Overview
Providing capital to funds can take a variety of different forms. This article provides an overview and a short description of the relative merits of each form. In 2023, Egan-Jones was the market leader in rating deals in the private debt space; the firm rated ~2,900 deals, most of which were in direct lending.
Figure I: Overview of Funding Structures
Funding Formats
I. Feeder Funds/Structured Notes – This structure is typically used to facilitate those investors who prefer to invest in fixed income-type instruments. Typically, a feeder fund is established to invest into an underlying fund.
On the asset side of the feeder fund is an equity interest in the underlying fund and on the right side of the balance sheet is a note (the “A” portion or “Structured Note”) comprising typically 80% of the capital in the case of middle market loans with the balance being loans (the “B” portion).
(The same investor typically invests in both “A” and “B” portion.) Since the “A” portion is viewed as debt, it typically obtains attractive regulatory capital treatment.
Figure II: Example of Weighted Average Asset Quality and Liability Distribution
In the above example, the weighted average asset quality is “BB” whereas on the liability side the Slice “A” is 85% of the Capital and Slice “B” is 15%. Since Slice “A” typically receives advantageous capital treatment, it is a more attractive format of investment.
Note, in deriving the rating major factors include asset diversification, asset quality (and corresponding estimated losses), yield on Slice “A”, and manager experience and quality. In some cases, the underlying entity is structured in the “A”/ “B” manner, obviating the need for a feeder. Otherwise, the asset side of the Feeder Fund is an equity interest in the underlying fund.
II. Subscription Lines – This structure uses the credit quality of subscribers of investors into the fund to establish the basis for loans or advances to the fund itself. The structure enables managers to make investments via the credit line and subsequently pay such drawdowns via proceeds from subscribers. Regarding advance rates, they are typically a function of the credit quality of the subscribers, the terms of the subscription documents, and the quality of the manager. Note, this type of funding is available at the front end of the fund since over time the subscription obligations will be fulfilled.
III. NAV Loans – This structure uses credit support derived from the value of the assets of the fund. Advance rates are typically a function of the credit quality of the fund's assets, diversification, liquidity, cash flow, and manager quality. These loans are typically structured in a flexible manner to reflect changes in fund holdings. For a well-diversified middle-market loan portfolio, with an advance rate of 80%, the rating on the loan might be in the A- area, reflecting the approach used for the Feeder Funds (FF) above. Note, all other things being equal, an NAV loan is often viewed as stronger than FFs since it has a direct claim on fund assets whereas FFs are essentially pari passu with other the underlying fund equity holders.
IV. Hybrid – This structure combines both the Subscription Lines and NAV Loans features. Commonly, there is an evaluation of the funding availability under both approaches and an advance is made accordingly.
V. GP Loans – This structure provides funding based on the expected fees accruing to the manager of the fund. Typically, these fees are senior obligations of the fund and basically pari-passu with other fund expenses. Consideration is often given to the fund’s longevity, the quality of the manger, and the fund performance.
Fund Types
The type of funds runs the gamut of the various types of assets available for investment. Regarding the funding available. The most creditworthy (and thereby providing the highest advance rates) are those of high credit quality, liquid, and widely held. Diversification, manager experience, and manager success also are typical considerations for advance levels and in turn, the credit analysis process.