Fund interest ABS space hit by tough exit climate: Fitch

The ratings agency's report finds distributions for notes backed by fund stakes fell due to decline in deals.

A steep drop in private equity exits is putting a damper on distributions available to fund interest asset backed securities (ABS), according to a study by Fitch. The study states that exit activity across Q4 2022 and Q1 2023 fell to its lowest since H1 2020, a period marked by the start of the covid-19 pandemic.

Fitch gleans its insights from tracking the activities of fund ABSs that it publicly rates, says Greg Fayvilevich, who heads its global funds group. (Fund ABSs are commonly referred to as collateralized fund obligations. Private Funds CFO uses the term fund ABS to avoid confusion with the acronym for chief financial officer.)

The fall in underlying fund distributions for fund ABSs should be familiar to anyone who has followed the downstream effects on regular investors.

The ratings agency’s findings are consistent with a PE market report that Bain & Company released last month. It shows that buyout-backed exits in H1 2023 plunged by 65 percent year-on-year, down to $131 billion.

The consulting firm also found that buyout funds had $2.8 trillion in unrealized value represented by about 26,000 portfolio companies. Most of these companies were either near or beyond the industry’s common five-year holding period.

Meanwhile, the seven fund ABSs rated by Fitch showed signs of relative stability in other key areas. The report states that their pace of distributions has outpaced that of their capital calls – and this speed has been enough so that the fund ABSs haven’t needed to tap contingent liquidity facilities.

Fitch also says that loan-to-value ratios were “generally steady.” LTVs for fund ABSs are the ratios of fund ABSs’ total outstanding amounts of their notes over the combined net asset values for their underlying funds, Fayvilevich explains.

Fund ABSs comprise LP-driven and GP-driven versions, Fayvilevich says – and Fitch primarily rates the former.

Under a GP-driven process, a sponsor will create a fund ABS as a way to get commitments for their funds.

“It’s a capital raise exercise, so they’re not generating liquidity,” Fayvilevich says.

A brighter future?

Prospective note investors have reasons to be sanguine about the prospects of fund ABSs. Fayvilevich says it appears that a “thaw” in the exit markets is starting.

“I think they’ll probably translate into somewhat higher distributions,” he says.

And interest from LPs in creating fund ABSs as a liquidity avenue could take off if market participants pry open the door. “Once you have one or two large pension funds come to market with this kind of structure, then others will follow,” Fayvilevich says.

This tipping point may come sooner than later. Private Funds CFO reported last month that the Teacher Retirement System of Texas is considering issuing a fund ABS by the end of this year.

One remaining bit of uncertainty on the investing side is that the National Association of Insurance Commissioners is reviewing the regulatory capital treatment of fund ABSs. The ramifications of the NAIC’s treatment are notable because US-based insurance companies are significant buyers in the space.

While Fayvilevich anticipates that some insurers will remain interested in purchasing fund ABS notes, he expects that other types of investors will emerge, such as pension funds and asset managers. Fayvilevich also anticipates that fund ABSs will be marketed overseas.