Fund Finance Partners on the perfect storm for asset managers

The failure of three prominent fund finance lenders has turned choppy waters into a full-scale hurricane watch, says Anastasia Kaup, a partner at Fund Finance Partners.

Anastasia Kaup

This article is sponsored by Fund Finance Partners

The past nine months in debt capital markets, and specifically fund finance, have proven to be anything but smooth sailing for financial sponsors. Late last year, US banking regulations went into effect that require depository institutions to increase capital ratios. This has constrained the bank balance sheets across the board, but particularly for larger US banks known to be active in the subscription facility and broader fund finance markets.

Most notably, for financial sponsors, the immediate impact was a meaningful reduction in the availability of subscription credit facilities and lines of credit for private credit managers. Combined with equity market volatility and the most challenging fundraising market in more than 10 years, by the beginning of 2023 it was taking fund sponsors longer than any time in recent memory to raise capital.

As if the waters weren’t rough enough for fund sponsors, this spring’s sudden failure of three of the most prominent lenders in the fund finance market turned a market already under a small craft advisory into a bona fide Category 5 hurricane watch. The ensuing storm for asset managers seeking fund financing, whether subscription credit facilities or portfolio-level financing, is arguably the most challenging in our industry to date.

Subscription financing

Subscription credit facilities have never been considered high margin products for providers, so they’ve primarily been based on institutional relationships. Banks have historically counted on ancillary business or accompanying deposits to make providing subscription credit facilities worthwhile.

Through early 2022, most fund sponsors – even first-time sponsors – stood a reasonable chance of obtaining a subscription credit facility. Now, even established managers with asset class-leading track records are having a difficult time obtaining subscription credit facilities, unless they can offer the bank ancillary business on day one, and a minimum amount of deposits during the term of the facility.

Subscription leverage providers no longer have an incentive to compete by offering them on a stand-alone basis to fund sponsors. Some banks are requiring never before seen deposit-to-facility commitment ratios as a condition to even extend credit. For example, for every $100 million of subscription leverage, some fund sponsors are required to keep $10 million to $40 million on deposit with the bank during the term of the facility.

Additionally, some banks are prioritizing revenues from investment banking relationships (eg, M&A advisory to private equity sponsored portfolio companies), fund administration services, treasury management services and other lines of business. Other banks are prioritizing their increasingly precious balance sheet capacity for larger fund sponsors and more profitable relationships with a history of carrying high deposit balances.

Over the past two decades, fund sponsors have come to rely on subscription leverage to bridge timing gaps in cashflows, build their portfolios or bridge to asset-level leverage, and other purposes.

This coincided with a relatively uninterrupted era of subscription credit facility market growth. Because many of those fund sponsors have already allocated ancillary business to other parties, or have no reason to maintain large amounts of cash in deposit accounts, this is an unpalatable situation for them.

For first-time and smaller fund sponsors without meaningful ancillary business or deposits to offer, it is challenging to obtain subscription leverage on viable terms. Further, subscription credit facility sizes are trending smaller – while large sponsors may still be able to obtain a subscription credit facility, it is likely not as large as they are accustomed.

Partner loan programs

If you ask almost any senior management team member in any bank with a strong fund finance offering, they will confirm that fund financing products have historically performed quite well. While Silicon Valley, Signature and First Republic banks were pre-eminent providers of fund financing solutions, fund financing is certainly not the reason that these three banks failed. As a result of those failures, however, fund financing has been materially and adversely impacted.

One of the most adversely impacted areas is GP/partner loan programs and management company lines of credit – ‘top of the house’ products that fund sponsors primarily use to finance GP and team members’ capital contributions to affiliated funds, and/or to bridge timing gaps in revenues from management fees.

Silicon Valley Bank and First Republic Bank were arguably the two most prominent providers of these types of facilities. Now, with the bank failures and ensuing acquisitions, fund sponsors have two fewer lenders to turn to that meet these financing needs. It’s more challenging than ever to obtain GP/partner loans or management company lines of credit, increasing fund sizes and delays in asset exits, the market is proving in greater need than ever for these very products.

The NAV financing market

The factors described above have had ripple effects in the broader fund financing market, including the NAV financing market. NAV financing (including, for purposes of this discussion, credit fund ABLs) has grown exponentially in recent years, within all asset classes.

Because of the disruption caused by bank failures, financial market volatility and a challenging fundraising environment, many fund sponsors are holding onto assets longer than initially anticipated. As a result, they are increasingly seeking liquidity in respect of those assets. As soon as a fund has at least a few assets in the portfolio that contribute to a meaningful degree of NAV, the fund can effectively leverage those assets to meet those liquidity objectives, whether to increase the fund’s effective balance sheet, accelerate distributions to investors or for other valid portfolio management purposes.

Once a tool used primarily for defensive (capital-preserving) purposes, NAV financing has become an offensive (value-enhancing) tool for the savviest fund sponsors, and for fund sponsors who find their subscription leverage and/or other asset-level leverage options exhausted and/or lacking.

Where do sponsors go from here?

Fund sponsors find themselves in a perfect storm of challenging regulatory, capital markets and fundraising environments that limit options for fund leverage and liquidity.

However, all is not lost – there are still banks ‘open for business,’ and many fund sponsors are still successfully obtaining fund financing to achieve their objectives. It’s taking more time and greater effort to achieve these objectives, but with experienced, knowledgeable, creative and resourceful advisers, fund sponsors are successfully navigating the inhospitable waters and delivering for their constituents.