Backdoor Private Credit Funds Are Luring Billions From Insurers

(Bloomberg) -- The world’s biggest private credit managers are turning to an obscure investment product to help raise billions from deep-pocketed insurance companies, testing the limits of industry safeguards meant to curb risk.

The vehicles, known as rated feeders, package stakes in private debt funds into bonds, making it cheaper for insurers to buy them by effectively cutting the amount of capital that they need to hold against those investments.

The transactions aren’t public and therefore hard to track, but virtually every private credit manager has begun taking advantage of the structure, market watchers say. Ares Management Corp. used one as part of its record-breaking capital raise earlier this year. Blackstone Inc., Carlyle Group Inc. and KKR & Co. have also utilized them, according to documents seen by Bloomberg and people familiar with the deals. Kroll Bond Rating Agency has graded over $20 billion of the products since the start of 2021, and says this year is on pace to be the busiest yet.

Rated feeders are part of a broader push by private credit firms to convince the US insurance industry, which controls trillions in long-term capital, to pour money into the asset class. In fact, for many of private lending’s biggest players, insurers have become so critical to their growth efforts that they’ve built out or bought large insurance units of their own.

Rated feeders allow those units and other insurers to funnel cash into private credit — which typically finances highly leveraged companies and offers juicier yields relative to conventional bonds and loans — in a capital efficient way, backers argue.

But the alchemy of turning stakes in private debt funds into top-rated bonds has attracted scrutiny. Industry regulators have cautioned that the structures are opaque and may amount to a bypassing of risk capital rules. They’ve responded by raising the cost to own the most speculative part of the deals, while other changes set to come into effect in 2026 will allow them to review individual investment structures and potentially assign higher capital charges. 

“It’s a way to funnel insurance money — a multitrillion-dollar pool of money — into private credit,” said Curasset Capital Management’s Michael Hislop. “With rated feeders, alternative asset managers are looking at the regulations and have found a way to push things as far up to the line as they can.”

Private credit managers, for their part, say that concerns about rated feeders are largely overblown. The vehicles are, in form and function, similar to other long-established Wall Street products, such as collateralized loan obligations, which have proven resilient during periods of financial stress.

So how do they work?

A private credit firm looking to raise capital will create a standalone investment vehicle to house a stake in its fund. Insurance investors will often buy a vertical slice of the securitization in the form of high-grade and junk-rated bonds as well as a subordinated equity tranche, in exchange receiving a share of the interest and principal payments from the assets in the fund.

Buying the vehicles lets insurers sharply reduce the money they must set aside to back their exposure to the private credit fund, since US insurance industry rules apply capital charges of 30% or more to holdings of fund shares, compared to low-to-mid single digits for most debt. 

Rated feeders and similar products ultimately allow insurers to cut their overall capital charge by half or more on average relative to buying a stake in a fund directly, according to a recent paper by the National Association of Insurance Commissioners, a consortium of state regulators.

Other structured-credit products like private credit CLOs also offer insurers exposure to direct lending strategies. But rated feeders have become increasingly popular given their ability to invest more in non-traditional types of private credit, including delayed-draw loans, distressed debt and asset-based finance.

New Mountain Capital has used multiple rated feeders to raise cash for a private credit fund it debuted in 2022. Their vehicles are more transparent than most because they were issued via public markets and because the underlying fund is a business development company, a tax-advantaged structure with more reporting requirements.

The BDC has investments in about 90 issuers, many of which are paying double-digit interest rates, including RealPage Inc., a real estate software company owned by private equity firm Thoma Bravo, and Sierra Enterprises, a California-based drink supplier, according to a recent filing.

Moody’s Ratings and Morningstar DBRS rated more than half the rated feeder bonds as investment-grade, well above the credit quality of the underlying loans, which Morningstar DBRS had estimated was on average equivalent to debt rated B-.

The bonds’ investment-grade rating, which typically comes with capital charges below 2% — compared to about 6% for junk-rated tranches — helps insurers reduce their costs even further.

“Private credit loans to growth-oriented companies often have features that CLO structures don’t accommodate well,” said Cyrus Moshiri, a director at New Mountain. “Rated feeders allow insurers to gain exposure to the underlying collateral they desire in an investment-grade rated format.”

Spokespeople for Moody’s and Morningstar DBRS declined to comment. So did representatives for Ares, Blackstone, Carlyle and KKR.

Regulator Scrutiny

Advocates of the structure argue that rated feeders allow insurers to pay capital costs more commensurate with the underlying loans in the funds they’re investing in.

Still, the growth of the once-niche product in recent years has resulted in heavy scrutiny from the NAIC, which has warned that feeder notes and a closely related type of securitization — collateralized fund obligations — might obscure the true risks of underlying investments.

It’s taken steps to discourage firms from engaging in especially risky types of deals, for example by giving itself the ability to effectively assign its own ratings and capital charges to a wider range of bonds and other securities owned by insurance firms. That’s in addition to increasing the cost of holding the riskiest portions of securitizations, known as the equity or residual.

“Rated feeders and other comparable asset types can provide a challenge to the extent the underlying risk characteristics are not transparent,” said Carrie Mears, chair of the valuation of securities task force at the NAIC. 

While much of the NAIC’s focus has been on securitizations in which the underlying investments are equity, the new rules will apply to those with debt as well.

Others say it’s critical to proceed carefully given private credit is still a young asset class relative to its vastly expanded scale.

“Rated feeders are evolving appropriately,” said Luke Chan, a partner at alternatives investment manager HighVista Strategies, but “the caveat is, it’s not a panacea. Private credit has expanded rapidly and hasn’t been through a 2008-style financial crisis, and investors should be prudent about new instruments exposed to it.” 

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Investment banks, law firms and ratings companies all say they’ve got their hands full with near-record deal volumes these days. 

KBRA is currently in the process of providing credit grades for several dozen rated feeders and CFOs, the most it’s ever worked on in a quarter, according to Bill Cox, the firm’s global head of corporate, financial and government ratings.

Lindsay Trapp, a partner at law firm Dechert who specializes in credit fund formation, says her team is working on helping set up so many of the investment vehicles that there’s little time for anything else.

“Virtually every major middle-market private credit manager now has a rated feeder or is raising one,” she said.

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--With assistance from Carmen Arroyo, Dan Wilchins and Davide Scigliuzzo.

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