A New Frontier for Fund Finance: Ratings for Subscription Line Facilities

A New Frontier for Fund Finance: Ratings for Subscription Line Facilities

The subscription line facility market has increased substantially – estimates suggest that 90% of newly launched European closed ended funds plan to use subscription line financing and that the market has nearly doubled between 2017 and 20221. This rate of growth in the market has resulted in supply-side limitations at the banks providing these facilities2.

One of the most significant supply-side challenges arises from the regulatory capital treatment of subscription facilities. As the capital adequacy requirements arising out of the Bank for International Settlements (BIS)’s Basel reforms are implemented at banks, there is increased regulatory scrutiny and commercial focus on the risk weighting (i.e. capital treatment) – and therefore profitability – of various lending products, leading some banks to only offer uncommitted facilities or in some cases scale back their subscription line finance businesses altogether3 , 4. These pressures have only been exacerbated by the regional banking crisis that plagued the United States banking market in 20235. Recognising these limitations, rating agencies have stepped into the fore.

A New Class: Rating Subscription Line Facilities

The biggest rating agencies – including the ‘Big Three’: Fitch Ratings, Standard and Poor’s (S&P) and Moody’s – have now all begun work to rate subscription facilities, with Fitch and DBRS Morningstar having both published their final rating criteria. While Kroll Bond Rating Agency (KBRA) has rated subscription facilities for some time, the introduction of rating methodologies by the larger players is a major development for the market.

In a sense this is a natural extension for rating agencies since, in many cases, rating agencies are already rating the credit worthiness of the world’s largest institutional and corporate investors. The key rating drivers in Fitch’s methodology are (i) the credit quality of the LP pool; (ii) the quantitative rating derived from structural features of the sub line documentation, such as the facility size, advance rate and overcollateralization; (iii) a qualitative assessment of the fund manager and the fund structure; and (iv) rating caps and limits, for example for funds where 20% of a fund’s LPs are unrated6.

Obtaining a credit rating improves the internal capital treatment for lenders offering subscription facilities, which are secured by the commitments of a borrower’s limited partners. Consequently, ratings effectively allow for a stratification of the sub line market according to risk profile, distinguishing between facilities secured by large financial institutions’ fund commitments and those secured by less credit-worthy institutions and individuals. The second effect is that subscription facilities will be commoditised, with increased comparability across issuers and lenders. As a result, lenders’ economics will be improved on the facilities, which can be more effectively managed from a capital charge and underwriting perspective.

Implications for the Fund Finance Market

Rating methodologies bring a myriad of benefits to the subscription finance market, including increased marketability, risk distribution, streamlined underwriting processes and ultimately enabling competitive dynamics to (re-)emerge7. All of these factors make subscription facilities more economical – both for banks and non-bank lenders offering fund finance solutions alike – allowing the market to grow and enabling enhanced price competition.

Where subscription facilities are being offered by banks, a key advantage is that they can be more quickly underwritten due to third party (i.e. rating agency) verification of the risk level. Banks will also be able to syndicate the facilities or re-package them into securitisations more easily, both of which improve the bank’s economics on the facilities. In the case of non-bank lenders, such as NAV lending funds, obtaining ratings on its facilities allows the fund to attract larger sums and higher quality of capital from institutional investors who are similarly concerned with capital charges on investments (including insurance investors concerned with their Solvency II ratios).

The net impact of having subscription facilities rated is that the market can be expected to grow with advantages, including faster execution times and lower costs, accruing to borrowers. Ratings by big rating agencies are also likely to lead to subscription line facilities being eligible for capital markets and structured finance products, such as bank securitisations and CLOs, allowing borrowers to access deeper pools of capital and lowering the risk and cost to banks8. While it may take some time for the benefits to land for borrowers, fund sponsors can expect to see increased competition in the market and ultimately better pricing and structural alternatives.