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Uneven Liquidity And Strained Valuations Are Pushing Some Funds Toward Debt

Pressure is slowly ratcheting up on a host of global alternative investment funds (AIFs), including private equity, venture capital, and secondary funds. The sharp turn in economic conditions has left them with a host of issues to deal with, including an inability to sell investments to return cash to their limited partners and a slowdown in fundraising. At the same time, inflation and increasing interest rates are squeezing their portfolio companies and prompting them to seek help.

In response, S&P Global Ratings expects some AIFs to turn to debt to shore up their positions and bolster their balance sheets. They can use the financing proceeds to purchase new assets, return capital to limited partners to lock in internal rates of return, and provide support to portfolio companies. However, a decision to assume more debt generally has a negative impact on ratings. Long-term leverage weakens our view of funds' financial positions, while the interest burden tests our view of liquidity.

The good news is that we expect most rated funds in our coverage to be able to handle this. First, the ratings in this industry tend to benefit from a low level of permanent leverage to begin with. Second, uncalled capital in place at the fund level provides some liquidity flexibility, and third, general partners are sitting on record-high levels of dry powder that could bolster their funds' financial flexibility. Dry powder is cash that limited partners have committed but that fund managers have left uncalled. Furthermore, some corners of the industry, like private credit or infrastructure appear to be in good health, with fundraising stable, and asset prices and volumes remaining supportive. All told, most ratings should be able to absorb AIFs' shift to long-term leverage, even as their foundations are tested.

Our publicly rated universe of global AIFs comprises a dozen peers. We also maintain a portfolio of AIFs with confidential ratings. Some AIFs include traditional listed funds investing in public equities, but most have exposure to alternative assets--a broad term that includes private equity and debt, real estate, venture and growth capital, and infrastructure. In general, our ratings on AIFs are robust and tend to be investment grade, mainly because of generally low levels of fund-level leverage, stable funding, and solid medium-term track records.

In this article, we draw on a cross-section of anonymized data from our ratings to demonstrate how we expect shifting industry dynamics to influence a variety of business models, including private equity, secondary funds, private credit, and venture capital.

Conditions Tighten For Private Equity And Venture Capital

The past 10 years have been bumper ones for fundraising for global AIFs. Across private equity and venture capital, total fundraising comfortably exceeded $8 trillion, while indexed total returns for private equity topped 420%, according to data from investment data company Preqin. However, the tide has begun to turn. Fundraising for private equity and venture capital has stalled in 2023, leaving this corner of the industry on track for its lowest fundraising year since 2019 (see chart 1).

Chart 1


Anecdotally, newer funds are struggling to reach the fundraising heights of their predecessors. According to reports, some large global venture capital funds have recently revised downward their fundraising targets for their new vintages--in some cases, by as much as 50%. At the same time, Preqin's private equity total return index is 10 points off its March 2022 peak, and venture capital returns are 93 points off their peak (see chart 2). Furthermore, and after years of generally positive industry-wide returns, the bottom quartile of private capital and venture capital returns are barely achieving breakeven returns this year, although some strategies, like private debt, have continued to report stable positive returns.

Chart 2


As valuations and returns have stalled, private equity deals have fallen to a three-year low on a trailing 12-month average basis. The average monthly deal total of $15 billion for the past 12 months is $9 billion below the March 2022 peak (see chart 3). The deal count has also fallen precipitously, with the average on the same rolling basis down by around one-third from March 2022. This tight market pulls asset pricing down further.

Chart 3


Underpinning this is a difficult environment for private equity's portfolio companies. Debt-servicing costs fell throughout the pandemic as central banks softened their stance, but the about-face in monetary policy has undone this quickly, with interest expenses rising 20% in the first half of 2023 (see chart 4). We now expect the trailing 12-month speculative-grade default rate to move firmly above 3.5% in our base case for Europe and the U.S. on the back of this (see charts 5 and 6). This will stoke pressure on private equity as they begin to deal with asset nonperformance in their portfolios after a benign period.

Chart 4


Chart 5


Chart 6


The Impact Of Tighter Liquidity Will Be Uneven Across The Industry

Slow fundraising and limited market liquidity will stymie liquidity inflows, while strained portfolio companies will likely turn to their owners for cash. This translates into broad pressure on fund liquidity--notably in the private equity and venture capital spaces.

