Hedge funds could benefit from credit ratings, but very few would earn investment grade scores, according to a new report from Fitch Ratings.

“While credit ratings could be beneficial in negotiations between fund managers and counterparties for ISDA agreements, prime broker agreements or direct securities lending, Fitch Ratings expects only a small percentage of hedge funds to qualify for an investment grade and many of them would not be expected to issue debt,” it says.

In the report, Fitch outlines its methodology for assigning credit ratings to hedge funds or their management companies. For a hedge fund to achieve an investment grade under Fitch’s rating criteria, it would expect the fund to: have a high percentage of liquid assets (95%+); diversified asset classes within the funds; risk measurement and reporting independent of daily traders; risk limits based on reasonable stress; performance that reflects risk appetite; institutional liquidity management; good rating agency transparency; at least five years of audited financial statements, and, $2 billion of assets under management. Fitch will also expect the fund to have its valuation process reviewed by a third party on a regular basis and the provision of strong evidence of good pricing process and calculation of net asset value.

For funds that meet these requirements, Fitch will assign an Issuer Default Rating to the issuer which will provide an indication of the probability of default at the issuer level. Issues will then be notched based on an expected level of recovery. Fitch will analyze the strategy of the fund, liquidity of the assets, the potential for margin calls or liquidation in stress scenarios and the redemption patterns of investors.

According to Fitch, credit ratings would be favorably impacted if a management company embraces a risk management function that is similar to market risk best practices. Independence is a key factor given the private nature within which most hedge funds operate. By independence, Fitch means risk measurement and management that is autonomous from trading. Ideally, the risk manager will report directly to a management committee, or similar structure, that is independent from the portfolio manager or trader. Portfolio managers that are actively trading and also the general partner of the fund and/or the majority owner of the management company would not be considered independent.

Fitch evaluates operational risk of hedge funds and hedge fund management ratings under a separate process and scale away from its credit ratings. But operational risk is also incorporated in assigning credit ratings, since the most frequent cause of losses at hedge funds is operational failure. If the hedge fund or hedge fund manager has obtained an operational risk review and rating, Fitch will review those results and incorporate that information into the credit rating. Third party reviews of operations and valuation processes including external audits are also considered, with results incorporated into the overall credit rating.