Morningstar DBRS' Takeaways From 2025 Credit Outlook New York: A Peek Behind the Curtain of Fund Finance

As part of its takeaways series, Morningstar DBRS is publishing several write-ups about pertinent topics discussed at 2025 Credit Outlook New York, an industry conference on our expectations for structured finance in 2025 as well as highlights on emerging asset classes. Jerry van Koolbergen, Managing Director, U.S. Structured Credit Ratings, at Morningstar DBRS moderated a panel on fund finance. The panel touched on this asset type's special features and trends given the increasing interest in private credit from institutional and retail investors alike.

THE ABCs OF BDCs
Our analysis of fund finance combines the asset style approach found in structured finance as well as the corporate style approach for business development companies (BDCs), according to van Koolbergen. Watson Tanlamai, Vice President, North American Financial Institution Ratings, at Morningstar DBRS specializes in BDCs and has noticed the focus on perpetual nontraded BDCs over the past couple of years. Nontraded BDCs raise a ton of capital both via equity and debt issuance. Just over the past three weeks, he noted, nontraded BDCs we rate have been able to raise more than $3 billion in debt from the unsecured markets.

A lot of private credit platforms will have both publicly traded BDCs and nontraded BDCs, though nontraded BDCs may be significantly larger. Tanlamai cited Blackstone Private Credit Fund as an example, which is a nontraded BDC and whose investment portfolio is 5 times larger than Blackstone's publicly listed BDC, Blackstone Secured Lending Fund.

Large BDCs have also begun to stretch the length of their unsecured debt issuance. Tanlamai has seen seven- and 10-year term debt from these types of issuers, longer than the five-year typical term for an unsecured issuance. He expects the larger, more predominant BDCs to continue this trend of being able to ladder debt maturities out further.

A FEEDING FRENZY FOR FEEDER FUNDS
Feeder funds are a relatively new structure type in fund finance, and their definition is quite simple. "It's just an investment vehicle that invests in a fund," said Lisa Kwasnowski, Senior Vice President, U.S. Structured Credit Ratings, at Morningstar DBRS. Feeder funds has been a bit of a buzzword lately, with Kwasnowski noting she has been receiving many calls inquiring about this structure type.

Feeder funds are structurally subordinate to any debt in the main fund, don't have any claim on the assets in the main fund, and are entirely reliant on cash flows from the main fund to service debt obligations. According to Kwasnowski, many times there isn't a requirement for the main fund to make distributions, so an assessment of alignment of interest is important. For example, we might rate a feeder fund that is attached to a BDC, in which case Tanlamai may step in to help. In these cases, BDCs are required to distribute 90% of ordinary income to remain tax compliant with regulated investment company rules. However, in most cases, we see a feeder fund attached to a closed-end fund that is typically structured as a General Partnership (GP)/Limited Partnership (LP) (often called a GP/LP fund). For these, we typically take a qualitative approach and determine if the main fund and the feeder fund are aligned in interest. Who are the investors for the feeder fund? Why is this feeder fund being created? And why do we think the manager would be incentivized to distribute cash flows from the main fund into the feeder fund? Because of this, per Kwasnowski, we spend time to review fund managers' track record for managing similar funds or previous funds in a series.

Van Koolbergen added that there are two types of distribution for rated feeder funds. The first is where the feeder fund is distributed to a single LP investor. However, we are seeing more of the second type, where the distribution angle is similar to a collateralized loan obligation with a rated component and an unrated component in the feeder fund, and these components are distributed to different investors. These two components accommodate different investor interests.

BREAK ME OFF A PIECE OF THAT ABL
Another trend in structure type is asset-backed lending (ABL) facilities. Per Kwasnowski, banks provide ABL facilities to funds and look for credit ratings when they want to get some risk off their balance sheet. We are seeing a lot of new entrants into this space, either those who have already been doing ABL facilities and want to syndicate or those who want to get into the ABL space. We are also seeing more tranches (all pari passu) in these transactions to serve investors' preferences, such as a revolving tranche, a term tranche, a U.S.-dollar-only tranche, and a multicurrency tranche. Kwasnowski's understanding is that insurance company investors, which are interested in ABL facilities, are attracted to the term tranche and maybe the U.S.-dollar-only tranche. This may explain why we are seeing more of those types of tranches.

PIK: A BALANCING ACT
The payment-in-kind (PIK) feature factors into our analysis. In funds and BDCs, this is when a borrower stops paying cash interest on its loan and instead the interest is added to the loan's principal balance. Tanlamai specified that we consider PIK as a percentage of overall total investment income, instead of individually at the asset level. According to him, PIK is roughly 8% or 9% of the total investment income for BDCs we rate, but it can have a wide divergence in that coverage universe. If that percentage creeps up to the 10% to 15% range of total investment income, then we would become concerned about the BDC's ability to cover dividends from a cash perspective. But this is somewhat sector specific. For example, if the portfolio is more focused on technology companies, then there likely will be a higher predominance of PIK for growing software as a service companies. However, if PIK is utilized purely because of liquidity issues from operating performance, it may be considered "bad" PIK.

WHAT COUNTS AS DEFAULT?
Middle market credit has benefited from the unusual period post-pandemic when there was so much stimulus in the market. It was hard for anyone, include middle market companies, to fold. At the end of 2023, the default rate for middle market companies we rate was only 0.6%, per Toby Moerschen, Managing Director, Private Credit and Credit Estimates, at Morningstar DBRS. That started to normalize in 2024, reaching 2.1%, per Moerschen. Still, that's below what we would consider a normal rate of default for a B-rated company, which middle market companies usually fall under.

It's important to note that our analysis for what counts as a default under our definition goes beyond failing to make a payment. In fact, payment default is less frequent among middle market borrowers. According to Moerschen, we more commonly see debt restructurings that we believe are distressed exchanges, and we count those as defaults. One way we determine if a debt restructuring is a distressed exchange is if the lender receives any benefits or not. If the lender receives a fee or has a higher margin, for example, then we may not consider the restructuring as a distressed exchange (and consequently a default). Distressed exchanges are usually characterized by extended maturities, PIK for several quarters, some debt becoming subordinate, and no improvement in the interest margin. Moerschen concluded with saying we do not consider covenant breaches or liquidity support as defaults.

Written by Caitlin Veno

Notes:
For more information on fund finance, visit https://dbrs.morningstar.com or contact us at info-DBRS@morningstar.com.

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