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Pressure point

by Alice Murray 6 January 2022

It will most likely mean banks will have to hold more capital related to these loans, which will further restrict their willingness to do big lending tickets without significant ancillary income

The fund finance market has experienced explosive growth in recent years. Estimated to be worth around $1trn currently, the market is set to continue growing exponentially in the coming years, in step with the private capital funds it lends to.

On the surface, this is positive - a booming fund finance market evidences the low risk nature of these products. It also highlights the demand from private capital funds, solidifying the belief that these loans provide multiple benefits to both managers and investors.

However, dig a little deeper and cracks are emerging. Banks are already struggling to finance these ever growing loan tickets. “This is about efficient use of balance sheet capacity,” says Jean-Paul Peters, founder of Kombit Consulting. “If a bank has capacity, then quoting for a loan simply comes down to its economics, but if capital is constrained or there are many concurrent loan requests, a bank has to look at other commercial factors.”

Capital call facilities are linked to new funds, so surely the availability of these products is linked to the fundraising cycle? “That’s how it used to be but now with the advent of
platformification, with managers raising funds across different strategies the cycle is changing and the relationships don’t behave in the way they used to,” explains Peters.

Cap in hand

To deal with rising demand some banks have introduced caps on certain managers. However, if those managers launch new strategies, their banks will cap out much sooner. “That’s an issue,” says Alex Griffiths, executive director, head of structuring at MUFG Investor Services. “Banks who run into those points will need to move with the times. Clearly it’s an internal safeguard to ensure there’s no over exposure to a single sponsor. However, in the growing sector of private investment funds where there’s more demand, and sponsors are broadening their strategies, it’s a big task to keep pace with that, especially for banks with balance sheet constraints.”

It’s also important to note how capital call facilities are perceived internally by banks. They’re not the most attractive products; yes, they’re low risk, but as we can already see, they’re tricky to manage. They require huge amounts of planning and crystal ball gazing. Furthermore, when it comes to subscription lines, pricing has reached a level of harmonization, leaving lenders little room to negotiate more attractive terms.

Says Neno Raic, co-founder of No Limit Capital, “Banks tend to treat these loans like corporate RCF facilities. Banks don’t necessarily meet their hurdles on the loans alone, but take into account the potential sale of ancillary capital light products so they can be justified internally.” Many banks offer capital call facilities in order to sell the fund manager another product such as fund administration services, depositary and FX hedging.

“There are very few banks lending in this space who focus purely on subscription lines as an isolated touch point with a borrower,” says Peters. “In my time as a credit committee member, I expected deal teams to bring something else to the table when they sought approval to deploy balance sheet and I think that’s true for any bank.”

Emma Russell of Haynes Boone and chair of the Fund Finance Association agrees, “A number of these loans are investment grade financing, so many lenders are under pressure to cross sell to FX, custody, deposit, administration services because those are more lucrative, which means that they are sometimes under pressure from their credit committees on these cross-sells.”

And while some lenders present themselves as pure subscription line providers, says one source, “I’ve worked with them all and have seen deals they weren’t able to support because there wasn’t a link to other offerings for their business.”

To add to this, there are also concerns growing around new rules (Basel IV) coming in to further curtail the bank’s capital requirements. According to Raic, “It will most likely mean banks will have to hold more capital related to these loans, which will further restrict their willingness to do big lending tickets without significant ancillary income.”

So how does this all play out? We’ve already seen a surge in club deals for these loans in recent years. Says Peters, “When I started out in this space, having a five bank club was unheard of but now double digit is normal.”

Competition leads to innovation

As well as sharing out the facilities, banks have been innovating to improve their competitiveness. The most notable development in this space has been ESG-linked loans. Typically, these facilities are standard capital call or NAV facilities but include ESG-related KPIs agreed between the fund and the lender. When the KPIs are achieved, the price of the loan is reduced.

At an event held by The Drawdown recently, when discussing fund finance, one speaker questioned a bank’s motivation to provide these loans, given the impact on the lender’s earnings.

