Absolute Credit Series: How Fitch is Rethinking Risk in a Changing Fund Landscape

LT (00:08)
Good morning and welcome to Kirkland & Ellis Absolute Credit Series. I'm Lindsay Trapp. I'm a partner in our New York office, and I'm joined today by my partner, Kate Luarasi. And we are very excited to have an external guest today, Greg Fayvilevich from Fitch Ratings. Welcome Greg.

GF (00:26)
Hey, Lindsay and Kate, thanks for having me here.

KL (00:30)
Great to have you, Greg. Excited to chat about what you're seeing and what you've been doing lately.

GF (00:36)
Yes, I've been an avid follower of your podcast, so excited to make an appearance.

LT (00:44)
Excellent. Well, let's dive right in. You guys have been very busy recently in lots of different areas. So maybe just give us a little bit of an overview as to what you're seeing right now in the market.

GF (00:59)
Sure, I'll give a little bit of background of where Fitch participates in the fund finance market. So in the funds group, we've been historically rating some of the more traditional products like '40 Act, closed-end funds, debt and preferred shares. And we've actually been rating CFOs for a long time. CFOs are actually not such a new product. Some of the first ones we've rated are from 2004. So we've seen a few of them go through the GFC. And in recent years, we've seen more and more market participants ask us essentially to come in and provide ratings on various fund finance products. And so we started with subscription facilities and moved on to NAV loans and rated feeders. And now we're much more focused on GP CFOs as well. So covering kind of the full scope of the market.

LT (01:52)
Excellent. And I think you guys are maybe a little bit more of a new entrant into the rated feeders methodology, but certainly your CFO methodology has been around for a long time. But I think you guys have recently updated it. What have you guys been working on in both of those methodologies?

GF (02:09)
Sure, yep, you're right. So maybe I'll start with rated feeders first. So we published a new methodology last year, and the way the methodology works, it's a shell in a way where rated feeders, essentially the issue to figure out with them is that you don't have an existing portfolio or the fund might be somewhat ramped but not fully ramped. And so the rated feeder methodology, in a nutshell, helps us construct an expected portfolio, whether it's a direct lending fund or a secondaries fund or an ABF fund, whatever it is, the rated feeder methodology will help us do that, will help us take a view on the manager quality, the historical track record and things like that. Once we have the expected portfolio constructed through the rated feeder methodology, we then do need another methodology to address the assets. And so that's going to be asset-specific. So let's say if it's a direct lending fund, we'll use our CLO methodology. If it's a secondaries fund, we'll use our CFO methodology. Say if it's an ABF fund, we'll use a combination of whatever the assets, whether it's resi and real estate debt, we'll use the expertise from the relevant teams across Fitch. And one easy way to think about it is if we rate the structured transactions backed by a particular asset out of our, let's say, structured finance segment, we have a methodology to take a view on the asset, then we can address that type of fund through the rated feeder methodology. So we construct the portfolio through the feeder methodology, then we will use the relevant team within Fitch to take a view on the assets. So that's the feeder methodology.

LT (04:03)
And your CFO methodology, I think you've recently changed it pursuant to something I believe that Kate and I are seeing a lot of in the market, which is GP-led CFOs. So, you know, kind of what was the impetus behind your changes there?

GF (04:19)
Yep, that's exactly right. So when I say we we've rated CFOs for a long time, historically, if CFOs were around or more LP-led CFOs, where an LP could be an insurance company, could be a sovereign wealth fund or pension fund, they have a portfolio that, you know, buyout funds, a credit fund, infra funds that they've bought for over time, and they need liquidity for whatever reason. I mean, now, now we see that because the markets have been a little bit weaker, and LPs are not getting as much in distribution, so they're seeking liquidity. Pre-GFC, sometimes it was for similar reasons. Sometimes it's for regulatory capital efficiencies. Sometimes it's just kind of portfolio management. In any case, so you have an LP with an existing portfolio of assets. They'll move those assets into an SPV that issues debt and equity. In that case, the LP sponsoring the deal would most often keep the equity, and then the debt gets sold externally to insurance or asset management investors, similar to other ABS. And that's been around for a while, but fairly niche market. When we've rated those, really it could be only two deals a year. And so I would say five or six years ago, when we would talk to people about CFOs, 95% people didn't even know what we were talking about. And so I think that just shows the significant growth in this market. 

