October, 2014 Securitisation of Alternative Investment Funds s www.scoperatings.com Introduction Alternative Investment Fund ("AIF") 1 managers are looking to respond to investors search for yield in a persistently low interest rate environment and tap new investor segments to increase their assets under management. This dynamic has helped to pioneer a new form of structured finance debt. Securitisations of AIF shares (or fund securitisations ) are becoming increasingly popular, as recent regulations 2 require certain investor types, such as European insurance companies, to invest in rated debt products rather than in equity-type shares of AIFs. This is particularly true for investors looking for investments that match the long duration liability profile of their insurance or annuity products. Scope Ratings AG ( Scope ), a European Credit Assessment Institution ( ECAI ) licensed by the European Securities and Markets Authority ("ESMA"), has a track record of more than 1,500 rated funds, with a combined issuance volume of more than 68bn. Over the past months, Scope has seen an increasing demand for debt ratings of fund securitisations. This report explains the concept of securitisation of AIF shares and what analytical considerations drive the rating process of the resulting debt issuance. What is AIF Securitisation? The securitisation of an AIF is typically a repackaging of the shares or profit participation notes (together referred to in this report as fund shares ) issued by the AIF through a special purpose vehicle ( SPV ). The SPV issues debt, often in the form of credit linked notes, and uses the notes issuance proceeds to purchase shares in the AIF and finance the set-up costs of the structure. The only sources of cash flow to pay the interest and principal on the notes are the proceeds received by the issuer from the fund s shares. The shares serve as collateral to the investors claims against the issuer. In this sense, AIF securitisations are very similar to other forms of structured finance transactions. However, there are two major differences. Firstly, the securitised assets are not debt instruments, but rather fund shares or profit participation notes with equity-like characteristics. Secondly, AIF securitisations usually do not have tranched liabilities; instead, they issue one single class of debt, without subordinated tranches to absorb first losses. Figure 1: AIF Securitisation Structure Analysts Guillaume Jolivet Managing Director +49 (0)30 27891-241 g.jolivet@scoperatings.com Dr. Stefan Bund Group Managing Director +49 (0)30 27891-258 s.bund@scoperatings.com Sonja Knorr Director +49 (0)30 27891-141 s.knorr@scoperatings.com Sebastian Dietzsch Senior Analyst +49 (0)30 27891-252 s.dietzsch@scoperatings.com Press Andre Fischer Manager Communications +49 (0)30 27891-150 a.fischer@scoperatings.com Scope Ratings AG Lennéstraße 5 10785 Berlin T: +49 (0)30 27891-0 F: +49 (0)30 27891-100 Service: +49 (0)30 27891-300 info@scoperatings.com www.scoperatings.com 1 According to regulation 2011/61/EU, the term AIF applies to collective investment undertakings which are not undertakings for collective investment schemes in transferable securities ( UCITS ). They comprise closed-end and open-ended funds. 2 Examples are the German Law on the Supervision of Insurance Undertakings (Versicherungsaufsichtsgesetz) and its accompanying investment guidelines (Anlageverordnung). October 2014 1 / 7
The issuer of the rated notes is typically a bankruptcy remote SPV with its activities being restricted to issuing debt and investing into the fund s shares. In addition, all counterparties to the SPV, other than the investors, agree not to petition for bankruptcy or initiate other collective or reorganisation proceedings against the SPV. Hence, the SPV issuing the notes should only default if it does not meet its obligation towards the investors, namely, if the cash flow received from the AIF shares do not allow the SPV to pay interest and principal when due under the terms of the notes. While the notes issued by the SPV entitle the investors to receive interest and principal payments, Scope has seen transactions with extra payments in the form of a performance dividend. Such extra payments are often optional and are drawn from the available cash in the fund, in excess of fees and interest payments due under the notes. As a result, the AIF securitisation allows for a direct pass-through of all cash flows generated by the fund to the notes. The rating addresses the credit risk associated with the interest and principal payments due under the terms of the notes and hence does not cover those optional extra payments. What is the difference between investing in an AIF Securitisation and directly in an AIF? From a technical perspective, shares in AIFs are an equity investment, while the capital raised by the AIF securitisation is a debt instrument. This means that, while the returns paid out under funds shares can vary in time and amount according to the funds performance and the fund manager s distribution strategy, the fixed income product issued by the AIF securitisation commits to pay a certain amount of interest at defined interest payment dates, and the full notional of the debt by a predefined maturity. From an economic perspective, though, an investment into an AIF securitisation should not differ from a direct investment in the AIF. In fact, due to the pass-through nature of an AIF securitisation, the