Greg Fayvilevich, global head of fund and asset manager ratings at Fitch Ratings, discusses how the rating methodology came about, the key factors assessed 
when rating a facility and how it could help to close the liquidity gap.

What are the key dynamics driving the subscription line market at the moment?

The market has grown significantly in the last couple of years, with the growth in the private capital markets and more widespread usage of subscription facilities. The market is estimated to be worth about $800bn today. 

Historically, banks have been providing these loans. But in the last year or two, capital has become constrained as banks have struggled to accommodate the larger size of the market, creating a liquidity gap between supply and demand. That is one of the key dynamics we’re seeing in the market now. This is leading to a widening of spreads and rationalising of relationships; banks are deciding which relationships are the key ones for them and which facilities are more profitable.

Does your rating methodology respond to this dynamic? 

The new rating methodology is directly related to this dynamic. During the last year or two, we’ve been approached by several banks and non-bank lenders who were looking to manage this liquidity gap.

There are two ways to close the gap. First, for existing lenders to better manage the capital they are allocating. And second is to bring institutional investors – non-bank capital – into the market. The thinking is that ratings could help with both of those approaches by adding further transparency. 

For banks, it’s about reducing the capital charges against subscription lines, which makes sense in the context of the strong historical performance of this sector. It’s considered a high quality, low risk type of asset class. With that, you’d expect relatively higher credit assessments, which then allows some banks to reduce the capital charges that they put against this business. 

For many institutional investors, this is a relatively new asset class as lenders. Certainly, insurers or pension funds know subscription facilities as LPs in private equity funds, but now they’re coming in to provide funding. Ratings are also required or helpful for many institutional investors. It could be for capital charges or it could be for investment guidelines or for risk management purposes. 

There’s also a third group this could be helpful for, and that’s banks entering the space now. As a commonly understood benchmark, ratings may help them standardise the risk management process and have the business approved.

What are the key factors assessed when rating a subscription facility? 

We look at it in a similar way to how banks assess these credit facilities. We start from the LP base, where we try to assess the quality and diversification and project potential losses under stress scenarios. We compare that to the deal’s documentation, namely the credit agreement and how much credit enhancement is available via the advance rate of the facility. 

It’s a case of putting those two factors together; the strength of the LP base plus the advanced rate of the facility. That’s the more quantitative side of the rating. 

Then you have the qualitative side, which is very important as well. Assessing the fund manager’s resources, historical performance, franchise and ability to raise capital from investors. There are other qualitative factors such as the fund’s strategy; so less risky strategies are better, or more capital called is better, and also the amount of skin in the game. 

Putting the quantitative and qualitative together gets us to the overall rating.

How is the macro environment impacting the market?

Part of the impact has to do with bank capital. On the supply side of the facilities, the macro environment has essentially reduced banks’ capital. There are some regulatory changes that have reduced capital availability, and you have higher interest rates, which have also impacted banks’ capital availability. 

On the other hand, you have a counterbalancing issue. If the funds are smaller, they need smaller facilities. So that reduces the funding gap. Similarly, with the higher interest rate environment, fund managers are thinking more carefully about how they use these facilities.

A couple of years ago, facilities didn’t really cost very much because interest rates were so low. Now, with interest rates above 5%, plus a spread of 200 basis points on top of that, it becomes quite expensive to use the facility. So we expect facilities might be smaller and may be paid down faster than in the past. 

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