The fund finance market was thrust into yet another phase of rapid evolution as borrowers and lenders responded to a supply-constrained subscription credit line market made even more so by a rapidly rising rate environment, which itself precipitated the downfall of three of the market’s most active lenders.
Private Funds CFO spoke to people involved on all sides of the fund finance market to gain insight into how borrowers could survive not just sinking valuations and a broad pullback from investors, but the intensified turmoil in sub lines – by now so widely used as an operational tool it has become all but integral to the private equity machine.
What we found was a market swirling with ideas, some of them already taking shape, as well as glimpses of hope in less developed financial markets and the sprouting up of new entrants into sub line lending.
End of an era
The economics of borrowing in sub lines has changed more drastically for lenders than borrowers. The downfall of three of the most active lenders – Silicon Valley Bank, Signature Bank and First Republic Bank – had the immediate effect of taking an immense chunk of available supply out of a market in which many lenders were pulling back due to internal capital and concentration limits.
Not only are floating rate loans less attractive for many banks in a higher rate environment due to their funding sources, but the so-called regional banking crisis caused many GPs to begin spreading their accounts around to different banks in order to decrease their own concentration risk.
But bank lenders who fund themselves with deposits need those accounts to make sub line lending worth their while, potentially further complicating and suffocating the supply lines.
“You can’t expect to move your accounts to JPMorgan and expect other banks you don’t have deposits with to lend to you,” says one banker formerly with a major sub line participant.
Another banker, who was employed by one of the two banks that were sold, suggested that GPs might need to develop more numerous, and more complex, banking relationships.
“People are going to spread [their deposits] around, but if you’re offering the product they need, you’re not going to allow the fund to have three operating accounts with separate banks,” the banker says.
Instead, he suggests borrowers might keep all of their accounts for each different fund at a handful of banks, rotating between them. “So the accounts for fund one would be with us, but fund two would be with [another bank], fund three for another,” he says. GPs would have to deal with more banks, yes, but at least, he adds, borrowers could try to keep the number of banks – and the teams they deal with at them – to a reasonable number.
For the time being, former clients of SVB and FRB (which were taken over by First Citizens and JPMorgan, respectively) say their new banks are still servicing existing lines. But while optimism abounds among many borrowers speaking with Private Funds CFO, it was still unclear by press time whether either First Citizens or JPMorgan would continue to provide new loans. (Executives and press relations staff at all the banks named in this story either declined to comment or did not respond to requests for comment.)
JPMorgan once serviced smaller, mid-market GPs, but cut ties with them after the financial crisis as more onerous capital requirement regulations set in. It has since served primarily larger borrowers out of its private banking unit. The FRB portfolio is being incorporated into JPMorgan’s Consumer & Community Banking division. The effect of this on FRB clients is unclear.
“JPMorgan doesn’t even know the answer to that question,” one fund finance lawyer who spoke with FRB staff said only days after the acquisition.
And it’s not just smaller borrowers that face challenges in obtaining lines. Market players have said that at least one megafund sponsor was turned down by a major investment bank for a line as the latter focuses on its closest relationships.
With all the uncertainty, one thing is all but definite: banks and borrowers alike are facing a different market than the one fund finance grew up with. Fundamental aspects of the business previously taken for granted are being reconsidered.
New paths being forged
But some steps forward have already been taken, sources tell Private Funds CFO.
Term loans, or some combination of them with revolving facilities, are one potential solution. GPs like revolving facilities because they can’t be sure when an acquisition and later capital call will be made. But under current circumstances, says one consultant, “some borrowers are going to have to make the decision of whether or not to go with term loans.”
Some insurance companies have short-term buckets, potentially allowing them to participate directly. And some are already teaming up with banks to provide a mix of term loan and revolving debt in lieu of a traditional sub line, according to a UK-based fund finance banker.
He says insurance companies are participating directly by structuring a series of term loans up to a certain value. In the meantime, a bank or team of banks provide a revolving loan, with the loans from both lenders ranking pari passu to each other. The borrower then draws from the sub line and refinances that out with one of the term loans from the insurance lender. Bank lenders might negotiate taking a piece of the term loans, since this model implies GPs paying back drawn amounts more quickly than they typically have in the past.
“With liquidity as scarce as it is, GPs are having to do this for big lines,” the banker says.
Other banks are taking from the playbooks of the likes of NLC (formerly No Limit Capital) and Investec. The former’s platform is designed to bring in both third-party bank and institutional capital to fund borrowers’ needs. The latter takes down a portion of its loans and then syndicates them out to its institutional investor base.
