Counterparty And Debt Rating

Methodology for alternative investment organisations

Tanya Azarchs and Nigel Greenwood, Standard & Poor's

As the hedge fund industry, along with other alternative investment industries, grows and reaches out to an expanding cadre of investors, it is meeting increasing pressures for greater transparency. Some investor classes are even requiring that the funds obtain credit ratings. In addition, some funds are accessing bank loans to boost their leverage. As a result, requests for credit ratings are increasing and can come in the form of counterparty ratings, as well as unsecured or secured debt, or bank loan ratings. In addition, various constituents, including prime brokers, fund of hedge funds managers (FOHFs), and equity investors take a keen interest in assessments of the operational risks facing the funds and their managers.

Standard & Poor’s Ratings Services has developed methodologies to determine the creditworthiness of hedge funds and hedge fund managers. Creditworthiness is expressed as counterparty, debt, and bank loan ratings. The ratings reflect the likelihood of a fund defaulting on an obligation, such as a bank loan (whether collateralized or not) or other debt, or a counterparty obligation such as a derivative contract.

The ratings incorporate all aspects of operational risk such as governance, risk management, valuation, liquidity management, and leverage, as well as performance to the extent that it affects liquidity. The credit rating, which could be a counterparty, debt, or bank loan rating, further incorporates the industry risk and the risks of the fund’s particular exposures. In other words, the operational risk assessment speaks to how well risks are managed, while the credit risk also incorporates the business risks undertaken. Importantly, the ratings are not an explicit comment on the quality or performance of the investment portfolio. Rather, they speak to the fund’s ability to liquidate its portfolio at any given time, in an orderly fashion, after satisfying all of its creditors. The emphasis on liquidation analysis is greater for funds than it is for other types of operating companies in the financial sector because funds may open and close, or shift strategies as various strategies fall out of favor or cease to be effective. It is not so much its longevity that determines a fund’s abilityto repay creditors, but its liquidity, which in turn, is in part a function of its performance during its life. Thus, the ratings are expected to be significantly more volatile than those of more traditional institutions.

It is very important to note the differences between credit ratings of secured and unsecured obligations of funds from other types of hedge fund ratings Standard & Poor’s provides. Some fund obligations are pooled into structured vehicles (collateralized fund obligations, or CFOs) that sell tranches of debt rated at various levels to support those obligations. Standard & Poor’s also assigns “fund credit quality” and “volatility” ratings to the shares of fixed income hedge funds. Fund credit quality ratings, identified by an `f’ subscript (i.e., ‘AAAf’, ‘AAf’, ‘Af’, etc.), provide an indication of the level of protection that a fund’s holdings (investments) provide against losses from credit defaults. They do not address the fund’s ability to meet any “payment obligations.”

Volatility ratings, identified by the ‘S1’ to ‘S6’ ratings scale, provide an indication of a fund’s net asset value (NAV) sensitivity to changing market conditions. Our Investor Services group provides other ratings that assess the investment performance characteristics and certain operational risk characteristics, but these are not credit ratings.

In assigning credit ratings, Standard & Poor’s receives substantial amounts of confidential information not disclosed to investors or the general public. For a generally secretive industry, Standard & Poor’s represents a credible intermediary for information that can be processed but not funneled through to the general public in any detail that would have competitive consequences for the funds. We rely on an open relationship to provide that information but if it proves inaccurate, or if we find that significant material information is withheld, we reserve the right to withdraw the rating.

The principal risks to creditors of alternative investment funds are:

  • Transparency risk;
  • “Key man risk” and the potential for fraud on the part of key individuals;
  • Liquidity risk;
  • Performance risk, which is closely tied to liquidity risk; and
  • Valuation risk.

Standard & Poor’s does not get daily reports detailing all positions, as they would be of limited value without access to the models and analytical tools used to design the trading strategies.

What is useful to us, however, are risk reports that group assets by asset types and strategies and give overall risk characteristics of the portfolio for comparison purposes. These help us understand the strategies being followed and to see concentrations of positions.

Thus, our ratings reflect a fundamental limit to the transparency of funds, regardless of how good operational risk controls might be. Standard & Poor’s relies on the operational risk reviews and an appraisal of management’s ability to monitor and control risk, rather than on our ability to analyze the positions ourselves. It is, after all, in management’s interest to articulate and enforce policies to ensure risk controls (except, of course, if fraud is intended).

In addition, a large cushion of equity is generally behind creditors’ exposures. The main issue is maintaining a liquidity cushion sufficient to permit orderly sales in a declining market such that, even if investors lose everything, the creditors can be paid out. Very few funds have failed before paying off creditors, except for situations involving fraud. Most “failures” have involved liquidation and return of capital to shareholders.

