Traditionally, private equity funds have turned to major banks to meet their financing needs. But recent developments mean institutions, such as asset managers, are playing an increasingly important role – creating a significant opportunity for investors to access a stable asset class that has historically generated highly attractive yields with relatively low risk.
The growing demand for fund finance
Global private equity markets have boomed in recent years: in the first half of 2022, several funds raised more than $100bn each in commitments and fundraising is estimated to have surpassed $1.3trn for the whole of last year.1
Alongside this expansion, managers of private equity funds are exploring ever more sophisticated financial solutions to boost liquidity and to provide timely capital injections for their portfolio companies. Fund finance now encompasses arrangements such as subscription line loans – a form of short-term credit that allows funds to bridge financing gaps until capital calls are made to investors – and net asset value facilities, which allow private equity funds to raise finance against the value of their current portfolios.
Institutional investors step up as bank involvement lessens
The world's largest banks have traditionally been the main providers of fund finance. But as demand has grown, these institutions have found it more and more difficult to keep pace, not least because of the increasingly onerous capital requirements placed on them by regulators since the financial crisis of 2008; indeed, in many cases, regulatory frameworks have forced banks to sell down portions of their fund finance facilities. At the same time, larger fund sizes have required larger credit facilities that are often simply too big for a single lender to provide. Banks have consequently started seeking out lending partners, such as institutional investors, so they can continue supporting their private-equity clients, while retaining an appropriate level of liquidity.
Market volatility generates new opportunities
Recent developments in the banking sector, most importantly the failures of several banks in the US and Europe in early 2023, have also influenced the funding landscape. The resulting contraction of financing supply to the private equity sector has had two positive impacts for institutional investors. Firstly, loan margins for short-tenor, investment-grade transactions have increased by around 30 basis points since the first half of 2022. This is because providers of fund finance are now able to capture more attractive illiquidity premiums than before. Secondly, general partners (GPs) and financial sponsors have become much more sensitive to bank counterparty risk, and therefore, are taking steps to broaden and diversify their lending sources to remove the reliance on one or two key lenders.
Overall, this means that the recent volatility in the wider market is positive for institutions looking to provide fund finance - not only has the opportunity set expanded, but the risk-adjusted returns can also be more attractive as well.
The appeal of fund finance as an investment
While yields on fund finance facilities have been climbing in recent months, this is not a reflection of deteriorating credit risk. Despite the challenging macroeconomic conditions, the credit-risk profile of fund finance remains stable. Subscription line loans, for example, are typically investment grade and their track record remains exceptional: there have been no known credit defaults in this space. In addition, these types of loans are short-tenor assets, where the credit risk is diversified across a large pool of high-quality institutional capital providers, with substantial levels of over-collateralization and first-ranking senior security built into the structure. Being first in line in times of possible trouble is one of the best defenses that debt investors can have.
Another positive is that the unique risk drivers and structuring of fund finance facilities mean that they often have less volatility compared to other interest rate sensitive assets, as well lower correlation with other major asset classes, thus potentially aiding diversification. Finally, in a rising-interest-rate environment, there is a strong case for having a strategic allocation to assets that provide attractive yields, combined with good protection against the risk of negative rate movements - given the widespread use of floating rates, which are reset as rates in the wider economy change, fund finance is one such an asset class.
1 Cadwalader, Behind the Numbers: The 2022 Fund Finance Market
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