The non-Darwinian evolution of fund financing vehicles

In 1972, palaeontologists Niles Eldredge and Stephen Gould published a paper arguing that evolution proceeds in relatively rapid leaps, prompted by significant changes in an environment, followed by periods of stability. Known as punctuated equilibrium, this theory cited evidence from the fossil record to challenge the assumption of a gradual evolutionary process. Charles Darwin noted this pattern in On the Origin of Species. Assigning it to gaps in the fossil record, he believed that once these were filled, a more gradual evolutionary process would emerge. Over time, however, as the fossil record became more complete, it became clear that gradual change alone did not fit the geological evidence. Sudden, significant adaptations due to ecological changes are now accepted to be a critical part of the process of evolution.

The fund financing space, and net asset value (NAV) finance in particular, has recently experienced one of these sudden changes, prompted by a shift in the landscape fuelled initially by covid-19. Almost overnight there was a need for managers to find additional sources of growth capital and/or liquidity. This demand, paired with the unprecedented pace of fundraising during the year, meant that 2021 saw a record level of fund financing activity. And this upward trajectory is expected to continue over the next decade and beyond.

Becoming essential

Capital call loans (also known as subscription finance) put in place at the start of a fund’s life and secured against the undrawn commitments of limited partners continue to see strong demand across the private equity industry. They are fast becoming an essential tool to provide working capital to private funds, now estimated to be used by more than 95 percent of managers. These facilities enable managers to access capital quickly, provide LPs with visibility on drawdown cashflows and avoid equalisations when making acquisitions during fundraising.

When LP capital has been invested, private equity managers need to look at different financing tools to provide flexibility during the period that they will hold assets and create value across their portfolios.

These factors, along with greater levels of industry awareness and adoption, have led to the rapid growth in the use of NAV financing, which involves borrowing against the fund’s equity interest in its portfolio companies. It is typically used once deployment periods are over and the fund doesn’t have capital to draw down from its LPs. Use cases include investing for portfolio growth, generating investor liquidity without selling performing assets, and supporting continuation vehicles and end-of-fund strategies. Financing is usually delivered by way of senior loans or preferred equity, depending on factors such as advance rates (loan to value), underlying diversification and the flexibility requirements of the borrower.

Subscription financing can influence the internal rate of return (IRR) of a fund as capital is not called from investors immediately and can be returned in advance of proceeds from exits flowing back to the fund. Since IRR is calculated between the time that the fund draws capital from investors and when this capital is returned, delaying calls and accelerating returns can see IRRs increased.

An analysis conducted by Montana Capital Partners showed that credit lines improved IRR by 4 percent net on average, although the report highlights that strong performing funds will see improved IRR relative to poorly performing funds.

The NAV financing market is growing at a double-digit rate and market participants forecast this to continue. “NAV lending will become an asset class on its own and will be the new direct lending in the next few years,” Augustin Duhamel, managing partner and co-founder of 17Capital, said at a recent IQ-EQ webinar on the latest developments in the fund finance market. “We estimate that the market opportunity for NAV financing is around $100 billion a year, and it will keep on growing.”

Private credit funds have taken note of this growth and have been increasingly active in lending on fund finance transactions. As these funds generally have greater risk appetite and flexibility – and require a higher return – than banks, NAV lending is a natural hunting ground for specialist providers with dedicated pools of investment capital.

Prompted by significant pandemic-induced changes, the fund financing market had a record year in 2021 and continues to go from strength to strength. Finance providers are increasingly willing to innovate and provide creative, bespoke structures to service the requirements of sponsors as comfort with fund financing grows. With aggregate demand at $750 billion a year and growing fast, fund financing is set to become a multi-trillion-dollar market in the coming years. Asset managers are fast recognising this opportunity, and their DNA means they are well equipped to meet the needs of borrowers. This combination means that fund financing is well on the way to becoming a standalone asset class.

Justin Partington is group head of funds at investor services group IQ-EQ. He leads the revenue growth, service offering and technology developments for the group’s funds segment.