The fund finance market represents a notable portion of loan markets, with its role consistently adapting in response to wider market conditions.
For fund finance to continue to develop in a sustainable manner it is important to recognise key trends and evolving considerations.
An overview of fund finance
Fund finance is a broad term which refers to financing provided to funds at a fund-level as opposed to the asset or investment level.
One of the key benefits of fund finance is to allow general partners (GPs) and any other fund managers to quickly access liquidity in relation to an acquisition or investment without the need to call for capital from investors and adhere to lengthy notice periods. This is also beneficial to investors who can benefit from greater certainty as to capital call timing.
Over the past years, fund finance has evolved to become a core part of modern fund strategy. In particular, subscription-line facilities have become the norm. These are loans which are secured against the capital commitments of investors who are referred to as limited partners (LPs). They typically have a short-term maturity length of between one to three years and are generally perceived to be stable and investment-grade facilities which have historically performed well.
While subscription line facilities remain the dominant mechanism, fund finance strategy has evolved to include a diverse range of mechanisms with net asset value loans (NAV facilities) being a key point of discussion.
The role of NAV facilities
Unlike subscription lines, NAV loans are secured against the net asset value of a fund's investment portfolios. These are then generally repaid from the sale of assets or cash generated from those assets.
They generally have a longer loan maturity date and a higher risk profile then subscription lines and therefore come with greater concerns around transparency and over-leveraging.
Nevertheless, NAV financing has experienced a significant growth and is expected to become part of the standard toolset for more mature funds particularly when combined with shorter-term subscription line facilities which allows liquidity to therefore be managed across a fund lifecycle.
Shifting lender landscape
Along with this shift in finance mechanisms, the fund finance market has also experienced a shift in key players. The market was historically dominated by banks, but the normalisation of fund finance has meant that there has been an increased participation of non-bank lenders also looking to reap the benefits.
The increase in types of lenders in conjunction with increased LP and GP demand has resulted in greater competition for traditional bank lenders and consequently greater negotiating power for borrowers, with lenders more willing to utilise different structures and tailored terms to meet this demand.
However, this evolution goes beyond market demand as it also reflects a key shift as to how stakeholders involved view fund finance.
Stakeholder considerations
Limited partners
LPs are more familiar with subscription line facilities which have had a long-standing presence in the market and more predicable terms and benefits and therefore being perceived as easier to assess risk.
However, NAV facilities are a more uncharted territory due to the less wide-spread use and more tailored terms. As such many funds do not have the key documents in place that set out the terms of a NAV facility and clearly regulate their use. This along with the complexity of the arrangements makes it difficult for LPs to fully understand their impact.
There is also the element of additional risk that comes with pledging a fund's investments which adds a further layer of leverage to the portfolio in addition to existing debt. This can also negate the benefits of the diversification of a fund portfolio if the facility is used in relation to a weak investment.
However, these issues are not isolated to NAV facilities alone, as LPs have also shared concerns in regards to subscription-line facilities as they present a way for GPs and fund managers to potentially inflate internal rates of return (IRR) by setting a preferred return hurdle based on the date that capital is called from investors as opposed to the date of drawdown. As such the reported IRR will be artificially increased as it shortens the span of time over which returns will be calculated.
Nevertheless, subscription facilities remain a well-established and fairly inexpensive way for managers to streamline the capital call process and NAV facilities have also shown increasing benefits.
It, therefore, falls to the managers to handle transactional risk by taking on a proactive role to ensure that these concerns are appropriately addressed through greater transparency and ensuring that there is sufficient capital in place to reflect riskier investments.
Lenders
The evolving market has also forced lenders to familiarise themselves and deepen their understanding of new fund finance concepts and mechanisms to take full advantage of these offerings.
However, with this opportunity comes regulatory requirements which require liquidity requirements to be balanced against the commercial risks of fund finance. More recently, we see that banks need to partner with private credit and insurance providers to address regulatory pressure. Bodies such as the Loan Market Association (LMA) have resultingly taken on the role of providing guidance as well as promoting regulation.
Moreover, each lender has its own preferences and practices when it comes to the types of fund finance it will lend to and the level of risk it is willing to take on. While some have not yet been willing to take on arrangements other than subscription facilities, others have embraced a full range of products and services to enhance competitiveness and cement their role as a strategic partner to GPs and LPs alike.
General partners and fund managers
Fund finance has now moved beyond simply bridging capital calls and has become a more sophisticated tool for managing liquidity and reducing administrative burden.
A key consideration for GPs and fund managers is enhanced communication and recognition of LP and lender requirements. GPs and fund managers must consider from the outset the potential impact of a fund finance arrangement and the justifications for entering into one. In this sense, ongoing dialogue and full transparency between all parties serves to effectively address concerns with key points to discuss being the rationale and use of proceeds and key economic terms. Indeed, LPs will be expecting (and managers should provide) full disclosure on these facilities in their quarterly reporting.
Reputational damage and legal disputes are also a consideration, and GPs and fund managers would be minded to ensure that there is a clear alignment of interest, with any potential borrowing is used for the full benefit of the fund and without creating undue risk for LPs.
Looking forward
Fund finance will undoubtedly continue to play a significant role in the market. However, given evolving perspectives and mechanisms its continued use comes with additional considerations that must be taken into account such as transparency and risk management.
As funds continue to develop, we expect that the standards on how and why they borrow and use this borrowing to remain in the conversation.
If you have any queries regarding fund finance, please do not hesitate to contact our banking and finance specialists.
