This type of finance comprises short-term loans to private market investment funds in areas such as private equity, private debt, infrastructure and real estate. It can benefit both the managers/general partners (GPs) of funds as well as a fund’s investors.
GPs require liquidity to fund investment activity and support portfolio companies during various stages of a fund’s lifecycle.
One type of fund finance – subscription line loans – are a form of short-term credit used by funds to bridge their investment activity – delaying the drawdown of capital from investors. It offers clarity on the timing of capital calls so investors can manage their cash productively.
Today’s environment of high inflation and rising interest rates has driven up yields. That makes this a good time for a strategic allocation to assets offering attractive yields with some protection against negative rate movements – such as from floating rates.
In fund finance, interest ‘coupons’ are reset in line with a floating reference rate. Frequent interest resets mean floating-rate loans have near-zero duration. If reference rates continue to rise, so do the interest coupons paid on underlying loans – increasing income to investors.
In the United States, the three-month Secured Overnight Financing Rate stands at 5.30%1, leading to all-in yields of around 6.71% for certain investment grade, short-maturity subscription line facilities.
Importantly in fund finance, rising yields don’t necessarily equate to a deterioration in credit risk. Subscription line loans are largely short-tenor, investment-grade assets where credit risk is diversified across a large group of high-quality institutional investors.
Moreover, over-collateralisation – more than enough capital to cover potential losses – and first-ranking senior security are features of most subscription line facilities. Senior debt is paid out first if a fund runs into financial trouble – one of the best defences a debt investor can have.
The diversification of credit risk in a subscription line also frequently equates to low levels of correlation with other asset classes, providing potential diversification benefits for investors at a portfolio level.
Growing demand
Market dynamics drove global demand for subscription financing to more than $900 billion annually by the end of last year2, and we see reasons to believe this demand will grow.
Allocations to alternative assets, including private market funds, continues to expand. Globally, fundraising in private equity markets reached an estimated $1.3 trillion last year.3
Large banks have been the main providers of fund finance. But they have found it difficult to keep pace with demand amid tighter capital constraints from regulators. Many banks have hit internal lending limits and been forced to syndicate part of their fund finance facilities.
Consequently, banks are reaching out to lending partners including asset managers so that they can continue to support private market clients while meeting their capital requirements.
Recent bank failures in the US and Europe have also removed supply from the fund finance market. As a result, GPs and financial sponsors have become more sensitive to bank counterparty risk and are also seeking to diversify by working with non-bank lenders.
This contraction in supply has been positive for fund-finance providers, enabling them to capture more attractive liquidity premiums. Since the first half of last year, loan margins for short-tenor, investment-grade transactions have risen by about 30 basis points.
Marriage potential
Fund finance is well-suited to asset owners with capital efficient investment objectives due to its credit quality, short duration, yield enhancement potential, uncorrelated returns, low volatility, structural protection and bespoke cash flows that can be used to match liabilities.
But overseeing investments can be challenging given the complexities of credit underwriting and loan documentation, allied to the time-consuming demands of due diligence and cash management.
Institutional investors might turn to asset managers with fund finance experience and broad capabilities in credit and liquidity management, currency hedging and operational, legal and structuring expertise. Well-connected managers can also offer access to bank lending programs for loans in different currencies with a range of tenors and pricing options.
Ultimately, we think now is a good time to participate in fund financing at a time when opportunities are increasing and risk-adjusted returns have become more attractive. It offers potential as a marriage of convenience for institutional investors and asset managers.
- Federal Reserve Bank of New York August 2023
- abrdn 31 December 2022
- Cadwalader – Behind the numbers: the 2022 Fund Finance Market