And so when we built our methodology at the time and the model, it was really geared towards these diversified transactions. So you might have 30, 50, 100 fund interests within a CFO, quite diversified by GP and strategy and fund. And the model that was designed was around that. And so the model wasn't really meant to address GP CFOs. In the last few years, we've seen significant growth in GP CFOs, and the motivation there is more frequently, really primarily capital raising. It's a way for GPs to get kind of more debt investors, more insurance investors to come into their funds in a capital-efficient way and raise more money. And so, however, in a GP CFO, you tend to have more concentration, right? So you might only have three or five or 10 funds. We have rated a couple of GP CFOs in the last few years, but really only with the largest GPs who could actually put together 10 or 15 funds at a time. With the new methodology, we've adjusted our data model to be able to reflect these structures that we're seeing with more concentrated fund portfolios. We still generally think that diversification is a good thing. You know, all else equal, a CFO with more diversified set of funds and strategies and underlying assets will get more positive results and higher ratings or higher LTVs under a model than a more concentrated CFO. But of course, we do take into account the quality of the funds and the managers. So there are some counterbalancing points.

And so some of the main changes in the new CFO methodology were around concentration. Previously, we had these very hard limits that would create cliff effects. If you have excessive concentration to a fund or a GP, again, it was just built for different types of transactions. We've adjusted those to have more linear concentration haircuts. We've added a framework to take a more specific view on a GP. How do we decide what type of GPs are high-quality that we're more comfortable with versus maybe ones that have less experience with a particular strategy, more limited staffing, or maybe less consistent performance in their prior funds. So we have a framework for that on that basis, the modeling and the rating would be adjusted. And that's something that was maybe a smaller part of the prior methodology.

The other change is really not related so much to GP CFOs. It was more a methodology change. So previously, the way we've modeled funds, we'd look at the funds in a portfolio of a CFO and look at how funds of similar profiles have performed in the past. So for example, let's say you have a five-year-old and a six-year-old buyout fund in your CFO, and the notes that the CFO issues have a 10-year maturity. So we would look at how do five- and six-year-old buyout funds perform over 10-year periods. So you might look at the period like 2005 to 2014, 2008 to 2017, or 2014 to 2023. So you look at kind of all these different periods in the past. And what that really gives you is the ability to test market cycles. So for example, the same, let's say, six- or seven-, eight-year-old buyout fund might distribute 25% or 30% of its NAV in a given year in a good environment. Let's say, think of 2018, 2021 or 2005. And this is fairly consistent, right? You're gonna have market cycle, you're gonna have a certain period in the cycle, you're gonna have late-stage cycle, and then you're gonna have a downturn. And downturns do happen. So we do model for those. In a week here, let's say like we've had in last, let's say three years or so, the same eight-year-old bio fund may only distribute 10% or 15% of its NAV in a given year. And so the methodology is really meant to address these kind of market cycles and timing of distributions based on what's going on, as well as the profile of the funds. Now the change that we've made is in how we scale that to more stressful rating cases. So in prior methodology, we'd look at the historical data. And if you look at the entire universe of, say, five-year-old buyout funds at a particular point, that is kind of our base case. And if we want to say, well, for a single-A stress, so a A rating, you really want to stress the historical performance more, because there could be changes in the future. For example, the current prolonged period of weak distributions is actually the longest that we've seen. So, you know, the GFC maybe saw a deeper, bigger decline, but it wasn't as prolonged versus what we're seeing now. You know, there are developments in the market like funds now using NAV loans. There's continuation vehicles, there's changes in interest rate environment. So, you know, the past is a decent indication of what could happen in future, but future is going to be different. And so we do want to stress the historical cash flows. So previously we would do that by looking at only fourth-quartile funds for a single-A stress. And now we've changed our approach. And essentially what we do, we'll look at the historical performance, set DPI targets for each fund, and then look at standard deviations and adjust those DPI targets. So let's say if your standard fund might do a 1.5 DPI in a kind of base case, maybe it drops to 1.3 or 1.2 under more or 1.0 depending on the stress case that you want to put on it. So that's in a nutshell, some of the changes. I know they're quite complex and in the weeds, so there's more detail, but I don't want to lose more people that maybe already lost through this description.

