Institutional investors such as insurance companies have been stepping into the role of lenders in the fund finance market – an area that, for a long time, was exclusively the preserve of mainstream lenders such as investment and commercial banks. Fund finance offers a number of attractive outcomes that align well with the unique pressures that liability-driven investors (LDIs) have grappled with since the Great Recession.
The entrance of insurance companies into the space represents an opportunity for borrowers as well. Insurers are beginning to use their in-house expertise in the private capital funds industry and their experience of participating in the structured credit space to offer fund finance products that compete very well with those available from the mainstream lending community.
Why do insurance companies find fund finance transactions attractive?
Some of the reasons why insurance companies have shown greater interest in the fund finance lending space include the following:
Hunt for yield: LDIs such as insurance companies continue to look for investment products that allow them to meet duration and cashflow obligations on the liability sides of their balance sheets. This ‘hunt for yield’ has prompted them to look beyond traditional structured credit instruments and at fund finance lending transactions that offer attractive risk-adjusted returns, particularly when structured in a capital-efficient manner.
Attractive risk adjusted returns that show low volatility: Fund finance lending transactions have an attractive track record of delivering high risk-adjusted returns, and a very favorable historical default experience when compared with other types of lending transactions. Transactions are generally structured as first lien, senior secured with respect to underlying collateral, incorporate significant equity cushions and include a significant number of covenants designed to protect a lender’s exposure. Finally, returns on most fund finance transactions show a high degree of predictability and low volatility. Taken together, these features make fund finance lending transactions attractive to conservative LDIs like insurance companies.
Capital efficiency: Insurance companies typically have lending transactions rated by leading nationally recognized statistical ratings organizations (NRSROs). Where these transactions achieve an investment-grade rating, they attract favorable capital treatment under relevant legislation which, in turn, contributes to competitive pricing.
Pre-existing expertise: Insurance companies have significant investment experience in private equity and private debt funds, and have sophisticated in-house risk evaluation expertise. This, combined with their broader structured credit investment expertise, means that fund financing transactions involving private equity and private debt funds are not a significant stretch in light of existing capabilities.
Diversification of exposures in asset portfolios: Fund finance lending continues to be a relatively niche area in the structured lending space and promises delivery of differentiated returns with relatively low correlation as compared with more mainstream credit strategies. Participating in such transactions introduces potentially material diversification in the structured credit portfolios of investors such as insurance companies.
What makes insurance companies an attractive lending option for borrowers?
In our recent work on a variety of fund finance lending transactions, we have identified a number of features that make insurance companies potentially attractive partners for borrowers. Some of the more significant ones are as follows:
Long-term perspective: Insurance companies are able to go long on the maturity spectrum in lending transactions – we have seen maturities of up to 10 years being some asset-backed lending deals. This provides borrowers with certainty of availability of financing and reduces refinancing risk and is a major competitive advantage when compared to offerings from traditional lenders.
Bespoke/flexibility in structuring solutions: Our experience of working with insurance companies has shown them to be flexible and creative in coming up with solutions that are tailored to meet the requirements of borrowers. In the asset-backed fund finance lending space, the ability to tailor an offering to the unique circumstances of a particular transaction is a major competitive advantage.
Lower cost of debt finance: Where transactions attract an investment-grade rating, insurance companies are able to bring to bear their lower cost of financing to provide very competitively priced solutions. This, combined with the ability to go long on the maturity spectrum and a high degree of customization makes them a compelling alternative to offerings from traditional fund finance lenders.
Proximity of relevant expertise: Insurance companies are able to offer clients expertise relating to risk underwriting and structuring in one proximate location, combined with flat decision-making processes. This drives efficiency when putting transactions together at inception, and with respect to any amendments that needs to be processed in the future.
What are some of the types of fund finance lending transactions that insurance companies have been involved in?
As a fund finance advisor, we have seen a steady growth in appetite amongst insurance companies that we speak with for participating in a range of fund finance lending transactions. We have provided below a high-level summary of some of these transactions. As a generalization, it would be fair to say that most (though not all) insurance companies tend to prefer so called ‘NAV’ or ‘asset-backed’ term financing deals as compared to capital call lines. The two main reasons being the considerably more attractive economics and substantially lower operational burden associated with the former category. We are, however, aware of notable exceptions to this generalization and expect the situation to evolve in the coming years.
- Five-plus-year term financing facility at 50 percent loan-to-value to provide leveraged exposure to a private credit fund of funds exposed mainly to mid-market lending strategy in North America;
- Four-year financing term financing facility at 60 percent LTV to provide leveraged exposure to a private credit fund invested in sponsor-backed, first-lien senior secured loans to borrowers in the US;
- Four-year amortizing credit facility at 40 percent LTV with a substantial delayed draw feature in favor of a PE secondaries fund to finance distribution to investors, and to facilitate late-stage acquisitions of certain assets;
- Three-year term financing facility at 10 percent LTV in favor of an LBO fund to facilitate repurchase of junior debt within the capital structure of one of the underlying portfolio companies;
- GP and management company financing secured by management fees and GP fund interests in order to help finance growth of the GP’s business and provide additional capital for investment in newly-launched funds; and
- Five-plus-year revolving line of credit at 25 percent LTV in favor of a PE secondaries fund to finance working capital requirements.
Apart from being asset backed, other features that are common to transactions that, we believe, are attractive from an insurance company’s perspective include:
- Diversification at the underlying asset level
- High utilization of the credit facility by the borrower
- Longer maturity
- Exposure to mainstream asset and geographical markets
- Demonstrable track record of cash generation at the underlying portfolio level
- Experienced investment manager/portfolio management team that has a track record of successful asset acquisitions and realizations
We are still in the relatively early stages of the involvement of institutional investors in the fund finance lending space and expect that their involvement will only grow as borrower demand for bespoke financing solutions continues to grow in the coming years. Such an increase in the variety of lenders and the solutions they provide will only be to the benefit of borrowers and will be another step in the continuing institutionalization and growth of the fund finance market.
Khizer Ahmed is founder and managing member of fund finance advisory business Hedgewood Capital Partners, LLC in New York