Why fund financing now?
In light of the Covid-19 pandemic, banks may have new priorities. One is a focus on balance-sheet management. Banks may now reach internal capacity constraints, so they either need to close their doors to new business or recycle or churn their books in order to remain competitive. Another new priority is pursuing more sophisticated ways to reduce exposure to individual financial sponsors and LPs — without damaging longstanding relationships. As a result, accelerating risk transfer has picked up pace throughout the ongoing Covid-19 pandemic.
Risk transfer refers to the risk-management strategy involving a shift of risk from one party to another. So, in the case of banks that have hit internal capacity constraints, they can employ risk transfer in order to keep their doors open to new business by shifting their existing SCF risk to some other party. Lately, we have seen a trend of banks shifting their risk to non-bank institutional investors. We expect this trend to have a profound and lasting impact on insurance assets going forward.
Historically, fund managers have conducted SCFs through bilateral transactions, which involve trades negotiated between two participants in off-market transactions. However, there has been a material increase in club and syndicated transactions since 2018. Club or syndicated transactions refer to several lenders coming together to fund a single SCF,. These transactions are necessary to support the ever-increasing size of SCF.
Why fund finance for insurers?
Currently, the global annual demand for fund financing is more than $650 billion. We expect this to grow in the coming years as fund sizes increase and SCF usage becomes more widespread. Today, several of the world’s largest banks dominate this market, but new banks are joining at the syndication level due to the attractive risk-adjusted returns available. Indeed, given the growing size of the financing facilities, a lead bank typically syndicates the facility across several other banks, which reduces risk exposure. This is because banks often have single-name credit limits, sector limits and counterparty risk to manager. Syndication can help relieve some of the pressure. However, given that other banks are also direct competitors, lead banks may turn to non-traditional lenders to participate in lending programs.
There is a clear opportunity here for insurers to serve as these alternative lenders. SCFs can offer institutional investors, such as insurers:
- Attractive, potentially stable, low-single-digit risk-adjusted returns
- Capital-efficient investing
- Diversification potential, since loans backed by undrawn commitments of a diverse pool of large institutional investors provides low correlation to other asset classes
- An interesting alternative to cash investments, because they can deliver a premium over cash returns without taking long-duration risk or undue credit risk. Although they’re not publicly rated, investors can consider SCFs to be quasi-investment grade, depending on the composition of the investor base.
- Opportunities to access the attractive fund-finance market, because non-bank lenders do not pose a competitive threat to the lead banks
- Potentially strong performance during periods of market stability as well as market disruption
It’s likely that in the evolving marketplace, we will continue to see more and more investors keen to participate in fund-financing action. Although the fund-finance market has generally been the preserve of banks, syndication requirements have spurred lead banks to pursue non-traditional lenders.
Institutional investors such as insurers may be well positioned to tap into fund-financing investments and enjoy the benefits banks have been privy to over the past few decades, but with new, creative structures. However, fund financing presents unique complexities that are embedded within the bank and fund documentation, which can be a hurdle for many potential non-bank lenders. Beyond these complexities, the alternative lenders need to have the capabilities to diligence fund investors, the manager’s track record, and the investment strategy. This can be time consuming and costly.
Insurers may benefit from partnering with asset managers who have robust resources and relevant experience. These transactions require operational, tax and legal support, as well as familiarity with the fund-financing market dynamics . Access to a wide network of relationships with major fund finance lenders, advisors and lawyers will also be critical to program execution. Asset managers, established in the asset class, may be able to help insurers successfully implement innovative investment and operational solutions.
The bottom line is that current market conditions have thrust the benefits of fund financing into the spotlight. Insurers, in partnership with asset managers with access to myriad fund-financing resources, capabilities and experience may have the opportunity to take the stage.
A version of this piece originally appeared on Insurance AUM.com.
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