As inflation runs rife and the world teeters on the brink of recession, the fund finance industry finds itself facing an economic environment that it has never faced before. So how will both supply and demand fare in a downturn?
Subscription finance’s fortunes will largely be dictated by the fundraising markets. Appetite for alternatives held up strongly through the pandemic, but the denominator effect could yet make itself felt. “Anything that lengthens fundraising cycles or reduces fund sizes will impact demand for subscription finance,” says Khizer Ahmed of Hedgewood Capital Partners, who adds that he expects lenders to pull in their advance rates to a degree.
It is also possible, of course, that the banking sector will come under pressure, creating a vacuum for non-bank lenders in the subscription finance space, akin to what happened with leverage finance during the financial crisis. The returns on offer will limit appetite from funds at this end of the risk spectrum, but there are non-traditional players demonstrating some interest.
What is less clear, however, is how the nascent NAV financing market will behave. On the one hand, a downturn could create opportunity. “We are facing a number of years of economic stress, and I think this market’s performance during covid has demonstrated that NAV financing will prove incredibly useful in those circumstances,” says Thomas Doyle, head of NAV financing at Pemberton. “A lot of lenders pulled back during the pandemic but, with its portfolio approach, the NAV market continued to support those businesses and so I think it will continue to be useful in these difficult times.”
“A challenging economic environment creates the need for liquidity solutions, which is why covid helped this market to grow,” adds Debevoise & Plimpton corporate partner Pierre Maugüé.
Nonetheless, risk tolerances will be impacted, and Ian Wiese, head of secondaries at Investec, says he is already seeing borrowers asking for lower LTVs. “There is a sense of caution starting to creep in as investors take a more conservative view on assets.”
And, of course, nobody knows quite how high interest rates are heading. The consensus appears to be, however, that modest LTVs, coupled with the potential for value creation that NAV lending offers, should maintain demand and insulate it from any severe shocks.
“When a sponsor decides to put a NAV facility in place, they will look at the cost and benefit,” explains Tom Smith, partner at Debevoise & Plimpton. “If the cost goes up, it may or may not outweigh the benefit and that could put a bit of a brake on NAV financing for certain purposes. But in most cases I suspect the benefits will still outweigh the costs.”
“Benchmark rates are going up, and it is likely that spreads will widen as well – both will inevitably have an impact on the overall cost load associated with a given facility,” says Ahmed, who adds that transactions may also take longer to consummate as lenders spend more time evaluating risk. “What we would hope, however, is that the increase in benchmark rates or spread widening is met or outweighed by the expected returns that a manager can generate through the investment activity that the NAV loan facilitates.”
Joshua Cherry-Seto, CFO at Blue Wolf Capital, also does not believe that increased interest rates will reduce the appeal of fund finance for borrowers. “Markets move as a whole, and fund borrowing will still represent cheap credit compared to the commercial markets. In fact, if anything,” he says, “NAV lines are getting cheaper on a relative basis as the industry matures.”
Meanwhile, Zac Barnett, co-founder of Fund Finance Partners, says that borrowers need not be overly concerned either. “Rising interest rates may very well have a negative impact on certain portfolios but not in a manner that would put a traditional NAV loan in jeopardy,” he says. “The LTVs on typical NAV loans are anywhere from 5 to 25 percent, so I don’t think a measured, steady creep in interest rates is too much of a concern. Other forms of leverage, with higher LTVs and less diversity, will likely fail first.”
It is expected, however, that there will be a shift from fixed rate structures to floating rate structures, in order to ensure that both borrower and lender are participating in the risk, says Dave Philipp, partner at Crestline Investors. But on the whole, the NAV financing industry appears relatively sanguine about the new economic environment.
“If you look at the decline in private equity values between 2007 and 2009 and the current LTV levels in the buyout space, it would seem that LTVs are conservative enough to withstand a major economic downturn,” says Samantha Hutchinson, fund finance partner at Cadwalader.
“We have seen two decades of low interest rates and QE and now we are seeing the reverse as inflation hits 40-year highs. Naturally, that is a concern for private equity and there will be a lot of focus on valuations over the next 12 months as the impact of inflation and increasing interest rates flow through. That said, private equity has record levels of dry powder to deploy.”