The tightening economic and market environment will not affect all private capital entities in the same way, though. After years of strong growth in assets under management, private credit now faces a significant investment opportunity as rates have risen and borrowers seek financing solutions outside banks and public markets. By the same token, we expect the impact on infrastructure funds to be more muted. The impact on other private capital providers will be uneven as well. Private equity funds that have selected the best assets, have the most stable and diversified funding bases, and the strongest brands will fare better than their peers as pressures mount.

All in all, as the market faces up to a tighter liquidity environment in the next 12 months, we expect the impact to vary according to funds' strategy, strength, and reputation.

We Expect Some AIFs To Turn To Debt In Response To Market Challenges

Those AIFs that are most vulnerable to tighter conditions and are searching for liquidity support will likely look to add leverage to their balance sheets. For example, AIFs can use drawings under net asset value facilities--a form of secured financing that has recourse to a fund's asset base--to return capital to limited partners following a drawing, commonly known as a dividend recap transaction. Returning capital in this way locks in net internal rates of return and boosts the ratio of capital distributions to capital received for a fund (also known as the distributed to paid in capital ratio; DPI), propping up its performance metrics even as asset liquidity is uneven.

Estimates suggest that secured, long-term leverage on fund balance sheets represents only 1% of the total alternative capital deployed, and that large, international managers have the lion's share. By contrast, subscription lines of credit (see below) have significant industry penetration but do not provide long-term leverage as they are rolling short-term instruments that extinguish as a fund becomes fully deployed.

How do alternative investment funds use debt?

Chart 7


Funds can use debt throughout their lives to meet their evolving needs. At inception, funds use short-term subscription lines to fund their investments prior to capital calls from limited partners. They secure these lines against the uncalled capital from these same partners, with the lines' capacity diminishing as capital is called and extinguishing as the fund becomes fully deployed. At that stage, funds can turn to secured financing, or net asset value facilities, to lever or lock in their returns and support their portfolio companies. These facilities are secured against the value of the fund's asset base.

Rising Leverage Will Test Ratings' Foundations

The further use of debt will give the most vulnerable AIFs fresh financial flexibility but will put pressure on the measures that inform our ratings.

To start with, a greater debt burden at the fund level will worsen our view of stressed leverage--calculated as our S&P Global Ratings-adjusted ratio of haircut asset value to recourse liabilities. A greater ratio generally correlates with a higher rating. The starting point of this assessment for a cross-section of rated AIFs is generally solid, being in the upper half of our assessment range. Only around 20% of AIFs in our sample sit below the 1.75x threshold for adequate leverage, a level below which the rating impact is generally negative (see chart 8). This is a solid base that could enable the least leveraged funds to turn to debt to meet rising liquidity needs while maintaining relatively solid ratings.

Conversely, some members of our cohort possess as little as 14% capacity for additional debt before they would move to a lower assessment, and thus rating, all else remaining equal. So while some funds have the flexibility to deploy leverage to meet their tactical funding and liquidity needs at the current ratings, others with more aggressively leveraged business models do not, and a material amount of additional leverage could result in a downgrade.

Chart 8


Like stressed leverage, liquidity coverage, or AIFs' capacity to cover their committed liquidity uses, can be a source of rating stability, although the illiquidity of their investments is a notable and offsetting weakness. While the issuance of debt can meet extraordinary liquidity needs, the addition of debt to the capital structure adds to pressure on liquidity by increasing the committed liquidity uses in each period through contractual interest and amortization payments.

As with leverage, the peer set tends to have a solid level of liquidity coverage by our measures, with more than half of rated entities sitting in the middle of our assessment range. That said, just under one-quarter of entities have a level of quantitative liquidity that could be negative for the ratings, that is, below 1.2x (see chart 9).

Chart 9


Headroom here is lower than for leverage. For instance, committed uses, which in our analysis include interest payments and follow-on investments, need to rise by as little as 6% to trigger a potential downgrade. This headroom could represent the interest expense on a minimal amount of incremental debt for a small fund, for example. In this example, new debt could also create ratings pressure when it is commensurate with our view of stressed leverage, but worsens our view of the fund's future liquidity position. However, this tension does not prevail across the peer set. By the same calculation, some funds have liquidity headroom in the hundreds of millions of dollars.