investors risk and return profile in the debt very much resembles that of a direct investment into the fund. The two examples below illustrate this link. Figure 2: Unlevered AIF Securitisation As illustrated in Figure 2, the investment in the debt issued by the SPV can only match the risk characteristics of the fund shares. In that sense, even though the SPV has issued debt, the risk profile of the securitisation is the same as that of a direct investment in the fund shares. Consequently, the AIF securitisation can be compared to an unlevered single tranche securitisation exposed to an entire pool of underlying assets, and without subordination. Figure 3: Levered AIF Securitisation Figure 3 shows an AIF securitisation where the fund has taken debt and therefore leveraged its investments. Again, the investment in the debt issued by the SPV matches the risk characteristics of the fund s shares and due to the leveraged nature of the fund, the securitisation s risk profile now resembles that of a leveraged first loss position. As a result of such leverage, both the risk and the October 2014 2 / 7
expected return of the SPV s debt will be higher compared to those of the transaction displayed in Figure 2. All else being equal, the rating of the AIF securitisation in the second example would probably be lower than that of the debt in the first example. Usually, AIF securitisations would not include credit enhancement provided by means of tranching. As a result, in the examples shown in Figures 2 and 3, the credit-linked note investor does not benefit from any protection against a first loss incurred by the fund. However, the notes may benefit from another form of credit enhancement, if the value of the fund s shares, driven by the amount and value of assets held in the fund, exceeds the notional amount of debt issued by the SPV, similar to what is described as overcollateralization in structured finance transactions. How is an AIF Securitisation rated? Scope s Structured Finance Instruments Methodology Guidelines form the basis for rating all structured finance transactions and are available on the agency s website at www.scoperatings.com. All structured finance and securitisation credit ratings consider the payment of interest and the full payment of principal on the issued debt when due, and the likelihood and severity of any shortfall to such payment obligations. This approach also applies to the rating of AIF securitisations. In order to assess the risk of the assets held by the fund, the agency either follows its rating methodology for AIF - Asset Based Funds, if the fund invests in equity assets, or its rating methodology for AIF Debt Funds 3. In either case, the analysis of cash flows generated by the fund s assets is at the centre of Scope s rating analysis. The underlying payment profile of AIFs is driven primarily by the type and quality of their assets. Over the course of its analytical experience, Scope has analysed AIFs invested in renewable energy, commercial and residential real estate, infrastructure finance assets, transportation assets, private equity asset, as well as investments in leveraged companies, small and mediumsized enterprises ( SMEs ) and structured finance securities (leveraged loan CLOs). For funds invested in equity assets, i.e. where the fund acts as equity sponsor in one or several projects or financings, Scope simulates the key performance parameters of the equity investment(s) and determines a distribution of cash flows. This distribution associates a probability of occurrence to a given cash flow scenario, which reflects a given asset performance. For each scenario, Scope computes the loss for the rated instrument. The rating level of the AIF securitisation is determined by comparing the average expect loss modelled on the debt under all those scenarios, to Scope s idealized expected loss table. Figure 4: AIF Return Distribution 3 Both methodologies are available on Scope Ratings website at www.scoperatings.com. October 2014 3 / 7
For debt funds, Scope will analyse the credit quality of each asset and the fund s overall portfolio credit quality, to determine the expected shortfall of interest and principal payments passed through from the AIF to the rated instrument. In essence, the analysis very much resembles the analysis of a non-tranched or unlevered portfolio securitisation of debt securities, for instance leveraged loans, real estate loans, project finance or SME loans. For portfolios that are not fully invested when the notes are rated, or that are expected to experience significant trading, Scope bases its analysis on the fund s asset eligibility and portfolio criteria, and monitors the portfolio over time. Analytical Challenges in the Rating Process Besides the assessment of the cash flows generated by the AIF portfolio, which is performed as described above, additional analytical considerations apply when rating an AIF securitisation. These considerations mainly stem from the challenges of converting an equity product into rated fixed income debt. Payment Profile passed through from the AIF to the Issuer Scope analyses whether the AIF securitisation structure allows for the efficient pass-through of cash flows from the fund to the issuer. In general, the costs and fees generated by the structure may marginally alter the cash flows produced by the fund s assets. Scope includes these costs in its quantitative analysis and measures how well they can