KL (12:19)
Actually, we love it. We're here for all of the detail. And I think our audience is too. And there were some nuggets in there, Greg, that I think will be really important to underscore for many market participants looking to branch out in these types of products. So first, it sounds like it's of less importance, still one of the factors, but of less importance if this is a nascent strategy or an emerging sponsor, it will be taken into consideration, but it's not necessarily a no for you guys right away. Did I understand that correctly?

GF (13:00)
You mean under the rated feeder methodology or CFO?

KL (13:04)
Well, I guess both for our audience, but with respect to the methodology that you recently changed, it sounds like you're pivoting away from some of the harder guardrails and into a more comprehensive analysis. And you've expanded the factors that go into it and are able to have a little bit more flexibility in your approach to rating these types of products.

GF (13:28)
Yeah, would say the asset analysis hasn't changed all that much. We've had kind of this change in approach from the fourth quartile to the DPI, but the results are not all that different, I would say. The concentration framework — that has changed. And again, we because you would get some very draconian results with certain GP CFOs that really didn't make a lot of sense under the old model, which like I said, what wasn't really calibrated for that. So that has changed. Under both methodologies, we can work, we do in fact work with new managers or new sponsors. For CFOs, I would say it's probably less important. We've rated CFOs where the original investor sponsored a deal as an insurance company, could be highly rated. We've done some deals where it's a family office, and they're looking to get liquidity. You know, the assets are the assets. They sit within the SPV. That's just like any type of structured finance type of vehicle. We do care about, of course, who's managing the CFO, but more from an operational perspective. Because if you have a static CFO, honestly, it's relatively straightforward. You need to meet capital calls. You need to do reporting. The portfolio was already selected, and we will take a view on the portfolio. Where the sponsor, the manager can come into play is if they are providing some credit enhancement or credit support to a transaction. For example, with some LP CFOs, particularly from highly rated insurers, they might provide a backstop to meet capital calls. They might say, you know, the CFO doesn't need to use cash generated to meet capital calls. The insurance company will put in basic additional equity, additional capital to meet those capital calls as we go along, or they might do it under certain conditions. But you also have some CFOs that are essentially, they're really a standalone vehicle and they're supposed to just survive, you know, with their own tool and viability. So in those cases, you're more likely to see cash reserve accounts, might see liquidity facilities, and that's meant to address any liquidity mismatches between when you're getting distributions and you have to meet capital calls and meet the interests. On your question, maybe, on rated feeders, probably more relevant there. We have worked with some first-time managers. Now, of course, the principals working there, they have a lot of experience, right? They might come from big shops, maybe they've helped set up a similar strategy before, they've certainly done the investing. So we're generally not really that concerned about the individual's experience. We do care about, you know, have they worked together? Is there enough depth on the team where, you know, if things happen, somebody gets hit by a bus or the partners have a fight and somebody leaves, that can have a material impact on a small manager. So we do look at mitigants there. There's key person provisions and the LPAs. Often, or sometimes there's a strategic relationship with, let's say, an anchor investor that might provide some operational support that could be important. But yes, I would say first-time managers besides these management operational aspects that we review, when you look at the portfolio, you don't have as much to go off of in terms of track record. Because the individuals might have a track record. Well, they will have a track record. But it's coming maybe from different places. And you're not exactly sure if the strategy has changed. So we model those more tightly. We'll basically assume that the portfolio is kind of worse than maybe what we expect versus let's say you have a fund manager, and this is their fifth fund and they've operated the strategy relatively consistently. We can have a higher degree of confidence that, you know, this is going to be the portfolio that we're going to look at, so we can model it. And again, it all goes back to rated feeder you're generally starting from no assets, right? So you have to come up with what are they going to do? You know, if it's a, let's say credit secondaries fund, and they say it's going to be X percent direct lending, some opportunistic, maybe some distressed. In our modeling, it's going to make a difference if you have, you know, is it 10 percent distressed debt or 20 or 30 percent? And the guidelines in fund LPAs are usually fairly wide. So you can't rely on those as much. You have to look at those plus the marketing material and the model portfolios that you receive.