We count on a close monitoring of liquidity positions as well as frank and frequent dialogue with management to understand changes in investment strategies and liquidity positions. The highest rated funds are those that provide the greatest transparency and demonstrate the most developed infrastructure and culture of risk controls.

In order to address a hedge fund’s risks, Standard & Poor’s unsecured credit assessment pays close attention to the following broad areas:

  • Background of the fund, its legal status and the status of its key personnel;
  • Legal/regulatory issues;
  • Investment strategies (composition and distribution);
  • Risk management (investment and risk management policies, infrastructure, and methodologies);
  • Model risk (pricing/valuation model design and vetting; risk measurement models);
  • Liquidity (asset liquidity, collateral management, covenants and other triggers, and redemption risk);
  • Profitability/performance (shareholders’ total return, investment income, and expenses);
  • Leverage (borrowings/embedded leverage in instruments); and
  • Quality and expertise of personnel.

Hedge Fund Managers

Our criteria for the management companies that sponsor hedge funds borrow heavily from our criteria for asset managers. Hedge fund managers are, in general, somewhat insulated from the direct market risks of the funds. Their cash flows are dependent on the management and performance fees generated by the funds they manage. Fund managers earn annual management fees of about 1 % to 2% of assets under management, and performance fees of approximately 20% of the price appreciation, though there could be provisions for carrying forward prior years’ losses, or a “high water mark,” or minimum total return, or hurdle rate, to be reached before such fees are paid. Other sources of income could be investments in the funds themselves.

Thus, the focus of analysis shifts slightly to forecasts of cash flows available to cover obligations, including fixed and variable expenses. Leverage plays a key role in determining the cash flow coverage calculations. Nevertheless, an analysis of the funds themselves is crucial to the analysis of the manager, as cash flow analysis depends ultimately on the performance of the funds.

The fund’s rating is the starting point for the fund manager’s rating. For a manager with a small number of funds, it would be hard to contemplate a rating above that of the funds as the closure of one of them would likely lead to the manager’s closure or failure. Higher ratings would require a large number of uncorrelated funds that could support the expense structure in the event one fund fails. On the other hand, high leverage could bring the manager’s ratings lower than that of the funds.

Conversely, the management company’s financial health is important to the fund’s health. When cash flows to the management company are insufficient to cover its costs and to adequately compensate the key employees, the likelihood is high that the funds will close, if not default. High leverage or inability to earn performance fees could result in such scenarios, not just a drop in NAV.

A special case among management companies is the FOHFs managers. These are analyzed in the same way as other asset managers other than the close attention paid to the FOHF manager’s due diligence process for fund selection, which should mirror closely the due diligence process for our credit ratings. Reputation risk is high for FOHF managers. Their choice of funds for their managed accounts and funds of funds is the foundation of their franchise, not only in terms of performance but also in terms of headline news about losses due to management failings at those funds.

RATING METHODOLOGY

Fundamental principles

As a general rule, Standard & Poor’s rates established, diversified funds with experienced management higher than other funds. The funds must be duly incorporated in an onshore or offshore jurisdiction with sufficient rule of law to provide creditor protection. The regulatory and reputational records of key personnel are also a part of the rating. The fund must produce audited financial statements on a regular basis. In addition, Standard & Poor’s will review the fund’s legal and regulatory framework as part of the rating process. Close attention will be paid to whether the fund is subject to any regulation, and if so, how comprehensive and rigorous the regulation is.

Organizational structure

When assigning ratings to a particular fund, Standard & Poor’s takes into consideration the structure of the entire fund complex and the implications that it might have for an individual fund.

A large fund complex typically consists of a management company organized as a general partnership, and one or more large funds, which one could call “master funds,” organized as limited partnerships. These funds may also be the majority investors in several satellite funds representing specialized investment strategies. In contrast to more regulated mutual funds, hedge funds are not required to have an independent board of directors (except in some offshore locations). There may also be a broker/dealer subsidiary. Outside investors could own shares of the master funds through “feeder funds” that invest all of their funds either in the master funds, or in some cases, directly in the satellite funds. To date, our ratings have generally applied to the master funds and their feeder funds, as their investments represent a multistrategy or diversified set of investments whose staying power is easier to get comfortable with.

Standard & Poor’s assesses the fund’s investment adviser, focusing on the adviser’s management, reputation, and solvency with a view to the impact that those issues might have on an individual rated fund. In view of the key man risk, we review management succession plans and personnel policies that help retain talent. Stock ownership by employees is another indicator.

