Fund financing can help improve diversification and manage volatility, plus it provides the potential for significant yield over cash. And now may be a particularly good time to consider fund financing, since its comprised largely of floating-rate debt, an asset class that can benefit from rising interest rate environments like the one we’re in today.
What is fund financing?
Fund financing facilities are loans provided to private market funds including private equity, credit, infrastructure or real estate across various stages of their lifecycle. The market is often divided into two areas:
- LP-backed or subscription line financing – backed by first recourse to undrawn limited partner (LP) commitments. These are typically by blue-chip clients, including insurers, pension schemes and sovereign wealth funds.
- NAV-backed – secured on a diverse portfolio of underlying assets and cashflows of private market funds, typically at a later stage of their lifecycle
Why fund financing?
There are several operational and financial reasons why these facilities may be beneficial to both investors and the manager/general partner of the fund. These include:
- Providing managers with capital to finance investment activity within a few days, rather than drawing capital from investors, which requires a much longer drawdown notice period
- Giving greater clarity of the timing of cash calls to help investors manage their own cashflows
- Allowing cash calls to be consolidated or batched to delay drawing down on investors, bridging the finance of a portfolio company
- Enhancing IRR-based returns by delaying drawdown from investors
What is the opportunity set?
The global annual demand for fund financing is more than $600 billion.1 We expect this to increase significantly in the coming years as private market fund sizes grow.
Currently, the world’s largest banks dominate this market. But, new banks are now entering at the syndication level due to the attractive returns available.
Indeed, given the increasingly large size of the financing facilities, a lead bank typically syndicates the facility across several other banks, reducing its risk exposure. This is because banks often have single credit limits, sector limits and counterparty risk to manage. Syndication can manage these.
However, because other banks represent direct competitors, lead banks are increasingly looking for non-traditional lenders to participate in their lending programs. This is where insurers come in.
Why is fund financing attractive for insurers?
Fund financing can be well-suited to an insurer’s financial objectives, including capital efficient investment. This is because fund financing has:
- Attractive credit quality
- Short duration – maturity between two and five years
- Uncorrelated returns to public credit markets
- Low volatility and credit risk
- Strong structural protection (Chart 1)
Fund financing strategies also have enhanced yield possibility. LP-backed strategies can pursue returns of 165-200 bps over a reference rate, and NAV-backed strategies can target 350-500 bps over a reference rate.
Chart 1: Sources of recovery of payment for LP-backed fund financing facilities
Why is now the right time for insurers to enter this market?
The lending market has generally been the preserve of the banks. But in recent years, stricter regulation has pushed banks to co-invest with private investors. And sourcing deals for private investors is a challenge.
Private market fund managers usually want to work with banks that can offer a range of banking services. This can be daunting for those not familiar with the legal documentation and the structure of funds.
The complexities that are embedded within the banking and fund documentation can also be a hurdle for many. Performing the required due diligence on the manager’s track record and strategy can be challenging and time consuming. On top of this, there’s the ongoing cash management and monitoring of each loan. Investment managers can provide an efficient way for insurers to participate in the fund financing market.
What’s important in a fund financing investment manager?
In our view, to choose a fund financing investment manager, it’s prudent to consider those with broad capabilities, including credit and liquidity management, currency hedging and, of course, operational, legal and structuring expertise.
It also helps if your fund financing manager is already conducting ongoing in-depth due diligence of private equity vehicles, managers and their investors. Access to lending programs across all the dominant banks active in this market is also essential.
Investment managers with these contacts and skillsets are best placed to provide clients with different currency loans, as well as a range of tenors and pricing options to support their specific requirements. Asset managers with these due diligence and cashflow management capabilities can also serve clients well, saving them clients time, allowing them to pursue other yield-enhancement opportunities.
1 Source: abrdn, December 31, 2021
Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.
Among the risks presented by private equity investing are substantial commitment requirements, credit risk, lack of liquidity, fees associated with investing, lack of control over investments and or governance, investment risks, leverage and tax considerations. Private equity investments can also be affected by environmental conditions / events, political and economic developments, taxes and other government regulations.