“You can’t expect to move your accounts to JPMorgan and expect other banks you don’t have deposits with to lend to you”
Sub line banker
Lloyds, for example, is experimenting with ways to scale up a test-case platform that funnels the drawn portion of a line into a bankruptcy-remote special purpose vehicle, which is then funded by an institutional investor, according to a banker there. “We’re trying to perfect it. These are not flow products,” he says, adding that the typical T + 2 settlement time for a bank-provided sub line can be much longer for an institutional lender. “They may need 10 or 15 days to fund the drawn amount,” the banker says.
Approaches like these can be added to the small pool of existing investors who buy portions of loans from banks for their own investment portfolios – abrdn being perhaps the most well-known among them in the fund finance market. And new entrants are popping up in quick order. Among them, San Diego-based Axos Bank recently hired former Signature banker Trevor Freeman to lead its foray into sub lines. New York-based Apple Bank hired former Silicon Valley Bank vice-president Matthew Doyle to its subscription finance business – though it couldn’t be determined if Doyle’s hire was part of an initial push into the business or an expansion of an existing platform.
The NAV loan market, too, is being tapped for entirely different purposes than for which the market was conceived. NAV came into its own during the height of covid as an effective defensive play against broad liquidity shortages at portfolio companies, and was quickly recognized as useful for additional investments during a fund’s holding period, when LP capital can no longer be called.
The idiosyncratic asset class is so bespoke as to defy a simple, general definition, but the concept has since seen additional uses for PE borrowers.
Since the leveraged loan market was first hobbled by the war in Ukraine, and further by increased rates and a souring economic outlook, many borrowers have been unable to get full funding or economic pricing for the leveraged loans they use to acquire platform assets. Some have been effectively locked out of the market entirely, market players say.
And so a small number of GPs – particularly megafund sponsors – have turned to NAV loans, buying assets with the cash they couldn’t borrow elsewhere and then back-levering them with NAV loans at rates comparable with, or cheaper than, the lev loan market, and with similar terms, says a second fund finance lawyer.
“Some borrowers are going to have to make the decision of
whether or not to go with term loans”
Fund finance consultant
Participating sponsors have in some cases achieved results “materially better than what they could get in the LBO market,” that lawyer says. And structurers can reposition the capital structure to approximate the originally targeted leverage ratio.
It has worked so well for one borrower that they reportedly hope to use NAV for every new acquisition, though the lawyer says that may not be realistic, given the small pool of active lenders for these kinds of loans.
For now, the activity seems to be confined to a small cadre within the group of the largest sponsors, he says. “But the mid-market should at least look into it.”
The structure generally works by having a fund provide some form of guarantee from the borrowing fund (or an equity commitment letter if the LPA restricts fund-level guarantees) to a syndicate of lenders who then extend the NAV loan to the holdco in which the acquired portfolio company sits. In some cases, where usual equity restrictions at the portco letter don’t exist, the portco pledges equity to the lending syndicate. Fund documents can prohibit such deals from getting done or require a tweak in structure. And what exactly is supporting the fund-level guarantee – the NAV of the relevant portco, a second lien on an existing sub line or uncalled capital, for example – is crucial to a deal’s successful execution.
A sample term sheet in a marketing presentation seen by Private Funds CFO suggests a deal with a closing and maximum LTV of 10 percent and 25 percent, respectively, with pricing in the SOFR plus 350-450 basis points or greater range and an optional payment-in-kind structure. Upfront fees would be around 1-2 percent, with mandatory prepayment for select covenant breaches.
Due to the nature of such a structure, the loan-to-value ratio achievable at the right price point will decrease with each subsequent deal – another reason why repeated back-leverage NAV deals in one fund are a challenging proposition.
The innovation in NAV doesn’t stop there. Perhaps more controversially, some GPs are using the loans to make distributions to liquidity-strapped investors, increasing their distribution to paid-in capital ratio, according to a survey by fundraising adviser Rede Partners (see “NAV resists lev loan market turmoil” article). While IRR is so often the return metric GPs and LPs focus on, a low DPI can represent a significant challenge to raising capital for a subsequent fund. In one of the most challenging fundraising environments in the history of the asset class, DPI has become a critical ratio to maintain.
And sponsors of continuation funds are using hybrid NAV deals to fill the gap left by smaller LP commitments, among other things (see “Hybrids and NAV loans offer unique uses in continuation funds” story).
“I think the future is in NAV loans,” says one sub line lender at a major investment bank.