Hedge funds' debt obligations represent some distinct issues that are not present for other types of corporate debt. Because hedge funds typically do not have permanent capital, the position of debt in the capital structure is unclear. In principal, it should be senior to equity in liquidation. In reality, if equity holders can redeem ahead of the maturity date of the debt, the debt effectively can become equity. Standard & Poor's Ratings Services evaluates the degree of permanence of the capital, as well as the effect of any covenants, to determine the degree of subordination inherent in the debt. On the basis of that analysis, we could rate the debt lower than the counterparty credit rating. The counterparty rating indicates a fund's general capacity and willingness to meet its financial commitments as they fall due, but does not address the issue of whether the obligations could be subordinated. Hedge funds' senior debt would receive that rating only when we have confidence that it will not become subordinated to equity.
Because hedge funds typically fund themselves largely on a secured basis, senior unsecured debt is already in some sense subordinated. The presence of senior debt alleviates the pressures of depending on short-term collateralized lines of credit (margin and repo lines) that can disappear, and that can trigger margin calls in periods of stress. The counterparty rating already factors in the priority position of secured debt. Unsecured term debt represents more patient capital that could withstand a more substantial drop in market values than collateralized debt ordinarily would. In that sense, it benefits the fund's liquidity position. That also means, however, that unsecured debt can be the last source of funding in times of major stress. Whether that becomes the case is a function of several factors, such as:
The liquidity the fund provides investors;
The amount of more permanent capital in the fund such as management's interest in the fund or deferred incentive payments;
The term of the debt;
The volatility of fund performance; and
Covenants of the debt.
To evaluate these concepts we look at the following three key ratios:
Unsecured debt-to-permanent net asset value (NAV);
Term of unsecured debt-to-time to liquidation (TTL); and
Volatility-adjusted NAV-to-unsecured debt.
Unsecured Debt-To-Permanent NAV Ratio
A certain portion of capital could indeed be regarded as longer-lived or even permanent. That is the deferred compensation, which can have long vesting periods. In addition, management typically has an interest in the fund, which it would not typically be able to redeem in periods of stress. We would regard the deferred compensation vesting later than debt maturities, as well as partners' interest, as permanent capital for purposes of calculations. If permanent capital exceeds unsecured debt, then unsecured debt is indeed senior.
Time To Liquidation
The liquidity provided to investors includes a combination of considerations such as redemption provisions, lock-up periods, "gates," and any other attributes that determine how quickly the investor can redeem shares. We calculate a TTL that represents the number of months it would take investors to redeem their entire portion of the equity if they withdrew the maximum permitted each month. We assume that the more permanent capital (i.e., that belonging to management) would not be withdrawn in times of stress as it would send a poor signal to investors. Most funds also have the right, and the duty, to cease permitting redemptions at will in cases where rapid liquidations of assets would favor investors paid out earlier over those that remain. That is, liquidating the better quality assets first, or selling assets at distressed prices, could mean that some shareholders retain more value than others. However, this clause would be invoked only in extremity. Unless there is a written policy as to exactly when such a clause would be invoked, we do not factor it into the TTL calculation, as it would be impossible to predict.
Term Of Unsecured Debt-To-TTL Ratio
The term of the debt also figures into the debt's potential subordination to the equity holders. If debt exceeds permanent NAV and the debt's term is longer than the TTL, then the debt holders can be at the bottom of the capital structure at time of default.
Volatility-Adjusted NAV-To-Unsecured Debt Ratio
Certain covenants can help insure that debt-holders can, in a deteriorating situation, be repaid ahead of equity holders. The simplest one is a covenant that requires accelerated repayment of the debt when the NAV of the fund falls below certain levels. This preserves the value of assets with which the debt can be repaid. What the appropriate ratio is depends on the volatility of the fund. More volatile funds need more cushion above the debt level to ensure that debt will not exceed the NAV. We rely on the historical volatility patterns as a guide, with an overlay of subjective judgment as to whether the trading patterns have changed in a way that could alter future volatility. We use a five-year monthly volatility of the percentage change in NAV measure with a 99% confidence interval to arrive at volatility-adjusted NAV, which is the numerator of the volatility-adjusted NAV-to-unsecured debt benchmark.
A higher volatility adjusted NAV-to-unsecured debt ratio trigger is not always better. Part of the reason for issuing debt is to obtain more stable sources of funding. If the trigger is set too high, such that it could be triggered by relatively normal volatility in NAV, the requirement to redeem debt could introduce undesirable pressures on the liquidity profile, and could negatively affect the counterparty credit rating. Therefore, the optimal trigger is one that is fairly close to the volatility-adjusted NAV-to-unsecured debt benchmark, or about 1.5x.
Other aspects of covenants play a role in our assessment as well. They could, for example, provide for less specific trigger points for early repayment of the debt, or for restricting redemptions by investors.
All of the mentioned issues figure into our assessment of the degree of subordination borne by unsecured debt holders. If covenants are weak or nonexistent, and if capital can be redeemed more rapidly than debt, then we would notch the debt rating down from the counterparty rating.
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