In recent years we have witnessed a considerable increase in the funds finance market, with more and more funds looking for subscription line or capital call facilities from lenders. As more banks enter this market, quick growth of these facilities has led to substantial pressures on pricing, as lenders compete among themselves for business. More recently, this has led to the growth of NAV, or asset-backed facilities.
Traditional debt facilities are provided to funds, by lenders, where the recourse of the lender is to the fund’s uncalled commitments. Typically, the bank will offer a short-term facility to the fund to efficiently bridge the commitments of the investors of the fund. Therefore, the credit risk taken on by the bank depends on the fund’s investors, and the chances of their honouring their responsibility to give the fund monies when called upon to do so. This process necessitates careful analysis by the bank to establish the creditworthiness of the investors against which they are effectively lending, generally tackled by rating each investor.
In contrast, NAV, or asset-backed, facilities are provided by lenders to funds, or to a special purpose vehicle (SPV) owned by the fund. They are not secured against the investors’ potential commitments, but rather against the funds’ underlying cash flows and distributions, resulting from underlying portfolio investments.
In a way, lenders using these facilities are therefore ‘looking down’ for recourse against underlying investments, rather than ‘looking up’ to investor commitments. The banks’ required credit analysis is consequently very different from that demanded by subscription line facilities. Put simply, the creditworthiness of the investors of the fund is much less important than the value of the underlying assets, for a pure asset-backed and NAV facility.
When it comes to secondary funds, lenders will typically need security over the limited partnership interests held by the secondary fund in any fund assets that it owns or is acquiring. Commercially and legally, it may be difficult to get direct security for these interests, which means that security is often simply taken by the lender over the shares of an SPV entity, set up to hold all of the limited partnership interests the lender is lending against.
For direct lending funds, lenders will take security over the benefit of the underlying loan portfolio. Therefore, in order to understand the level of loan-to-value ratio on offer, the banks will be analysing the underlying loan portfolio of the fund. Furthermore, eligibility criteria will need to be met if a particular loan is to be included in the asset pool that the lender is lending against. For example, the loan might need to be senior secured, exempt from any default, or provided to a borrower established in a certain jurisdiction.
These facilities are sometimes structured as loan facilities, or as note purchase facilities similar to a securitisation structure. Also important for the loan-to-value ratio is the diversification: typically, the more diversified the underlying loan portfolio, the more favourable the loan-to-value terms that might apply.
But are these options secure enough? In the case of private equity (PE) funds, lenders would typically take security over shares in the relevant holding companies of the PE fund that acquired the underlying investments. It is often the case that the lenders providing these facilities to PE funds may themselves be structurally subordinated to other lenders that have provided finance secured directly against the underlying portfolio companies. These facilities therefore carry higher risk, since the portfolio of assets is not as diversified as the facilities provided to direct lending funds or secondary funds.
Sometimes, lenders that are lending to a special purpose vehicle owned by the fund will demand a guarantee from the fund. However, lenders should be careful to ensure that, if this is proposed, none of the fund’s borrowing limits are exceeded. Additionally, if the fund has a subscription line facility, its terms will need reviewing carefully to ensure there are no restrictions on other financial indebtedness and that no negative pledge is included.
In principle, at least, these NAV or asset-backed facilities could be provided to any form of closed-ended fund holding assets for a given period.
Along with banks, there are ever-growing numbers of new lenders entering this new market, in light of returns that are generally higher than those offered by subscription line and asset-backed facilities. These new entrants are not just the banks that already provided fund finance facilities, but also credit and special situations funds that are searching for higher yields.
For example, these products would be highly attractive to a PE fund with urgent liquidity required at the fund level, but with no imminently available distributions from portfolio investments. To ensure existing investors are able to make investments into the fund manager’s newly formed fund, a fund may need to make distributions to its investors from historical/vintage funds.
Therefore, access to liquidity can help fund managers to continue fundraising fruitfully. Alternatively, follow-on expenses or investment may need to be made. If the fund’s investor commitments are fully drawn, it may have a desperate need for short-term liquidity until distributions are raised from its investment portfolio.
From the direct lending side, it is key that leverage is applied to the fund by way of NAV or asset-backed facilities, to help ensure that drawdowns are bundled up and to obtain some benefit for its internal rate of return promised to investors.
Recent months have also seen a substantial increase in ‘hybrid’ facilities. These are provided by lenders that look down to the value of the underlying assets but at the same time have recourse against investor commitments. These facilities are particularly useful to funds that are looking for long-term financing facilities, available from the fund’s first close until the end of its life, when all of its commitments have been drawn down and the fund is fully invested.
Execution of hybrid facilities has proved challenging for some banks. Primarily this is because different parts of a bank have expertise regarding different elements of the facility, and may struggle to synergise. However, some banks have very successfully engineered collaboration between their asset level teams and fund finance/financial institutions teams, to facilitate these offerings.
Perhaps the most recent trend has been that of asset-backed/NAV lenders requiring second ranking security/recourse to the undrawn commitments of investors. If the fund has or intends to have a subscription line lender provide financing to the fund, this can give rise to detailed discussions on intercreditor arrangements with the subscription line provider and asset-backed lender negotiating to get the strongest position possible with respect to the fund’s assets.
As investors and lenders continue to search for meaningful and reliable yield, we expect to see further growth in these innovative facilities. Their hybrid functions are a neat way for lenders to cultivate close relationships with their funds and help encourage long-term cooperation. Furthermore, as more and more funds become aware of the benefits of fund finance, more bespoke opportunities will arise for banks to provide hybrid facilities that are tailored to specific situations.
Leon Stephenson is a partner and member of the Financial Industry Group and Head of Funds Financing in the London office of law firm Reed Smith.