Moody’s lays groundwork for sub line ratings

Moody’s is making a foray into rated subscription lines, marking the latest signs of broader acceptance of the fund finance industry and interest in the potential for a capital markets solution for lenders.

The ratings agency published a draft methodology this month, which gives LP and GP sides equal weighting in a scoring process. Moody’s is soliciting requests for comment on the draft until December 4.

Growth in the sub lines market and interest from participants such as banks have driven the creation of this developing framework, said Rory Callagy, associate managing director at Moody’s.

KBRA already rates sub lines via its fund-level debt framework, and Fitch Ratings finalized its methodology earlier this year. The addition of Moody’s is another step toward the mainstreaming of the sub line asset class.

“Many market participants have said to Moody’s that Moody’s opinion in this market would help as the market develops and evolves,” he said.

And issuing ratings for sub lines could help address two problems that have been salient within the industry over the past year.

Many banks have reined in lending for the instruments due to regulatory capital and internal allocation limits, Private Funds CFO has previously reported. The market also experienced a supply shock last spring when three major banks in the space – Silicon Valley Bank, Signature and First Republic – either failed or were acquired on an emergency basis.

Ratings could broaden the investor base for sub lines and give them more favorable capital treatments, and perhaps thus easier to syndicate among banks – something constrained lenders have had to resort to in order to keep abreast of demand.

How the methodology works

Moody’s plans to produce ratings by using three key factors: assessments of funds’ LP bases, assessments of managers and the funds themselves, and “structural considerations” like curbs on fund-level borrowing and lenders’ enforcement rights.

The first two factors will be equally weighted for scoring to determine a preliminary outcome.

Structural considerations will be used to determine if any upward or downward notching of scores should be done. Once the scorecard portion of the review is wrapped up, Moody’s will entertain other considerations – such as financial controls and ESG – before finalizing its ratings.

For the LP assessment, the firm will run a Monte Carlo simulation model to estimate losses caused by investor defaults.

Moody’s said it will use LP details as inputs, as well, including credit ratings or equivalent data, advance rates assigned by lenders, locations and industry types. The rating agency will run simulations on each LP and add their expected losses together to project sub lines’ overall losses.

After the simulations are completed, Moody’s will run analyses – typically three, it says – to determine how the portfolios will hold up in stress scenarios. The outcomes will be used alongside the simulations to determine final scores for LP reviews.

For the manager and fund assessments, Moody’s plans to consider sub-factors that will have their own scores. The sub-factors will each have weights that will total 50 percent of the overall score’s weighting.

On the GP side, the rating agency will weigh managers’ AUM, brand and market positions, and historic performance. For funds, Moody’s will review the vehicles’ amounts of committed capital and investment strategies.

Moody’s will score managers the more favorably if they are larger, have wider brand recognition, are more diversified and deliver strong performance consistently. LPs are less likely to default on their obligations to these types of GPs, the rating agency explained.

“The size and quality of a fund manager are important in our assessment of a subscription credit facility because larger, more diversified and better performing managers tend to attract and retain more established, higher-quality LPs,” Moody’s said in its document. “Because such managers provide a rich array of investment strategies and opportunities, LPs are more likely to be incentivized to honor their capital commitments in order to maintain access to these managers.”

The firm also plans to give more favorable scores to funds that are larger, with investment traits such as focusing on developed markets and stronger portfolio diversification.