LT (18:13)
Interesting point there. So one, one thing that I have kind of been grappling with in in a couple of different CFOs, and Kate and I and the team have more CFOs than I had ever expected to have going at one time in my life. But there's such a variety of things that people are looking to do. You know, so everything from quite a variety of asset mixes right now as well, which I would presume having sort of different, let's say, sector assets, so call it some corporate, maybe some real estate, some infrastructure, some PE, something like that. I would presume that something like that would also be of benefit in the context of the methodology, but certainly not dispositive one way or the other.

GF (19:06)
Yeah, like I said, we do like diversification, and it can be fairly obvious things. For example, let's say I have a CFO that's all real estate funds or majority real estate funds. We've looked at those and obviously real estate can perform well, but there are going to be some periods where it doesn't perform well, and you don't have anything to counterbalance that. But actually similarly, we see that now with buyout and the whole discussion around software exposure. I mean, a couple of years ago, in fact, like during COVID, when we looked at the CFOs that we had, the ones that had software exposure performed much better because that was still in demand and there's still some exits and that was great. But this is the thing about diversification. You never really know what's gonna happen in the future and here we are and now software is out of favor. So having diversification is important. It could be across strategies, vintages — also very important. If you have a CFO that's invested across three or five years, maybe you go into a downturn at some point in the middle and they've bought some assets at the peak, those are not going to perform as well, but then they might have an opportunity to buy some assets at the bottom. So it balances out, versus if you have everything from a single vintage, let's say if you bought a bought a lot of assets in 2021 at the peak, I think that's not going to perform as well. So, you know I think sometimes we find these things are a bit lost in the market. Everybody obviously is scrambling to do lots of CFOs and rated feeders. And we haven't had kind of big downturns in a long time. So we'll see what happens when one of those comes.

LT (21:01)
Exactly. 

KL (21:04)
I have a question. All right. So I guess piggybacking onto that last point, and before we kind of get ahead of ourselves guessing what sectors or asset classes are going to be subject to headlines next, what are, if you have any, no-fly zones for a rating from Fitch. So there are some rating agencies that feel uncomfortable with commercial real estate in the rated note feeder context or in the CFO context. If commercial real estate is over a certain percentage of the overall portfolio composition, it tends to be a no-fly zone. Are there any asset classes? Are there any percentages, ceilings? Lindsay and I have seen a ton of momentum and increased interest in more esoteric asset classes, you know, kind of like specialty finance type assets. So really curious to get the lay of the land from your perspective, you know, what are those no-fly zones for you as a platform? If, again, if any, or if there are any ceilings or thresholds where you would kind of get uncomfortable and it would make you rethink the overall portfolio composition for a specific strategy in rated note land or within a CFO?