be covered by the cash flow generation power of the fund. In addition, the issuer s liquidity available to cover the costs and interest payments due under the terms of the rated debt needs to be carefully considered in light of the amount and frequency of the fund s cash flow distributions. Any liquidity shortfall preventing the issuer from fulfilling its payment obligations in a timely manner would affect third-party service agreements or could cause an event of default under the terms of the notes. Alternatively, the debt investor may be exposed to the market value risk of the AIF assets during the life of the transaction, if the debt issuer needs to sell AIF shares leading the fund to liquidate assets in order to rapidly disburse the required cash flows. In general, AIF securitisation structures may provide for a minimum cash reserve covenant within the AIF, or with the issuer, providing sufficient liquidity in the structure for the issuer to meet its payment obligations. Scope has seen structures in which the interest due under the terms of the notes is deferrable, and often also much lower than the annual net return expected from the AIF. Similarly, specific expenses such as management fees may also be deferrable in certain structures. These features reduce the risk that the volatility in the generation and distribution of the fund returns could lead to a shortfall of cash available for interest payments by the issuer. Similarly, any excess returns at the fund level over and above the distribution required under the terms of the notes can be paid out as an excess payment, similar to excess spread paid to equity investors in other structured finance transactions. While the amortisation of the debt s principal will typically occur following the full redemption of the fund s shares, some transactions may also allow for the excess payments to be classified as principal payments under the securitisation notes. It is important to note that the legal final maturity of the notes in the AIF securitisation structures will typically be set after the scheduled maturity of the AIF s assets. The purpose is to mitigate any delay in the AIF liquidation that could occur if the funds assets are illiquid, or if a secured creditor to the fund needs to enforce its security rights and hence causes a delay of allocation of proceeds to the AIF s shares. Should it be necessary for the issuer to sell fund shares or the AIF to sell underlying assets in order to generate the required cash flow at maturity to redeem the debt, the notes will be exposed to market value risk upon fund s shares or asset liquidation. Scope incorporates this risk by applying market value decline assumptions appropriate to the respective asset type. If the above mentioned allocation of excess payments is treated as a principal payment, or if the dedicated principal allocations from the AIF to the securitisation are made over the term of the transaction, this reduces the amount of outstanding principal that is subject to market value risk at maturity of the transaction. Return Distribution Strategy of the AIF Depending on the return distribution constraints of the AIF, its total return in excess of costs and interest payments due on the rated debt may be distributed to the investor or retained within the fund. If the fund reinvests excess returns, it will increase its October 2014 4 / 7
net asset value, ultimately leading to an overcollateralization of the debt. This excess value in the fund will compensate for losses arising in the fund s portfolio. To the extent the AIF manager is not authorized to reduce overcollateralization through extra payment distributions to the investor, or if such distributions are treated as principal payments under the terms of the notes, the overcollateralization will improve the credit risk profile of the notes and enhance the rating. Another analytical consideration related to the distribution strategy of the fund includes the equal treatment of fund investors regarding the redemption of the shares. Redemption of AIF shares may result in a deterioration of the fund s asset characteristics, for instance in terms of diversification or credit risk profile. As a result, an AIF securitisation may be affected negatively, if other investors in the fund wish to redeem shares prior to the maturity of the AIF securitisation transaction. In general, this issue will be addressed by offering all fund investors, including the AIF securitisation issuer, the option to redeem their shares on demand, on a pro-rata basis of the fund s available cash or through a vote by the investors to decide upon the redemption procedure. Impact of the AIF Collateral Manager By nature, AIFs often grant significant flexibility to collateral managers regarding the investment and distribution strategy of the fund. For funds in which the manager has discretionary trading capabilities, Scope looks at both the initial portfolio composition and the alteration that the portfolio might experience given the fund's investment guidelines. Scope s opinion on the risks and returns on the fund s investments also takes into account, among other key elements, the manager's intention and incentives to trade the portfolio, and the assets' liquidity. Scope assesses the collateral manager s investment strategy and its ability to preserve and maximize the value of the fund s assets. In particular, Scope considers the manager s profile as a company, its