Moody's Investors Service has published a methodology for rating the unsecured debt of hedge funds in response to their growing interest in accessing public debt markets. Moody's expects to issue its first ratings on unsecured hedge fund debt in the coming months.
The emerging prospect of hedge funds issuing debt is a sign that the industry has entered a new, more mature phase, Moody's says.
"Some of the larger funds are adopting not only the infrastructure and risk management systems of more established and diversified securities firms, but also capital structures, including ones with unsecured debt," says Joel Levine, a Senior Vice President at Moody's.
Moody's says that hedge funds remain fundamentally different from currently-rated securities firms and traditional asset managers, and that these differences generally work against high credit ratings. Most significantly, the equity capital in hedge funds is not permanent˜investors can require that the fund redeem their investment, reducing the reliability of equity as a "cushion" for unsecured creditors.
This can effectively subordinate unsecured creditors not only to the interests of secured creditors but also to those of the equity investors, Moody's says, though some funds do have provisions that act as a brake on investor redemptions.
Additional rating weaknesses common to hedge funds are the lack of regulatory oversight, weak corporate governance, and, frequently, their unfettered ability to shift investment strategies.
Levine says the hurdles for a hedge fund in achieving an investment-grade rating on its unsecured debt, absent specific covenants in the security,are challenging but not necessarily insurmountable.
Features supportive of investment-grade debt ratings would include the following: redemption limits; a high level of diversity in investment strategies, investments, and investors; robust liquidity; strong management and corporate governance; and excellent operational quality.
Since September 2006, Moody's has assigned Hedge Fund Operations Quality (OQ) ratings that assess the operational strengths of a hedge fund's infrastructure, and the unsecured debt rating approach incorporates an assessment of operations quality as part of the overall risk management assessment.
Moody's methodology for rating the unsecured debt of hedge funds rests on three pillars: risk management and governance, business profile, and financial profile. Additional rating considerations include legal structure and debt covenants, market considerations, manager's equity participation, and other manager-related considerations.
Moody's methodology also examines causes of hedge fund failures, and finds the most prevalent being fraud or major operational failure, and the sudden loss of liquidity following a market event.
Moody's notes that hedge funds have grown substantially in number and size in recent years. In terms of assets, they have shown a five-year compound annual growth rate of about 21% and a ten-year compound annual growth rate of about 27%. At the end of 2006, hedge funds managed about USD1.4 trillion in total assets globally, with the largest funds managing roughly USD30 billion each.
The methodology is titled "Assigning Unsecured Credit Ratings to Hedge Funds."