By Max Bower
(LPC) - The size of fund financing loans is increasing along with banks’ exposure to the US$400bn market as managers raise ever-larger funds, but the wall of cash pouring into the sector is also encouraging smaller debt funds to leverage portfolios to maintain returns.
Up to 50 banks are now competing to offer subscription lines of up to €2bn to support multi-billion dollar private equity funds, but fund financing specialists are also seeing rising demand for Net Asset Value (NAV) lines from smaller debt funds, including direct lenders, CLOs and real estate funds.
Fund financing is one of the fastest growing areas of the syndicated loan market as it supports the booming institutional buyside. Two thirds of managers now use fund lines, according to a recent eVestment report.
But the market is opaque and deal structures are becoming more sophisticated and complex as more banks compete aggressively for business.
“Structures have changed and become more complex as business have got more complex. This gives borrowers some power,” a banker said.
Subscription lines make up around 80% of the fund financing market and are typically used by private equity firms to cover the gap between calling for LP investors’ commitments and receiving funds. They are based on investors’ credit profiles and do not add leverage.
Net Asset Value lines are based on the value of assets in funds’ portfolios and do add leverage which helps to boost returns. General Partners (GP) lines are secured against fund management fees.
Hybrid lines, which combine subscription lines and NAV lines, are being hailed as the future of fund financing, but are growing slowly as they are complex and difficult to execute in practice.
“There’s been a lot of talk of hybrid lines,” said Ben Griffiths, global head of fund financing at MUFG, citing the mixture of expertise from banks and complex documentation as hindering its growth.
‘DEEP WATERS’
NAV lines are becoming more popular with smaller debt funds, according to Gavin Rees, head of global fund banking at Silicon Valley Bank. Funds are turning to leverage to maintain returns as yields have sunk across the capital markets.
Demand for NAV lines increased noticeably in the first quarter, according to Phil Lovett, head of leveraged finance UK at Silicon Valley Bank.
“There’s a need for leverage at the debt fund level because managers have over-promised on returns to their end investors.” Lovett said.
Using the facilities can increase returns to up to 10%, compared to 6%-8% on an unlevered funds, Brent Humphries, president at AB Private Credit Investors said.
Lenders are more comfortable giving additional leverage to debt funds, as the assets that they invest in are more liquid than private equity commitments, but not all market observers are sanguine.
“These are very deep waters,” a London-based head of leveraged finance said. “All signed deals look good on paper and no one goes into them thinking they’ll lose money, but there will be a lot of pain ahead.”
NO DEFAULT
Although the fund financing market has had no defaults to date on subscription lines, the growing size of deals and more aggressive terms are requiring lenders to read the fine print of the legal documents more carefully, and look at the bigger picture.
Banks deal with fund financing in several different departments, which can make aggregating exposure difficult, and even potentially problematic in a severe downturn.
“Fund financing usually sits in the fund-related products division, but often the expertise required sits in different parts of the bank,” the first banker said.
As subscription lines effectively bridge LP investors’ commitments, any possible funding exceptions need also need increasingly careful consideration. Side letters can allow LP investors, including high net worth individuals, pension and insurance funds and sovereign wealth funds, to potentially avoid funding.
“There are more most favoured nation clauses today in side letters which can increase the risk of LPs being able to walk away from fund commitments in extreme circumstances – this increases the need to review and understand the side-letters which appear to be getting more complex,” said Lee Doyle, global head of bank industry at Ashurst in London.
Some sovereign wealth funds have sovereign immunity that could allow them not to be called on funding commitments which provide security for subscription lines and some US State public pension funds can also be exempt, which is prompting lenders to do more intensive due diligence.
“When you see funds with fewer LPs, and especially with single investor sovereign wealth funds, due to the lack of diversity there could inherently be more risk,” Doyle added. “In Europe there is certainly more due diligence done on LPs and the contractual arrangements than two years ago.”
Although there is a high reputation risk for LPs not to lend, some banks were burned in the last crisis and still will not lend against sovereign wealth fund commitments or high net worth individual commitments, the first banker said.
“I know of a few family offices that said to their GP ‘don’t hit me for my funding commitment now’ during the last financial crisis,” another banker said.