According to one source, it’s not a big hit to lose 5bps for a fund to be doing good things. Griffiths points out, “It can be trickier for smaller funds who may be buying or lending to underlying investments which are perhaps less well versed in ESG, and whom the fund will likely not know yet. Our clients often ask us about setting KPIs because they have little visibility over what companies they will be buying, and therefore are unsure of how to calibrate the facility.”

And that’s not to mention the additional workload required for a 5bps differential. So far there have been less than 15 ESG-linked loans granted in the private fund space, since the first was announced back in October 2019 by Quadriga Capital, a Singaporean healthcare investor.

While any effort to increase ESG should absolutely be applauded, are ESG-linked capital call facilities really going to move the needle, or are they a way to win deals?

“I don’t think we should be patting ourselves on the back for the small number of deals done to date,” says Peters. “We should be pushing as an industry to think more carefully about how every transaction can consider relevant ESG factors. Coming out of COP 26, fund finance must play its part. It needs to be driving the right conversations. None of this happens in isolation; it needs deal teams, CFOs, banks and other lenders - they all have a part to play. ESG is not an ancillary process or financing feature, it is not just about thought leadership – fund finance needs to be driving change.”

That will likely be an unpopular view with lenders, but what it highlights is the overriding focus remains on money, rather than doing good. With the success or failure of reaching one’s ESG KPIs whittled down to simple financial consequences - a few basis points either way - for some industry observers, these products are coming off as talking the talk rather than walking the walk.

Another complexity

With or without linking capital call facilities to ESG goals, these loans are cumbersome to implement, largely because they require the lender to conduct due diligence on the fund’s investors. When there is only one lender, that requires a lot of work. When there are clubs, that work is multiplied.

“Some of the due diligence is pretty granular,” says Griffiths. “The overall objective on sub line due diligence is to tease out any points in the fund documents that might inhibit money coming down from investors, because that’s the sole recourse of the financing and basis of the credit analysis. The lenders are not so concerned with the fund’s remit, the focus is anything that cuts across money coming down.”

And that’s not all. Credit facilities will often create a new set of side letters, already a major headache for managers. “We still see it debated frequently as to whether we get side letters, or memoranda. Bigger funds will give a summary of side letter provisions, covering anything that’s materially adverse to the lenders, but nothing on reduced fees, which is fine,” comments Griffiths.

These credit lines still need banks to participate because they are revolving credit facilities and not fixed term amortising loans

Another report

Fund credit facilities have also given rise to more cumbersome investor reporting. Following concerns raised around the impact of subscription lines on IRRs, ILPA published its Subscription Facility Guidance in 2017, which requires managers to report IRRs with the impact of the sub line removed. The guidance also advised reporting on a fund’s capital call policy, costs, purpose of each advancement and new investments as well as the number of days each advance is outstanding.

Last month ILPA incorporated that guidance into its DDQ 2.0. One of the key changes is recommending LPs ask questions around credit facilities prior to investing (previously managers reported on credit facilities once an LP is already invested in a fund).

Specifically, in the DDQ 2.0, new section 7.0 (Credit facilities) requests a GP answer a series of questions relating to credit facilities, including historic use in predecessor funds, impacts on LPs (documentation required from LPs or restrictions on LPs). Questions around net IRR calculations, LP’s opt-out rights and alignment of reporting to ILPA recommendations.

Additional stakeholder

What ILPA’s guidance and the due diligence requirements of the lender make clear is that bringing in fund finance creates an additional stakeholder in the fund. That in itself raises questions over the unique alignment that private capital fund structures offer investors. It also creates unintended consequences.

Ryan McNelley, managing director at Duff & Phelps, A Kroll Business, sees the impact of this. “We’re an independent valuation provider and most of the work is done at the behest of LPs who want to know the fair value of their investment. To the extent a fund is capitalised with LP commitments and leverage you now have an additional stakeholder with interest in the assets; the debt provider.”