Standard & Poor’s generally views a fund that has more institutional elaboration as a stronger credit compared with a fund that relies on a single manager with no support staff. The funds themselves normally have no employees of their own and rely on the adviser for portfolio management, research, distribution, and other services. The better the adviser’s financial health, the better able it should be to provide high-quality support and service to the fund. Standard & Poor’s will not, however, assume that the adviser would provide any needed financial support for the fund, which is, or should be, a separate legal entity that cannot be consolidated in the event of the bankruptcy of the management company. However, problems at the management company, or potential negative publicity could cause a redemption and/or liquidity problem for the fund, and vice versa. In general, we would not assume that a fund would survive its manager’s demise, though the reverse would not necessarily be true if the manager had several funds whose fees it could continue to collect.

Standard & Poor’s also conducts operations and risk management reviews within the context of assessing a fund’s creditworthiness. A key review includes the portfolio management and investment research staffs in terms of size, organization, and experience level. We review the process for, and controls on, implementing trades, as well as portfolio pricing and other back-office operations. This includes operations that are performed at the fund as well as those that are outsourced to third parties. Standard & Poor’s examines the fund’s use of prime brokers and its relationship with those institutions as well as any operational capacity issues. Standard & Poor’s also reviews the composition and role of a fund’s governing bodies and the audit functions. When assigning ratings, Standard & Poor’s examines the financials and performance records of each of the legal entities that are related in any way, through cross investments or loan arrangements. The performance of each of the funds, as well as their liquidity, contribute to the liquidity of the master funds, which are typically the funds being rated.

Risk Management

In the course of a risk management review, Standard & Poor’s considers the policies governing risk, the infrastructure surrounding risk monitoring and measurement, and the risk measurement methodologies.

Policies

An important aspect of risk management is the firm’s risk culture. Written policies outlining the responsibilities and authorities of personnel are only a formal manifestation of the risk management organization. More critical are the less formal aspects of how risk is communicated within the firm, how the risk appetite is defined and then enforced, and reinforced through incentives and/or disincentives. While the alternative investment funds are evolving, most do not have the kind of independent risk management organization found in commercial or investment banks. Rather, risk management is seen as the business managers’ responsibility, and is defined predominantly as the risk of not meeting investment objectives. Standard & Poor’s also inquires into the ways in which trading limits are assigned and monitored to prevent unauthorized trading and position concentrations. Also important is credit risk management and administration for counterparty risk in derivative transactions.

Infrastructure

The firm’s risk infrastructure consists of systems that track, report on, and analyze risk positions. The sophistication and integration of these systems are important not only for the ability to design and analyze trading strategies for funds that are model intensive, but also to permit senior management to understand the positions. Back offices also need to have adequate resources to handle the volume of trades, and they need to be independent enough and with enough controls in place to preclude interference with the correct reporting of positions. We also look into the relationships with the fund administrators to determine the level and tracking of failed settlements, and the quality of the independent verification of valuations.

Methodologies

Risk analytics are critical for firms with model-driven strategies. Standard & Poor’s evaluates:

  • The robustness of value-at-risk (VaR) models and other methodologies for assessing risk and/or providing risk limits;
  • Role of stress testing for gauging market, liquidity, and credit risk; and
  • Credit risk measurement for derivative instruments.

Valuation methodologies are a crucial issue to creditors, who need to be assured that the NAV is accurate. They are especially critical to funds that deal in complex derivatives whose pricing is model driven, and less-liquid securities. Standard & Poor’s evaluates the robustness of the model vetting process. We also review the independence of checks on the model inputs as well as outputs. We cannot, however, provide an audit to verify the accuracy of the valuations.

Investment Strategies

Beyond the risk governance issues, we also look at the risk strategies:

  • Investment objective, philosophy, strategies, policies, and practices;
  • Permitted/eligible investments represented in the prospectus or other descriptive documents versus internal policies;
  • Approval and selection process of investments;
  • Diversification/limits by type of security, issuer, counterparty, and/or industry;
  • Specific trading strategies, including leverage and hedging;
  • Prohibited/restricted activities;
  • Actual mix of securities types and strategies;
  • Change of portfolio mix in light of market conditions; and
  • Percentage of illiquid or unregistered securities.

The review also encompasses the analysis of different portfolio asset classes and the factors relevant to each asset class’ particular potential market value volatility, such as:

  • Equity securities. Market capitalization, industry mix, liquidity, and domestic versus international exposure; long versus short exposures;
  • Money market, fixed income, credit derivative, and hybrid securities;
  • Credit rating, maturity, duration, yield, call risk, issuersize, outstanding issue size, industry mix, and geographic mix;
  • MBS structure types. Domestic versus international exposure;
  • Derivatives activities. Specific strategy, counterparty risk, and long versus short positions taken for either hedging or position-taking purposes;
  • Other investing activities. “Side pockets” of less liquid investments such as real estate and/or private equity and bonds or bank loans funded through CDO structures.