Moody's, the ratings agency, has developed a methodology for rating the unsecured debt of hedge funds in preparation for a predicted rush to the public debt markets by alternative investment firms.
The move comes after Citadel Investments, one of the world's largest hedge fund companies, late last year became the first hedge-fund manager to sell debt publicly, offering $500m in five-year notes.
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Moody's Investors Service expects to issue the first ratings in the coming months.
"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," said Joel Levine, a senior vice president at Moody's.
Moody's says that for ratings purposes, hedge funds remain fundamentally different from most securities firms and traditional asset managers. Most significant, the equity capital in hedge funds is more transient - investors can redeem their investment at short notice, reducing the reliability of equity as a "cushion" for unsecured creditors, according to Moody's.
This can in effect subordinate unsecured creditors not only to the interests of secured creditors but also to those of the equity investors, Moody's says, though certain hedge funds do have provisions that act as a brake on investor redemptions.
Additional weaknesses common to hedge funds that may affect their ratings are the lack of regulatory oversight, weak corporate governance, and their frequently unfettered ability to shift investment strategies.
This is not Moody's first foray into the hedge fund ratings market.
Last September it started to issue hedge fund operations quality ratings designed to assess the operational strengths of a hedge fund's infrastructure.
Moody's methodology for rating the unsecured debt of hedge funds rests on three basic 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 new ratings methodology has examined causes of hedge fund failures and found that the most common are fraud or large-scale operational failure and the sudden loss of liquidity after a market event.