GF (22:30)
OK, yep. And I can address it across a couple of products. And I'll try to address the theoretical and also the practical. So really, we don't really have kind of no-fly zones. The type of assets that are chosen for a transaction will really drive the modeling results. And where I guess we can't model something is probably around information availability. So, but we don't have kind of like a principled no-fly zone. Let's say in the CFO, we've rated a number of CFOs that had venture exposure, energy, natural resources. We've even rated kind of know, NAV loans are, and other CFOs are primarily backed by venture or real estate or infrastructure assets. You should just expect lower advance rates and may more favorable structures where they amortize faster or have more stronger LTV tests, for example. So sometimes that still works. Sometimes the advance rate is just kind of well below what the other party expects. We decline plenty of transactions. In a way, we don't really decline them. We provide feedback that basically just doesn't work for the other party. Either the rating is too low or say, yeah, fine, you can get to single A but it'll be 20 % LTV or whatever something. It's not economic for them or they might go somewhere else to try to get a better result. And then in terms of rated feeders, again, this is kind of theoretical and practical. If we have a methodology to address the assets, then we can rate a rated feeder for that provided there's enough guardrails. The most straightforward things would be direct lending or secondaries, more established classes. If you start getting into ABF, that becomes a bit more complicated, but we do work on ABF funds. For example, let's say you could have a bucket that's resi, some CMBS and consumer ABS. If they're well-defined enough, then we'll get the right teams at Fitch involved and then we can certainly take a view on a resi or consumer ABS. I think real estate-backed debt and to some degree, infra debt is doable, but I'll give an example for example, in CRE CLOs, which we do rate, those are usually structured with rating agency confirmation. So every deal you want to do, you come to Fitch, say, here's the deal, and will it have an impact if I add this deal to the CRE CLO? We might say, no, this one's fine. And then it gets added. So this is what's called the rating agency confirmation. It's a method that market has gotten comfortable with in context of some transactions. So we can do the same with rated feeders. The problem with CRE, why do you need this kind of process with CRE CLOs or certain infrastructure debt, is because it's so bespoke. If you have a direct lending fund, it's relatively easy to define, okay, they're all corporate loans, they have certain features. I'll give an extreme example in the CLO, it's even easier. They're all rated, very standardized, so you can relatively easily define investment guidelines. With real estate, you could say, LTV of 50 or, you know, certain parameters and profitability, but it's gonna make a big difference if it's a building, know, an office building in New York City versus, you know, retail property somewhere, in the middle of the country, right? So it's very hard to define some of those characteristics in investment guidelines pre doing the deal. That's why, you know, in CMBS, all the emphasis is on the asset and analyzing that particular asset. So I think it's very difficult to do without having this kind of rating agency confirmation concept. So that's, again, kind of a little bit of the theoretical and a little bit of the practical aspects of that. I hope that answered the question there.

KL (27:07)
Yeah, that was excellent. 

LT (27:09)
Speaking of RAC, that's something that folks in CFOs are also curious about, right? So not the underlying assets per se of the funds themselves, but the idea of perhaps adding funds, you know, throughout an investment period or maybe switching some of the funds out, be that in possibly vintages, of the same fund or just an actual swap out of one fund for the other, perhaps in a similar asset class, perhaps not. But is that something that your methodology kind of permits or would that be something that if you were probably looking to do that, you would need to go for rating agency confirmation on that swap out?

