Over the last few years, Fitch has fielded an increasing number of inquiries to rate hedge funds (also known as alternative investment funds) and related fund-of-funds structures, both in the U.S. and Europe. While the greatest interest has been in developing structured products, such as collateralized debt obligations (CDO) backed by hedge fund strategies, Fitch has assigned a limited number of counterparty and secured debt ratings.
The universe of assigned ratings, to date, have performed well, including during the stressful periods in the third quarter of 1998 and second half of 2000. This can be attributed, in part, to the conservative approach taken toward the asset class as a whole and a bias toward high-quality participants. Given the potential for dramatic losses and the industry's relative lack of transparency, this conservatism is fully warranted.
The incentives for hedge fund and fund-of-fund managers to access the structured finance market, issue secured debt, or to pursue a counterparty rating include:
*The ability to diversify funding sources and lock in term financing
*Increase assets under management
*Leverage existing infrastructure
*Provide leverage for underlying investment strategies
*Potential lowering of a fund's cost of funding
For example, following the Long Term Capital Management debacle in late 1998, several hedge funds suffered substantial losses when they were forced to liquidate assets involuntarily due to termination of credit facilities or to meet margin calls. Recognizing the dangers of relying on a limited supply of market-reliant funding sources, a number of hedge fund managers have utilized CDO structures to complement their goals.
There are unique challenges associated with analyzing hedge funds and structuring securities collateralized by their investment strategies. Some of the issues and attendant risks that arise for this largely unregulated industry include: loose definitions of investment strategies, which make it difficult to set sufficiently restrictive parameters; manager-specific risk issues, such as investment style drift' and key-man risk; use of leverage, including off-balance sheet derivatives; liquidity management; and quantifying overcollateralization/credit enhancement levels. Two major applications for hedge fund related ratings are counterparty risk ratings and collateralized debt obligations.
Counterparty Risk Ratings
Whether rating hedge funds for counterparty risk or secured CDO structures, the rating criteria for hedge funds start with a fundamental credit and risk analysis. The largely unregulated nature of this market, low barriers to entry, complex trading strategies of some funds, and limited track records of many managers argues for a rigorous due diligence and selection process. The current hedge fund market is dominated by a relatively small number of very large funds (over $1 billion in capital) while most hedge funds have under $50 million in capital. Also, the returns of hedge funds within the same investment category exhibit surprisingly low correlations. This lopsided distribution of capital in the hedge fund industry and varied performance of funds utilizing similar investment strategies further supports the need for a rigorous examination process.
Rating hedge funds for counterparty risk raises important issues such as style drift, liquidity management, single manager risk, event/fraud risk, reliance on historical performance, and management succession problems. As a result, the preference is towards higher quality hedge funds with a strong franchise, an established infrastructure, and a well-defined, lower risk, transparent strategy. The initial assessment focuses on the following key issues:
*Portfolio and Risk Management
*Legal Review and Documentation
The initial assessment is largely a pass or fail test. Funds that are unable to satisfy the basic due-diligence evaluation will have difficulty achieving the desired rating regardless of the structure or investment strategy. Even the strongest participants may face a natural cap' on their ratings given their inherent risk profiles.
Market value or cash flow CDO technology may be appropriate for certain hedge fund strategies. Some strategies and funds are more viable for structured deals than others, particularly those with longer track records, consistently below-average volatility, and transparent investment strategies. Some of the challenges in using CDO structures for hedge funds are:
*Defining investment and portfolio parameters (e.g., leverage and other investment limits) that protect debt holders, without overly constraining the manager.
*Measuring downside risk by investment strategy to arrive at advance rates/subordination levels. Techniques used may include applying multiples of the worst case performance to size the rated debt/subordination level, taking into account the strategy type, individual manager performance, and the relevant stress case.
*Assessing fraud risk and the propensity for hedge fund operations to rely on a few key individuals.
Fund of funds strategies may be more leveragable in CDO structures than single hedge funds. This is due to lower concerns with single manager and style risks, greater diversification, and institutionalized manager selection process.
The general parameters for a fund of funds CDO structure include:
*Maximum allocation by number of funds, managers, and strategies/sub-strategies
*Percentage in a single fund, manager, and strategy/sub-strategy
*Percentage in a cash reserve fund, if applicable, and/or other sources of liquidity
*Redemption rights of the underlying hedge funds
*Advance rates for the hedge fund portfolio
In addition, overcollateralization tests, minimum net worth tests, and other CDO-inspired features may be utilized.
Advance rates will be set by a combination of qualitative and quantitative factors, with particular attention paid to the fund of fund's historical performance, fund selection policies, diversification guidelines, and liquidity profile. Fitch may examine the fund's worst historical peak-to-trough decline and apply multiples to that decline to determine the advance rates for various rating levels. In addition, Fitch may perform Monte Carlo scenario analyses of stressed historical returns
In a fund of funds CDO, central issues include diversification, liquidity, and quality of the investment manager.
An adequately diversified fund of funds portfolio is paramount but not to a point where returns are sacrificed. Diversification should be across different funds, investment managers, strategies, and substrategies. Diversification standards may require a maximum allocation per individual fund, maximum per any one strategy, and a minimum number of different managers or funds.
Most hedge funds offer limited and restrictive redemption features. Therefore, requiring a percentage of the underlying hedge funds to be redeemable within a specified time frame, maintaining a cash reserve account, and/or establishing an external liquidity line are necessary to satisfy the CDO's liquidity needs. Liquidity requirements arise from periodic coupon payments on the CDO liabilities and ongoing expenses of the CDO, as well as principal repayments at maturity.
As in all market value CDO structures, the quality of the investment manager is extremely important. In the due diligence process, not only will there be an assessment of the investment process of the fund of funds manager but also of their ability to effectively monitor the underlying hedge fund investments.
Generally, Fitch will strive to work with the fund manager and their advisers to develop a structure that provides the same safeguards found in more traditional CDOs and to arrive at advance rates and subordination levels that are consistent with the investment strategy.
Fitch recognizes that hedge funds are gaining prominence as an alternative asset class. As a result, we expect to see more rating requests from hedge fund and fund-of-fund managers. Without question, certain hedge fund managers will be able to leverage their underlying investment portfolios to access the capital markets in the form of rated debt. However, given the potential for dramatic losses and the industry's unregulated nature and relative lack of transparency, these structures warrant an extra measure of caution and due diligence. For the complete report titled "Hedge Funds: A New Asset Class in Structured Finance," please visit www.fitchratings.com.