Rating action

Scope Ratings GmbH (Scope) has today assigned a preliminary rating of (P) BBB to the notes that will be issued by Muzinich Luxembourg Funding Sarl - Compartment Pan III 1K.

Muzinich Luxembourg Funding Sarl - Compartment Pan III 1K Notes, up to EUR 30m: assigned new (P) BBB

Scope’s Structured Finance Ratings constitute an opinion about the relative credit risks and reflect the expected loss associated with the ultimate payment of principal and interest contractually promised by an instrument by its legal maturity. Preliminary ratings rely on the information made available to Scope up to 31 July 2023. Scope may assign final ratings subject to the review of the final version of all transaction documents and legal opinions. Final credit ratings may deviate from preliminary ratings.

Transaction overview

Muzinich Luxembourg Funding is a public limited liability company, incorporated in Luxembourg as a securitisation company, under the Luxembourg securitisation law of 22 March 2004. The securitisation company acts in respect of its Compartment Pan III 1K, the notes’ issuer. The notes’ performance will be linked to the investments made by Muzinich Pan-European Private Debt III, SCSp (MPEPD III) through the acquisition of limited partner interests by the issuer compartment. The notes to be issued will pay a fixed-rate coupon of 1.5% per annum, a subordinated variable return coupon and will mature 18 years from the first closing date of MPEPD III.

MPEPD III targets European lower mid-market corporate borrowers with, among others, an EBITDA up to EUR 25m and at least five years of operating history. The fund will invest mainly into senior secured and unitranche debt but can also invest up to 20% into subordinated loans. MPEPD III will be actively managed by Muzinich & Co. (Ireland) Limited and its affiliates.

Rating rationale

The rating reflects the legal and financial structure of the transaction as well as the investment strategy, which follows the investment objectives of MPEPD III. The rating also accounts for the capabilities and experience of Muzinich in selecting corporate debt obligations that fulfil the issuer’s investment strategy and in building a diversified exposure in terms of both industries and geographies.

Scope’s analysis considered an expected portfolio, taking into account the ramp-up timeline, target debt obligations of MPEPD III, and the transaction’s investment objectives. The rating reflects the default risk and recoveries upon default of the underlying loan portfolio, the notes’ available excess spread and the transaction’s structural features.

The rating also addresses exposures to the key transaction counterparties: i) Muzinich & Co. (Ireland) Limited together with Muzinich & Co. Limited (Muzinich) as the fund manager; ii) J.P. Morgan Bank Luxembourg S.A. as account bank of the issuer; iii) State Street Bank International GmbH, Luxembourg Branch as MPEPD III’s account bank; and iv) Alter Domus and affiliates as corporate services provider, calculation agent and registrar of the issuer. Scope’s analysis of counterparty risk accounts for the high credit quality of both account banks, which Scope assessed using public information, including external ratings.

Key rating drivers

Funds and assets selection and related monitoring (positive).¹ The issuer has mandated Muzinich to implement the investment strategy. Muzinich’s longstanding experience in managing private debt funds, as well as its track record and market access in European direct lending benefit the transaction.

Investment strategy focused on smaller mid-market borrowers and senior secured loans (positive).^1,2 MPEPD III will invest predominantly in senior secured loans with strong capital preservation mechanisms. These loans have better recovery prospects than unsecured or subordinated loans.

Excess spread capturing (positive).² The issuer has sound means to capture most of the expected high excess spread and to create substantial overcollateralisation. After the payment of taxes, senior costs, and the fixed-rate notes coupon excess funds will be used to amortise a certain amount of the notes and to fund a cash reserve with a target of 5% of the notes’ principal balance outstanding.

Limited protection against portfolio losses (negative).² On the first issue date, the notes will not benefit from first-loss protection in the form of overcollateralisation. The related risks will be partly mitigated by the sound mechanisms that are designed to capture the expected high excess spread.

Ramp-up period (negative).² From the first closing date, MPEPD III will gradually invest committed capital over an expected five-year investment period. The notes will therefore be backed by a highly concentrated portfolio in the early stages of the transaction.

Reinvestment option (negative).² During the ramp-up phase, MPEPD III can also reinvest proceeds from the realisation of early investments, preventing early amortisation, effectively extending the risk horizon and potentially exposing the notes to economic downturns.

Payment of variable coupon (negative).² Variable coupons can be paid throughout the transaction’s life upon the availability of interest proceeds and irrespective of the portfolio’s net asset value. However, variable coupons are only paid after payments relating to i) the fixed-rate interest; ii) the notes’ targeted amortisation; and iii) the funding of the cash reserve up to its target level.