Our approach to committed liquidity uses is conservative. For example, we typically expect AIFs to meet follow-on investments following full deployment of the fund, even when this need is not contractual. Nonetheless, funds' slow shift toward leverage has the potential to hamper their liquidity, but as with their stressed leverage, not all funds are created equally.

Uncalled Commitments And Dry Powder Can Provide Back-Up For AIFs

Even as conditions have hardened for private equity and venture capital, a bumper decade has left them sitting on an exceptionally high stock of dry powder, particularly international players. At the fund level, we estimate that rated AIFs have reserves of uncalled capital commitments from limited partners in the low hundreds of millions of dollars. This reflects a relatively common financial policy, whereby AIFs leave some capital uncalled across the life of the fund to serve as contingent liquidity. AIFs could use this store of cash to meet the rising funding needs that we anticipate, particularly follow-on investments in portfolio companies seeking to shore up their businesses or invest opportunistically. By extension, we tend to have a more conservative view of funds that hold a very limited or no contingent liquidity reserve. Indeed, a lack of dry powder is often a ratings weakness.

Above the fund level, general partners are also sitting on a record-high stock of dry powder after a decade of fundraising, and to which funds could turn to keep leverage under control. Indeed, private equity and venture capital general partners have seen their dry powder grow fourfold in the past decade (see chart 10). Alongside this, more sophisticated general partners are turning to in-house secondary funds to enable continuation (a process whereby one fund transfers assets to a newer fund) and support their older vintages' liquidity.

Chart 10


Elsewhere, funds can use their subscription lines of credit strategically to create leveraged returns early in their lives while leaving limited partner capital in reserve. However, this is not a permanent funding solution.

Covenants Help To Keep Leverage In Check, But They Are Not A Silver Bullet For Ratings

Permanent debt for AIFs usually comes with a covenant package, which is most often linked to a loan-to-value (LTV) calculation. Generally, the calculation is the fund's recourse debt divided by the reported fair value of its asset base, although there can be exclusions from the asset side of the calculation due to lender asset selection or concentration limits. Across the cross section of AIFs in this report, half are subject to LTV covenants, of which the majority are in a comfortable position relative to these requirements even though the maximum LTV ratios vary significantly (see chart 11). The bucket with the lowest headroom is the cohort that has the lowest covenant limit (the 10% covenant), and the tight headroom in this group does have a negative impact on our ratings.

Chart 11


Given the nascent phase of their investments, venture capital funds tend to have the lowest permitted LTVs on their facilities. This reflects their lenders' desire to have comfortable headroom in their security packages to guard against highly uncertain asset valuations. By contrast, secondary funds, also known as funds of funds, will have more generous security packages available to them, reflecting the significant granularity of the assets they hold through their stakes in a range of funds.

Covenants can therefore help to keep debt in check by capping indebtedness at the fund level. However, the presence of covenant packages alone does not necessarily correlate with strong ratings. For example, for rated funds, we estimate that the total incremental leverage headroom under maximum LTV covenants is significantly higher than the additional debt capacity commensurate with the existing ratings on the same entities. As such, full utilization of debt facilities would likely entail downgrades.

On top of this, we do not regard these covenant packages as being overly restrictive. Indeed, covenant breaches are typically not defaults, rather they will lead to some form of cure. For example, breaching the lower limit in a covenant package (meaning the lowest covenant in a range of covenants) on a net asset value facility could lead to a partial cash flow sweep on the facility. A cash flow sweep involves using the proceeds from asset sales to directly repay debt, thereby curing the LTV covenant breach and allowing the fund to operate as usual. The prioritization of creditors in the distribution waterfall in the event of a breach can be credit supportive, but the effect on the ratings depends on the initial LTV covenant limit and the quantum of debt that this covenant allows a fund to accumulate.

