Fitch Ratings, a global leader known for publishing forward-looking credit ratings on the relative ability of an entity or obligation to meet certain financial commitments, has entered the global advancing market that is subscription finance facilities (“SFFs”). Just last week, Fitch Ratings published of a draft set of ratings methodology. The ratings agency is now actively seeking comment to the document until March 19, 2023. Notably, a second global rating agency, KBRA plans to release its own methodology for the product, and Fitch Ratings is also considering a similar methodology document for NAV loans. So what does this mean? For starters, lenders can be optimistic about the advent of ratings for the SFF credit instrument, which will help broaden the investor base and ease supply side constraints resulting from the most active lenders in the market reaching concentration limits, balance sheet capacity and risk-weighted asset requirements at the second half of 2022. It also opens to door to the potential of a capital markets exit of the product – with the product itself being distributed to deploy additional capital in a secondary type market...

The timing could not be better. By year-end, Basel III reforms (or, Basel IV) is expected to increase risk-weighted asset capital requirements for globally systematically important banks, which have been keen on finding solutions. While some bank lenders have sought out non-payment insurance and credit-risk-transfer deals to free up their respective balance sheets, other participants have suggested the securitization of the SFF market. Still though, a workable long-term solution in response to the new regulatory regime has yet to come forth. Perhaps, a capital markets based solution may be exactly what the space needs in order to satisfy the demand that currently exists in the SFF product, but for one reason or another, cannot be deployed in the current environment.

Henceforth, using the proposed Fitch Ratings’ methodology, the private capital market will be able to assess the credit quality of SFFs specific to their funds’ obligations backed by capital call commitments, from the manager level down to the fund level and then further to the limited partner level. To arrive at a quantitative rating indication (“QRI”) of a SFF, Fitch Ratings will look to the following process, highlighting certain key rating drivers:

• Fitch Ratings will review the capabilities of the SFF’s originator/lender as well as the organizational and governing documents of the fund. Stronger lending covenants reduce the risk of the facility by controlling the quality of the LP base or the size of the loan relative to collateral, limiting the lender’s exposure period, reducing default risk and providing the lender additional rights.
• Fitch Ratings will classify and assess the Limited Partner Pool Quality depending on public or private ratings assigned to the LP by Fitch, Moody’s or S&P. If the LP rating cannot be derived, Fitch will look to the entity type as well as a suite of other factors centered around the entity’s historic performance, assets under management and usage, and will then assign a tiered rating from ‘CCC’ to ‘BBB-’ per LP.
• Fitch Ratings will then differentiate results derived from Fitch’s Portfolio Credit Model (“PCM”), used to project LP capital call defaults and potential losses at the applicable rating levels, to the over-collateralization corresponding to the maximum permitted borrowing specified in the fund documentation to provide a QRI. The main drivers for assessing projected defaults are the LP rating assumptions and domiciles.
• After assigning the QRI, Fitch Ratings will review the manager, fund and documented facility structure in order to adjust the QRI by notching up or down as well as consider implementing a cap for the SFF rating as applicable (i.e. capping the SFF rating at ‘AA+’ if more than 20% of the LP pool is unrated). Certain factors of the manager rating include resources and scale, franchise and fundraising ability and historical performance. When looking at the Fund, Fitch will assess strategy, alignment with the manager and/or sponsor, funded percentage, performance and, default remediation provisions.
• Fitch Ratings will then analyze the SFF’s sensitivity to additional scenarios and stresses linked to the credit product. This testing may include additions/subtractions to the LP pool, revisions in default and recovery assumptions in PCM, internal or external changes/pressures on the manager, performance changes impacting incentives for LPs to satisfy capital calls, and material alterations to the facility terms themselves via amendments.
• Fitch Ratings will continue to monitor the SFF’s ongoing performance after initial rating assignment in line with any updates to the collateral pool, structure and modeling, or changes to the manager. Ratings are to be reviewed at least annually and on an ad-hoc basis coinciding with material changes to the SFF or macro-economic conditions.

While Fitch Ratings continues to work out any wrinkles in the methodology and other rating agencies prepare to enter the SFF space, it is important to recognize that the space for SFFs has evolved and continues to see tremendous growth, with SFF origination from $400 billion in 2017 to around $750 billion at the end of last year. Could SSF ratings change the game and take that number even further? Only time will tell!