Sub lines hit a milestone with Fitch’s draft ratings methodology

Ratings could broaden investor base, and may open the door to a future capital markets solution for the fund instruments.

The subscription credit line market took a major step forward in its maturity when Fitch Ratings’ released a draft ratings methodology document for the credit instrument.

It is the first such methodology published by a major ratings agency, said Greg Fayvilevich, head of Fitch’s global funds group, in a written statement.

The advent of ratings in the market may help to broaden its investor base, easing supply side constraints resulting from banks, the most active lenders in the market, hitting concentration limits, balance sheet capacity and risk-weighted asset requirements. It also opens the door to the possibility of a capital market exit, though some think the short-tenor, revolving nature of sub lines, among other things, may stand in the way of that solution, as Private Funds CFO recently reported.

“Historically, this was a buy-and-hold product,” a panelist at the Fund Finance Association’s annual gathering in Miami Beach said about sub lines. “I’ve been hearing a lot about distributing in order to… deploy more capital.”

Fitch’s plan to publish a methodology was noted by an employee of the agency earlier this month at the FFA conference. Whether ratings might help increase the liquidity of the instruments or lead to a capital markets solution was among the major topics discussed.

The space for sub lines has grown immensely in recent years. Fitch estimated in a primer that it also published this month that sub line origination soared from $400 billion at the end of 2017 to around $750 billion at the end of 2022, with over 70 banks involved.

But that number has dwindled, anecdotally, as banks hit concentration limits or balance sheet capacities. FFA conference attendees repeatedly estimated that only 50 or 60 banks are active right now.

Fitch’s Fayvilevich said that the agency is considering a similar document for NAV loans, a possibility that was also raised at FFA’s conference.

“Given the growth in this space we have received many requests from market participants to provide ratings on these facilities, and may look to do so in the future,” Fayvilevich noted.

Fitch will soon have company in sub lines; a spokesperson for KBRA said that it will release its own methodology “over the next few months.”

A spokesperson for S&P Global declined to comment, while Moody’s did not respond to a comment request.

Fitch is seeking public comment on the document until March 19 through a designated email address.

The methodology at a glance

Fitch proposes four important “drivers” behind its sub-line ratings.

First, the agency will examine the credit quality of funds’ LP pools. Fitch will use LPs’ existing ratings if they have them. For unrated LPs, the agency will employ a classification framework to determine credit quality.

The framework designates unrated LPs at either Tier 1, corresponding to a BBB-minus rating; Tier 2, corresponding to B-minus; or Tier 3, corresponding to CCC. Fitch will include LP longevity and assets under management to designate LP tiers. Certain types of LPs, such as sovereign wealth funds and defined benefit pension funds, will have additional criteria.

Fitch’s second driver entails inputting LPs’ ratings and other investor data, such as their jurisdictions and amounts of uncalled capital, into a quantitative model to estimate rates of default and recovery.

The agency’s third driver is a qualitative assessment of managers.

That assessment comprises several of its own factors, which are graded on a scale from one to five, with five being the lowest quality. Factors include a manager’s performance; a manager’s scale and resources; a fund’s performance; a manager’s alignment in a fund; and a fund’s remediation provisions for capital-call defaults. The factors are weighted and combined for an overall number, using the same scale.

Under its fourth driver, Fitch reserves the right to employ limits and caps on its ratings in some cases. For example, the agency said it will cap its highest allowable rating to AA-plus when funds’ unrated LP pool levels exceed 20 percent. Fitch will also employ limits if its qualitative assessment concludes there are “asymmetric risk factors,” such as “fund manager weakness.”