Chart 12


As funds tentatively increase their leverage, we see their covenants and the remedies they can precipitate as being broadly supportive of ratings. At the same time, we don't see them as a silver bullet for keeping leverage under control, as some covenants allow a material level of indebtedness under our framework. Our ratings will therefore continue to reflect the idiosyncrasies of funds' covenant packages and how creditor-friendly we believe them to be, including how far they materially limit indebtedness.

AIFs Are Using Debt To Play A Growing Role In Global Sustainable Finance

The number of AIFs focusing on the global energy transition, biodiversity, and on enhancing social capital in emerging economies is rising. These funds often use a combination of equity from development banks or sponsors; hybrid capital, typically structured to allow nongovernmental or supranational organizations to participate; and public debt.

While this corner of the industry remains nascent, we expect funds' role in the sustainable finance market to continue to grow in the medium term, and the range of investors in the fund structures to continue to expand. As global economies continue to grapple with ambitious net zero targets and diverse sustainable development goals, we anticipate that private capital channels like AIFs will increasingly take part in global sustainable finance.

AIFs Have The Rating Headroom To Adapt To Shifting Conditions

A decade of extraordinarily low rates and limited volatility has sheltered AIFs, in particular private equity and venture capital. Adapting to a world of nonzero rates, tight liquidity, and uncertain asset prices will be tricky, and the leverage we expect AIFs to take on to meet these challenges will change the look of many. Not all funds will be able to withstand these changes, and we expect some to struggle, with differences between funds continuing to grow.

Furthermore, this environment affords different fund structures varying levels of flexibility, with permanent or closed-ended funds, for example, having the flexibility to hold onto their investments and wait out periods of turbulence. Similarly, asset classes like private credit look set to thrive, with buoyant fundraising and some structural insulation from swings in rates. Importantly, the low level of long-term leverage in existing structures gives many funds room to maneuver and means that the low-to-mid investment-grade ratings in the sector should be able to withstand changing conditions.

Table 1

List of publicly rated global alternative investment funds and their rating factors

3i Group

Mercantile Investment Trust

Pershing Square Holdings

Metrics Credit Partners Real Estate Debt Fund

Metrics Credit Partners Diversified Australian Senior Loan Fund

Drawbridge Special Opportunities Fund

Fincraft Group

The Currency Exchange Fund

Citadel Kensington Global Strategies Fund

Citadel Kensington Global Strategies Fund II

Issuer credit rating BBB+/Stable /A-2 AA-/Stable /A-1+ BBB+/Stable A-/Stable /A-2 A-/Stable /A-2 BBB/Stable B/Stable /B A/Stable /A-1 BBB-/Stable /A-3 BBB-/Stable /A-3
Risk-adjusted leverage Adequate Strong Moderate Strong Very Strong Adequate Moderate Adequate Adequate Adequate
Stressed leverage Very strong Strong Adequate Very strong Very Strong Adequate Adequate Adequate Strong Strong
Risk position Weak Adequate Moderate Moderate Adequate Adequate Moderate Adequate Moderate Moderate
Funding and liquidity Adequate Strong Strong Adequate Moderate Adequate Moderate Strong Adequate Adequate
Jurisdictional risk 0 0 0 0 0 0 -2 0 0 0
Anchor bbb+ aa- bbb+ a- a- bbb b+ a- bbb bbb
Impact of modifier 0 0 0 0 0 0 -1 -2 -1 -1
Track record and performance 0 0 0 0 0 0 0 0 1 1
Risk management 0 0 0 0 0 0 0 0 0 0
Transparency and complexity 0 0 0 0 0 0 -1 -1 -1 -1
Comparable rating adjustment 0 0 0 0 0 0 0 -1 -1 -1
Likelihood of extraordinary support +3
Source: S&P Global Ratings.

Please join leading S&P Global Ratings analysts on Oct. 11, 2023, at 10:00am EDT, for a live interactive webinar on the outlook for the AIF sector and the rating implications of an uneven market. Click here to register (or copy and paste the website address into your browser):

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:William Edwards, London + 44 20 7176 3359;
Secondary Contacts:Thierry Grunspan, Columbia + 1 (212) 438 1441;
Andrey Nikolaev, CFA, Paris + 33 14 420 7329;
Philippe Raposo, Paris + 33 14 420 7377;
Sharad Jain, Melbourne + 61 3 9631 2077;

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