GF (27:59)
It depends on how tightly the guidelines are defined. We have rated some CFOs in the past, including some publicly rated deals where there was a RAC concept. Whether you want to do that, I think really depends on how often you intend to use it. Let's say you're going to add a fund or switch out a fund once a quarter. You can send Fitch an email, tell us, hey, this is the fund I want to add. Within a day or two we can get back to you if it's not a problem. It's usually probably not gonna be a problem, and it's fairly easy process. If you're, every week you're making changes, then that becomes a more cumbersome process, right? And you probably don't want to do a RAC, so then you want to define investment guidelines. We can work with investment guidelines. They need to be sufficiently well-defined. And again, our analysis is done primarily kind of based on the type of fund that you add. And it's kind of similar to what I was just talking about where there are certain factors that are relatively easy to describe. You can say, “I will buy a fund that's between let's say three and six years old of these strategies.” Let's say it's gonna be buyout or infra, no real estate, no venture. Okay, so that eliminates a lot of things. But then how do you define the fund's performance or number of assets or the GP quality. That's a very qualitative factor or how much NAV there is versus unfunded. You can probably add some parameters around that. But, again, it's much more difficult than, or cumbersome, than let's say in a CLO, you have a WARF factor. And that's going to be driven by maturities and ratings, which you already have preexisting on the individual loans. In a CFO, the funds are much more bespoke. And particularly, for example, now we might have, you know, might have evergreen funds. If you say I can add an evergreen fund, well, is it distributing or accumulating share class? What kind of redemption mechanisms do they have? What kind of gating mechanisms do they have? Changes can happen to fund terms, where you go from, you it's an interval, you go to a tender or you close it or you try to do something else with it. How do you define these kinds of parameters for something that might happen across many funds, you know, five or 10 years down the line? We think that's very difficult. So, it depends on what type of funds you want to put in and how tightly you're willing to make the parameters. Otherwise, we think at some point the analysis becomes a bit nonsensical. You're really just not gonna know what kind of assets you're gonna get in there in the end. And then I don't think the analysis becomes very credible.

LT (31:02)
Maybe let's switch gears a little bit away from those two methodologies. You did mention a couple of other things, which we certainly are seeing an increase in looking for ratings on certain types of facilities. So what are you seeing in kind of the subscription facility, NAV loan, kind of more traditional fund finance area as regards people looking to rate those loans?

GF (31:30)
Sure, and we find the more traditional areas still quite exciting. A lot of innovation still happening there. So let's say with subscription facilities, since we started rating these about three years ago, we've rated about 350 facilities. The demand has been driven by both banks looking for regulatory capital relief, primarily in Europe, some in Asia or other areas, but also by institutional investors coming into the market and institutional investors like insurers or pensions often need ratings either for capital reasons, could be investment guidelines, could be risk considerations. We're seeing lots of new participants coming into the markets, both institutional but also some banks that historically haven't participated. We often do teach-in sessions for banks, for the risk departments to explain methodology and the data that we have. So that's been a lot of the demand for the ratings. You have some very plain vanilla facilities, you large funds might have 500 LPs, mostly institutional, 60% advance rate, that's fairly straightforward, that usually gets like a AA type of rating. We've seen a very good history of performance of these type of structures. But there's innovation there as well. We're seeing more tranche B structures where some lenders might be willing to go to a higher advance rate. Maybe the senior is 60 and the junior might be 80% or 90% advance rate. And that would be obviously rated a bit lower. We're seeing actually a lot of separately managed account sublines. So you'd have large institutional investors coming into, they wanna have a bespoke strategy, so they'll set up an SMA, but they still want a subline. So that rating is generally going to be driven by the quality of the LP. We're seeing more ECLs or back leverage type of facility where a fund is buying a new asset. So it's about funds buying an asset. It's financing its equity check via debt. And you might get a guarantee or an equity commitment from the fund with some requirement to maintain unfunded commitments. That could be the case if maybe the fund is already maxed out on its subscription facility, maybe has some limitations on taking on additional leverage at the fund level. So we've rated a couple of those and that seems to be a growing area. Those are more complex and still can be high-quality IG, but not quite as high as standard subscription facilities. And then we've recently rated a securitization of subscription facilities. Those are all term tranches, which itself is an innovation because institutional investors really have a hard time generally dealing with the revolving nature of your traditional facilities. So new products are developed to provide them term tranches. It's usually one- to two-year term, but we've rated some that go out five, seven, 10 years out and that can work for certain types of funds. So there's a lot of demand for those. You can take those and also securitize them. We see a lot of interest from the market in subline securitizations, but really people are trying to do more. The holy grail is to securitize a pool of revolving facilities. And there are some challenges there. So, you know, I won't get into that here, but yeah, that's a lot of what people are trying to do. And then separately on NAV, so we currently only participate in NAV loans to secondaries funds. And we use our CFO model. It's same assets, the structure, whether it looks quite similar. We have some additional consideration for NAV loans, but we've rated about 15 of those since we published the new methodology last year. There's a lot of demand. Obviously, the secondaries market is at record highs, a lot of fundraising. So we expect that segment to continue growing. And we're developing methodologies to cover more concentrated primary buyout NAV loans and ABL credit funds or some segments that we were really not that active in yet.