According to McNelley, lenders take a different view on fair value. “An LP wants to know what it would be worth if sold today - and the higher the value the better - whereas the leverage provider is more concerned with covenant compliance, that the facility is safe. The lender simply wants to know whether it’s worth at least a certain amount.”

With traditional banks already creaking under balance sheet pressure, they are also hampered by a lack of investment in new technology that would streamline reporting and data flows. These inefficiencies will only be exaggerated further by innovations such as ESG-linked facilities, which place huge demands on data feeds and information sharing.

Says Peters, “This is only going to be a bigger problem as loans and clubs get bigger, it only gets more tricky. The leading banks know exactly what they are doing from an underwriting perspective but their internal infrastructure does need constant investment and ESG will require more cross-functional collaboration from within; fund finance probably isn’t the largest component that is asking for that investment and for that commitment from specialist internal resource.”

New participants

Of course, none of these developments have gone unnoticed, hence an influx of non-bank lenders into this space. Non-bank lenders don’t have the same balance sheet concerns as banks, with the ability to raise capital from institutional investors. The increased participation of non-bank lenders in the fund finance market appears to solve the majority of the problems faced by banks, but they also bring about new considerations.

“These credit lines still need banks to participate because they are revolving credit facilities and not fixed term amortising loans. That doesn’t align with raising capital that matches lending activity. Non-bank lenders face the same issues that banks do around the unpredictability of utilisation once a facility is committed,” explains Peters.

This is important. LPs are comfortable with subscription lines because they are revolving credit facilities - their key function is to provide GPs with quick cash to fund deals and to smooth capital calls.

Speak to an advisor

With more players entering this busy market, what’s clearly needed is more intermediation. Experts who can connect the dots, create efficiencies and share best practices.

“The level of belief from market participants that intermediary support is needed is still growing,” says Peters. “GPs are complaining about certain pain points, but they’re not at the stage where they’re driven to use external solutions, instead they’re still dealing with it themselves.”

For buyout funds, managing capital call facilities appears to still be manageable in-house. But for strategies including secondaries and private debt, which rely heavily on subscription lines to remain competitive, the complexity of managing these facilities is becoming untenable. Collar Capital’s recent decision to work with an external advisor to support the management of their fund finance is clear evidence of this.

And it’s not just sponsors feeling the pressures of managing increasing complexity. With only a handful of intermediaries currently active in the fund finance space, other participants frequently find themselves doing brokerage work. Says Russell of Haynes Boone, “The market is extremely relationship driven; I spoke to a borrower client recently who wants to move from their existing bank and have spent quite considerable time making introductions for them. However, we are now seeing an increase of debt advisers which some investors find favourable as it demonstrates a level of independence from the GP/service provider relationships.”

Could this be the next phase for fund financing? Having teams of advisors focused solely on securing the loans, managing the lender due diligence, the investor due diligence in relation to credit facilities, the reporting requirements? And if so, do the benefits of fund financing still hold true?

Put all of this together - the growing demand for fund finance, the banks’ increasing restrictions on financing loans, incoming rules, increased reporting and due diligence requirements, the advent of non-bank lending and the need for more intermediation - it’s clear that the fund finance market is reaching an inflection point. Whichever way this market develops or progresses, there are several factors that must be prioritised.

First, if institutional capital is to play a greater role in meeting demand for capital call facilities, will these loans continue to serve their original purpose of providing liquidity to execute deals and smooth draw downs, or does this become a new asset class?

Second, if banks are forced to be more selective on which sponsors they can work with, will GPs be more selective towards their LP base, reducing access to less ‘institutional’ investors that are not bank friendly? Within that, could we see lenders focusing solely on largecap sponsors because they attract more institutional investors, leaving less lending capacity to smaller managers?

Third, and perhaps most importantly, what does the growing reliance from private capital fund managers on fund finance do to the unique alignment offered by the structure? Especially given the growing likelihood that these loans will come from consortiums of lenders dependent on various advisors.

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