repay the facility and, where favorable, further boost credit ratings.
The quantitative factors are aggregated to produce a total credit rating that is then adjusted for the qualitative factors and asymmetrical risks. The facility undergoes continuing scrutiny, typically in the form of annual reviews, which can adjust the final credit rating over time.
Benefits of a Subscription Credit Facility Credit Rating
In some situations, subscription credit facility lenders and sponsors may want to go through the extra effort of obtaining a credit rating for the facility because of the benefits the credit rating can offer, such as:
- Increased marketability. Some nontraditional lenders, such as insurance companies, are limited to investing in rated debt instruments and are subject to capital reserve requirements, which can be lower for rated instruments. By obtaining a credit rating, the facility expands the pool of potential investors, including nontraditional lenders in regulated industries. Recent market developments have included reductions in exposure to subscription credit facilities by some market lenders and exits from the market by other lenders. Rated facilities could counteract some of the impact of these developments by bringing non-traditional lenders to the market.
- Distributes risk. Some investors, such as insurance companies and secondary institutions, have capital reserve and risk-based capital requirements that limit the amount they can invest in unrated debt and equity instruments. A credit rating for the subscription credit facility may enable these investors to satisfy these requirements and invest in subscription credit facilities, which they otherwise might not be able to do. As a result, they can further diversify their risks.
- More favorable pricing. Because a favorable credit rating can increase confidence in the subscription credit facility, it may enable the facility sponsor to seek more favorable pricing relative to unrated facilities.
- May assist with lenders' underwriting efforts. Underwriting is a vital part of the diligence process that enables lenders to assess the risk associated with a credit facility. Credit ratings offer a third party's assessment of the risk for the subscription credit facility that can help the underwriting process because the underwriter won't need to assess individual limited partners' ratings.
- May help facilitate securitizations of subscription credit facilities. Obtaining a credit rating for the subscription credit facilities backing a securitization transaction will facilitate the rating of the debt obligations issued in that securitization and may broaden the securitization investor base. Additionally, a rated subscription credit facility may be more likely to satisfy eligibility requirements for inclusion in a collateralized fund obligation.
Lenders and sponsors seeking a credit rating for the subscription credit facility should consider:
- When to seek the rating. The sponsor may engage the rating agency after closing the subscription credit facility, though sometimes this will happen before closing with the rating agency attempting to anticipate the final limited partner list. Since this is not a point-in-time rating, the facility's credit rating can change based on new investors, the underperformance of the sponsor, market uncertainties, and other fluctuations.
- When and how to involve rating agencies in the process. It's recommended to have ratings agencies in mind during the documentation process. Rating agencies will typically review the legal documents governing the fund and the facility, including any limited partnership agreements, subscription agreements, management agreements, legal opinions, notices to regulators, and other related documents. Legal counsel for the sponsor and lenders should consider explicitly permitting disclosure of the loan documents to ratings agencies when preparing the fund and facility documentation.
The use of credit ratings for subscription credit facilities continues to increase not only in Europe, where they have been traditionally used, but also in the United States. A credit rating may improve the facility's marketability and broaden the pool of possible investors for such a facility; however, obtaining a credit rating may not be necessary—or advisable—for all credit facilities. Therefore, facility sponsors should consider the potential benefits, along with the challenges, before undertaking the credit rating process.
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