Moody’s Investors Service plans changes to its methodology for rating securities backed by the debt of start up companies that could result in downgrades of up to two notches on outstanding transactions.
Most of the obligors of loans in these transactions are developmental stage growth companies in which venture capital firms invest. So cash flows are dependent on the ability of these companies to raise additional rounds of venture capital, which in turn is based on the their ability to reach product development milestones, rather than on product revenue. And a pool has loans from a diverse range of obligors, there is little correlation between the ability of one obligor to meet a milestone and the success of failure of another obligor.
"For example, the test phase/development failure of one drug of a company in the life sciences sector will have little bearing on other companies in another sector or even in the same sector, unless they happen to be pursuing a drug targeting a similar condition with similar test or development plans," Moody's stated in its request for comment.
However Moody’s is concerned that, in a recessionary environment, many these companies may have a harder time raising additional equity and therefore not meet a transaction’s debt service obligations. “This cyclical risk will induce default correlation in the performance of the loans in a venture debt transaction," the request for comment states. As a result, Moody's plas to revise its assumptions about asset correlation, obligor default probabilities, and recovery rates on defaulted loans.
Market participants are invited to provide feedback on the proposed changes by Sept. 30.
Venture debt securitizations may be backed by senior-secured term loans, real estate loans, working capital loans, equipment loans and equipment leases.
Typically, securities backed by venture debt benefit from several types of protection, including overcollateralization, a reserve fund, excess spread, concentration limits, and rapid amortization, or repayment of principal.
Among the deals currently rated by Moody's is Hercules Capital Funding Trust 2012-s, which was sponsored by Hercules Capital Growth, a business development company based in Palo Alto, Calif., that specializes in lending to tech companies in various stages of development. A single $231 million tranche of notes is rated A2’ by Moody’s. The notes are backed by $231 million of senior secured loans originated by Hercules. Guggenheim Securities acted as arranger.