KL (36:01)
I mean, we want to hear the considerations, the extra considerations of the NAV loan. Honestly, there's different structural priority in play, and those documents look probably night and day when you compare them to the same type of facility, like an inventor for one will look nothing like the other. So curious to hear from a rating perspective. Obviously there's a structural priority, first and foremost, and those types of facilities are secured directly against the assets. So there's first recourse on those assets as well. Is there anything that kind of stands out to you other than those two components in terms of how you approach a rating for those types of facilities?

GF (36:52)
Yep. So the analysis we do for both secondaries NAV loans and CFOs is bottoms up cashflow analysis. We'll look at each of the funds and the portfolio symptoms. We'll look at the assets and we'll model out how much they're going to distribute, how much they're going to call capital over time, over different potential market cycles. We'll do that for both. And you have this cashflow and then you kind of basically drop it through the waterfall. So the waterfalls, as you say, they can be very bespoke. We're seeing more and more cash sweep holidays. That can be fine. But, you know, NAV loans generally have shorter maturities than CFOs. CFO maturity might be 10 or 15 years. NAV standard is five years. And so what that means is you have one year and year and a half sweep holiday and a max LTV that's kind of above your starting LTV. In some scenarios, again, imagine 2005 or 2006 or 2018 or 2021, you could have a lot of distributions coming in, you know, in the short term, that money leaks out to the equity, the LTV increases. And then when you need to start amortizing, you're in a weaker, more difficult market environment, leaves you less time to do that. So with NAV loans, we often see some of the more stressful modeling, you have some residual LTV at maturity, didn't repay the NAV loan.

Now that's a starting point for us. And then the additional consideration would be, well, what other options does the fund have to repay the NAV loan? Let's say you have 20% LTV left at maturity in this particular modeling scenario. Well, the fund can call capital from above. It can sell some assets. It can refinance it. So we assess that, the ability to do that. And if you have 20% LTV and you have a high-quality fund with good LPs, you're not going to default on that, right? You're not going to lose 80% equity. So we think that's a lower risk. However, if you started with a very high LTV and the structure is not good and money leaked out, then you end up with, you know, 70% LTV in the scenario. Well, I'm not sure LPs would want to throw in additional money after good. And so how much we model that would depend on, well, do you have a guarantee from the fund or some ECL, something that would tie you to it or is it non-recourse? So there are lots of these considerations. A lot of them will come through in the modeling. So that's what we think doing the cash flow analysis is paramount. I think that some of the investors are coming into these various markets. Sometimes we'll do more of high level kind of analysis or more of a scorecard type of analysis. So they look at LTVs, they look at, hey, it's a good LTV, a lot of assets, good manager, but they miss a lot of the nuances because of the cashflow analysis. And we actually see this with CFOs as well. Since we've updated our methodology, we've been looking at lots of proposals, and we are providing feedback that's sometimes more negative for bankers or the fund managers. A particular issue for us is a standard that's developed in a market, which is IIPP versus IPIP structures. And I know in structured finance its kind of different products and they can work with different of these types of amortization schedules. This is really a key because in some scenarios you could have a fund or CFO or if you know it's performing decently well, some money will leak out to the equity early on. And then there might not be enough to pay the seniors because LTV is very high, 75% or 80%, and the interest that's being paid on the B's and C's is very high and if that gets paid before the A's are amortized, then a lot of the cash flow that you're actually generating could be eaten up by the B and C interest. And so we've been going back and forth. We think that we're gonna slowly turn the market a little around or away from this. Yeah, you know, it might not be always great for the equity returns. But we think there are ways to address it. There are ways to set up a deal that, you know, if everything's going well, it's performing well, sure, you know, leak out to equity, et cetera. But when things start turning south, there are additional protections for the senior notes. So that's kind how we've been approaching it. That's kind of one of the biggest issues that we're seeing in the market these days.