skills, expertise and track record as per its Asset Management Rating Methodology. The manager s economic incentives play an important role in the assessment, and Scope evaluates how and to which extent the interests of the manager are ultimately aligned with those of the debt investor. Scope also takes into account the asset manager s standards of care and general liability in the specific context of the rated transaction. In general, the alignment of interests between the debt investors and the fund manager is relatively strong in AIF securitisation transactions given their full pass-through and bespoke nature. The absence of first loss protection and tranching of the AIF securitisation s liabilities also prevent diverging interests between senior and junior/equity investors. In cases where the manager plays a crucial role in the performance of the notes because the assets need intensive care (for instance active hedging or workout upon default in a debt fund), the structure may include termination mechanisms protecting the notes investor, or efficient mechanisms to replace the manager, should the manager no longer fulfil its duties under the fund. Integrity of the Structure Similar to other structured finance transactions, the objective of AIF securitisations is to offer a structure that does not create risks in addition to those of the AIF s underlying assets. Typically, the debt issuer will therefore need to be set-up to be bankruptcy remote and to allow for the adequate enforceable security of the fund s shares to the benefit of the debt investors. Those features, which offer additional strengths to the structure, constitute standard structural components of any securitisation. As such, AIF securitisations include market standard security over the issuer s assets, namely the fund s shares and the moneys held in the issuer s accounts. A deviation from market standards may create additional legal risks difficult to quantify and likely to affect the rating outcome of the product. The validity and enforceability of the transaction documents, and especially the structural safeguards provided under the security and trustee agreements will typically be confirmed by indisputable legal opinions. Additionally, Scope carefully assesses whether the structure is affected by the credit risks of the agents holding and channelling the cash flows from the AIF to the debt investors on behalf of the issuer. Scope may decide to carry out individual credit assessments on any unrated party that introduces substantial additional credit risk to the AIF securitisation. October 2014 5 / 7
Conclusion Driven by changes in investors regulatory environment and the resulting adaption of investment strategies, AIF and securitisation structures have started to converge, resulting in the still infant asset class of AIF securitisations. Scope expects this trend to continue and AIF securitisations to develop from a currently still very much German investor focus towards more international cross border transactions. The rating of AIF securitisations requires multiple analytical considerations including the analysis of the underlying assets of the AIF, the structure of the AIF itself, the structure of the securitisation, and the interplay between these three elements. Given the resulting complexity, it requires in-depth technical expertise and analytical thoroughness from all parties involved in the structuring, rating, and investment process. Given its long-standing experience in rating funds and expert knowledge in structured finance, Scope is well prepared to assist investors in their investment considerations and can assign either a public or a private rating to an AIF securitisation. While there is no difference in the analytical rigour applied to the analysis, depending on whether the rating will be kept private or made public, the agency emphasises that the dissemination and use of its private ratings is subject to the regulation applicable to ECAIs licenced by ESMA. 4 4 Under ESMA s guidelines, private ratings shall only be distributed to the recipient (typically the sponsor of the rating or the issuer) on a confidential basis, who in turn shall only share it with a limited number of third parties subject to the same confidentiality. Furthermore, the recipient shall also confirm that the private ratings will not be used for regulatory purposes. October 2014 6 / 7
Disclaimer 2014 Scope Corporation AG and all its subsidiaries including Scope Ratings AG, Scope Analysis GmbH, Scope Capital Services GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope s ratings, rating reports, rating opinions and related research and credit opinions originate from sources Scope considers to be reliable and accurate. Scope cannot however independently verify the reliability and accuracy of the information and data. Scope s ratings, rating reports, rating opinions, or related research and credit opinions are provided as is without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or otherwise damages, expenses of any kind, or losses arising from any use of Scope s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party, as opinions on relative credit risk and not as a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings AG at Lennéstraße 5 D-10785 Berlin. Scope Ratings AG Lennéstraße 5 10785 Berlin T: +49 (0)30 27891-0 F: +49 (0)30 27891-100 Service: +49 (0)30 27891-300 info@scoperatings.com www.scoperatings.com October 2014 7 / 7