Fund finance is here to stay

The use of facilities is so ingrained in the private equity industry that nothing short of an extreme event can turn back the tide.

Debevoise & Plimpton’s financing lawyers have never been busier on the fund financing front. In the last two years, work in this area has exploded; the firm is doing $15 billion to $20 billion worth of deals each year, and there’s no sign the pipeline is slowing down.

“Not only is there demand from the funds, but there’s also a larger number of providers than there’s ever been, many willing to provide either bilateral facilities or large syndicated fund financings,” says Alan Davies, a corporate partner in the firm’s European finance group.

The considerable uptick in the use of fund finance in the last couple of years has been buoyed by low interest rates and access to cheap debt. But even with potential rate rises on the horizon – the US Federal Reserve raised its benchmark interest rate by 25bps to 2.5 percent in December, with the possibility of further hikes in 2019 – fund managers have found such facilities so useful that modest rate increases are unlikely to have much of an effect on their use.

“Because there is such a breadth of use of fund facilities for varying purposes, to my mind, the impact of a rising interest rate isn’t going to have a substantial effect,” says Tom Smith, a partner in Debevoise’s finance department in London. An increase in lenders in the market has brought margins down, which in turn has muted the impact of increasing interest rates on borrowers.

The CFO of one mid-market manager who uses a capital call facility on a short-term basis says an increase in interest rates is unlikely to change the way that firm uses its credit line, as ultimately it is still beneficial to its LPs.

Fund managers will only think twice about using a fund finance facility once interest rates exceed the fund’s hurdle rate, the CFO says. With the typical hurdle rate on a private equity fund set at 8 percent, that would require interest to reach rates not seen in the US since 1990 – an unlikely scenario.

Another mid-market CFO clarifies this threshold is partly down to optics; even if, technically, in an 8 percent interest world PE investments should be delivering a lot more than that, borrowing at that rate is a tough sell to LPs.

The widespread use of long-dated subscription credit lines could be curtailed if LPs again become concerned about unrelated business taxable income, generated by a tax-exempt entity – such as certain pension plans and endowments – as a result of taxable activities.

If the tax-exempt LP receives income from an investment made with money borrowed by a fund during the period of the loan and for 12 months after a GP has paid off the credit line, that investor will be subject to UBTI.

“To the extent LPs ever become concerned about that again, then you’ll see them diminish,” the first CFO says. “But frankly I don’t see LPs moving in that direction to become sensitive again to UBTI.”

The Debevoise lawyers see two possible scenarios which would lead to a drastic scale back: a significant number of defaults, or regulation.

“There’s not much sign of it yet but, theoretically, you could see a regulator taking objection, particularly to leverage at the fund level,” Davies says.

“If there were to be a large number of defaults the market would turn very quickly, just like it can do in the leveraged finance arena. At that point, this historically nice, secure product with a low interest rate would suddenly cease to be appealing.”

With just one known case of a default on a credit line facility – which was not caused by external market factors – that scenario looks highly unlikely.