KL (41:36)
Fair enough, I know that's something our clients are very focused on, and there's a lot of synergies with investors as well as they're looking to make sure that there are some payments going out to the higher coupon debt in order to preserve kind of the long-standing nature of the fund, its ability to continue operating, etc. Usually Lindsay and I see in that context is, you know, if there's real pressure on the rating or if there's real pressure on the depth of each tranche, the next step that we would see is essentially bifurcation of that waterfall into income and principal proceeds, allowing a little bit more freedom and flexibility for that income proceeds waterfall to continue on the IIPP while the principal proceeds waterfall may be subject to more stringent standards to give more rating protection.

GF (42:31)
Yep. And you make a good point about investors coming in. We are seeing more and more investors from a structured finance background. So I was at SF Vegas recently and ran into Lindsay at the airport. 

LT (42:36)
Very briefly, yes.

GF (42:38)
So I was surprised to see how many fund finance market participants were there. There were a couple of panels in fund finance. You see a convergence of two industries, I guess. I think it's actually good because the fund finance investors are bringing in their perspective, they're used to certain standards. And I, you know, I think in the fund finance industry, you know, sometimes the deals are historically more relationship based, you know, particularly the banks, the way they're structured, their sub lines or NAV loans, sometimes is more relationship based. They'll put a lot of emphasis on the GP, and investors coming in from a structured finance perspective, will say, well, I want an institutional type of structure. And in fund finance, some of these segments are relatively new. I mean, even rated feeders, you guys talked about this recently, kind of the evolution toward more horizontal structures. For us, if there's a horizontal versus a vertical structure, we don't have a different methodology for it. It's just, you have the assets, asset analysis, that's gonna look the same. And then if the structure is different, horizontal structure might look better because it's potentially more debt friendly. It could be structured the same way, but we're going to look at it from that perspective. And the markets are evolving, right? So I think they're some of the really early rated feeders that I'm aware of get like a 98% LTV and things like that.

LT (44:23)
Like in the good old days when Kate and I were first starting out in this industry 10 years ago, everything was wonderful, just, it's like, “some of this is debt.” And went with it that way. It was great.

GF (44:36)
So those kinds things of, I think, institutionalized things are getting standardized. You're getting a lot of scrutiny, which is good for investors, the NAIC. I know people are quite concerned about how the NAIC is viewing a lot of these structures. And so they're structured appropriately. I think that's good.

LT (44:57)
Well, it has been fantastic to have you on. This has been such an amazing dive into just you know the way you guys are thinking about ratings. Obviously, we are incredibly busy, and there's a lot of people joining this market for the first time or doing, you know, their millionth deal in this way. So I think it's super helpful for folks to get this kind of level of information. And I did want to highlight, you guys actually put out some really cool market update papers as well, which I think cover pretty much a swathe of all the different products that you are rating, which can be really helpful to folks. So we'll point them towards your website. And if some of these words, maybe for someone who's viewing this, if some of the things that we were talking about are things that you haven't heard too much about, certainly go back into the archives of the Absolute Credit series and take a look at some of those prior episodes we discussed all the structures that we've been discussing here. So it's been really wonderful to have you on, Greg. We hope to do it on a more regular basis as well. And see you again soon. So thank you very much for taking the time.

GF (46:08)
Thank you for having me. It's been great having the conversation and I look forward to seeing what you have next on the pipeline here.

LT (46:18)
Absolutely. Thank you to all of our audience members. And as always, catch all of the episodes of Absolute Credit on the Kirkland.com website.