abrdn - Wed, 05/01/2024 - 00:48

Fund finance: evolution, insights and opportunities

AUTHOR Shelley Morrison Head of Fund Finance and ABS

Fund finance is a versatile asset class, offering growing opportunities.

Fund finance refers to fund-level debt provided to private markets funds, including private equity, private credit, infrastructure, and real estate funds. There are two main types of fund finance: subscription-line facilities, also known as capital-call facilities, and net-asset value (NAV) loans.

Large, global banks have dominated fund finance for several decades. However, the asset class is now opening up to institutional investors looking for lower-risk, income-generating assets that can deliver attractive risk-adjusted returns and capture high illiquidity premiums.

Subscription lines vs. NAV-backed finance for return expectations and risk?

Subscription lines, or capital calls, are loans secured against a fund’s limited partner commitments. They are usually multi-currency, revolving credit facilities with a legal maturity between one and three years. These are high-quality assets with first-ranking collateral and the diversification of credit risk across a large pool of committed investors.

Subscription lines are typically investment-grade quality, with a low correlation to equities and other credit assets. They also have a stable credit risk profile: the asset class has a near-zero loss rate and performed well during the global financial crisis and the pandemic.

Investors should not confuse subscription lines with fund-level NAV loans, which are a form of structural leverage. Fund finance NAV loans are secured by the portfolio assets and are repaid from asset sales or the cashflows from those assets. These have a different, usually higher, risk profile and are typically longer in tenor.

Why do general partners use fund finance?

General partners, or GPs, use subscription lines to bridge a fund’s investment activity. This includes funding an acquisition or investment rather than calling capital from investors with a 10-day notice period. This finance provides certainty and flexibility of funding, short-notice access to liquidity and reduces administrative complexity.

GPs use this finance in order to batch capital calls to avoid drawing down on investors too often. Such activity smooths the capital call process and reduces the number and frequency of capital calls. Subscription-line facilities are now an integral part of a GP’s strategy – it’s increasingly rare to see a fund without this arrangement.

What is the benefit of fund finance to limited partners?

A squeeze on liquidity is a growing concern for limited partners, or LPs, in the current environment. The lack of a clear, detailed understanding of how and when the fund will call capital increases uncertainty.

The GP’s use of subscription-line facilities means LPs no longer need to hold their capital commitments in highly liquid, lower-yielding investments pending an uncertain and unpredictable call timetable. Greater certainty around the timing of capital calls allows LPs to be more strategic with their liquidity and better manage their cashflows.

How's fund finance being used in portfolios?

Fund finance is a versatile asset class. Investors are making allocations to subscription-line loans to achieve many different objectives. These include portfolio diversification, optimizing risk-adjusted returns and, where relevant, capital efficiency. By investing in subscription-line loans, it’s possible to achieve higher yields without compromising credit quality or taking on excess credit risk. This asset class is therefore an interesting alternative to assets like shorter-dated government bonds.

We recognize fund finance to be one of the more attractive investments from a capital efficiency vs. expected return perspective. Depending on the loan’s tenor, rating, and the insurer’s ability to model the collateral benefit of asset-backed lending strategies, such as fund finance, the solvency capital requirement (SCR) is approximately 2%–3%.

Final thoughts

There’s an insufficient supply of subscription-line finance to meet the growing demand from GPs and financial sponsors. Bank balance sheets have not been able to keep pace with the demand. Furthermore, the 2023 bank failures in the US and Europe removed significant supply from a growing fund finance market. This sudden supply-side contraction had two positive impacts for institutional investors.

First, loan margins for new issuance of investment-grade quality transactions have increased by more than 50 basis points since the first half of 2022. Fund finance lenders can now capture more attractive illiquidity premiums than before.

Second, GPs and financial sponsors are understandably sensitive to bank counterparty risk. Many are broadening and diversifying their lender groups, removing reliance on one or two key lenders. Subscription-line facilities are floating-rate assets and typically priced above other rates, depending on the currency of the loan. Many facilities also benefit from a floating-rate floor, protecting investor returns in a falling interest rate environment.

Important information 
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