Rating-change drivers

Upside rating-change driver

Better-than-expected asset performance will support the use of capital gains and excess spread to build up overcollateralisation and may result in an upgrade of the rating.

Downside rating-change driver

Worse-than-expected default and recovery performance that causes a substantial deterioration of the underlying portfolio may result in a downgrade of the rated notes.

Quantitative analysis and assumptions

Scope analysed the model portfolio on a loan-by-loan basis using a Monte Carlo simulation. For each loan, Scope assumed: i) a specific default probability; ii) a specific recovery upon default; and iii) asset correlations between the loans. The resulting default distribution has a mean default rate of 24.4% and an implicit coefficient of variation of 51.1% over a weighted average portfolio life of 5.1 years. The resulting base case portfolio recovery rate is 68.2% and the BBB rating-conditional portfolio recovery rate is 58.7%.

Scope’s base case considers the default timing derived from the Monte Carlo simulation. Additional front-loaded and back-loaded default timings were tested, with the results showing little sensitivity to this parameter.

Using the resulting default rate distribution, portfolio recovery rates and default timing, Scope projected the transaction’s cash flows, taking into account senior expenses and fees as well as structural features, including reinvestments, the cost liquidity reserve, the distribution liquidity reserve, variable interest and partial early repayments.

The rating assigned to the notes reflects the expected losses over the instrument’s expected risk horizon, commensurate with the idealised expected loss table. Scope accounted for possible reinvestments when deriving the instrument’s expected risk horizon.
 

Sensitivity analysis

Scope tested the resilience of the rating to deviations in the main input parameters: the mean default rate and the portfolio recovery rate. This analysis has the sole purpose of illustrating the sensitivity of the rating to input assumptions and is not indicative of expected or likely scenarios. The following shows how the results change compared to the assigned rating when the assumed mean default rate increases by 50%, or the portfolio’s expected recovery rate decreases by 50%, respectively:

• Sensitivity to mean default rate, two notches;

• Sensitivity to recovery rate, three notches.

Rating driver references
1. Company presentation (Confidential)
2. Transaction documentation (Confidential)

Stress testing
Stress testing was considered in the quantitative analysis by considering scenarios that stress factors, like defaults and Credit-Rating-adjusted recoveries, contributing to sensitivity of Credit Rating and consider the likelihood of severe collateral losses or impaired cash flows. The impact on the rated instrument is weighted by the assumptions of the likelihood of the events in such scenarios occurring.

Cash flow analysis
Scope Ratings has primarily analysed the distribution of portfolio losses and its impact on the rated instruments, with the use of Scope Ratings’ Portfolio Model (Model) Version 1.1.
Scope Ratings performed a cash flow analysis of the transaction with the use of Scope Ratings’ Cash Flow SF EL Model Version 1.1, incorporating default and recovery rate assumptions over the portfolio’s amortisation period, taking into account the transaction’s main structural features, such as the notes’ priorities of payment, the notes’ size and coupons. The outcome of the analysis is an expected loss and an expected weighted average life for the notes.

Methodology
The methodologies used for this Credit Rating, (General Structured Finance Rating Methodology, 25 January 2023; CLO Rating Methodology, 28 April 2023; Counterparty Risk Methodology, 13 July 2023), are available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The models used for this Credit Rating are Scope Ratings’ Portfolio Model (Model) Version 1.1 and Scope Ratings’ Cash Flow SF EL Model Version 1.1 available in Scope Ratings’ list of models, published under https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. Also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.

Solicitation, key sources and quality of information
The Rated Entity and/or its Related Third Parties participated in the Credit Rating process.
The following substantially material sources of information were used to prepare the Credit Rating: public domain, the Rated Entity, the Rated Entities’ Related Third Parties, third parties and Scope Ratings’ internal sources.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting the Credit Rating originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Scope Ratings has not received a third-party asset due diligence assessment/asset audit. Scope Ratings has performed its own analysis of the data quality, based on information received from the Rated Entity or Related Third Parties, which is not and should be not deemed equivalent to the performance of due diligence or an audit. The internal analysis was considered when preparing the Credit Rating and it has no impact on the Credit Rating.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Rating and the principal grounds on which the Credit Rating are based. Following that review, the Credit Rating was not amended before being issued.

Regulatory disclosures
The Credit Rating is issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Rating is UK-endorsed.
Lead analyst: Sebastian Dietzsch, Senior Director.
Person responsible for approval of the Credit Rating: David Bergman, Managing Director.
The preliminary Credit Rating was first released by Scope Ratings on 3 August 2023.

Potential conflicts
See www.scoperatings.com under Governance & Policies/Regulatory for a list of potential conflicts of interest disclosures related to the issuance of Credit Ratings.

Conditions of use / exclusion of liability
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