Mixed signals for fund finance

The collapse of three of the most active players in the subscription finance market – Silicon Valley Bank, Signature Bank and First Republic Bank – has had a profound impact on lending capacity, at a time when capital requirement regulations were already dampening bank appetite in the space.

“Even before the regional banking crisis, there had been headwinds in the subscription finance market,” says Crestline Investors partner Dave Philipp. “The [risk-weighted asset] treatment of the product limited the amount of capital available from most banks, and Citi’s exit put pressure on new borrowings.”

“Lending is materially tighter than it was at this point last year,” adds Khizer Ahmed, founder and managing member of Hedgewood Capital Partners. “That is a function of multiple pressures on lender balance sheets.

Pre-existing capacity issues, when combined with continuing monetary tightening and well-known challenges in the US regional banking sector, have materially affected the supply of capital.”

Debevoise & Plimpton partner Tom Smith says: “Lending capacity is more constrained in the US than Europe, where there have been a number of notable departures from the market. Those lenders that do remain in the US are focusing heavily on existing relationships making it harder to raise capital call facilities.”

Ahmed, meanwhile, says lenders are showing greater caution in certain sectors, such as venture capital. “VC funds are finding it more challenging than other sectors to source fund finance facilities. As some lenders have left the market and others are not as active as before, those that remain have greater choice with regards to the nature of clients they take on, and the relatively higher risk ascribed to VC as a strategy has certainly resulted in lenders pulling back from increasing their exposure.

“This is also reflective of a broader trend of risk aversion, which has led to an increase in spreads. Combined with an increase in benchmark rates, this has resulted in facilities becoming considerably more expensive.”

Tightening supply following the demise of major market participants, coupled with the rapid rise in base rates that precipitated the collapse, has inevitably sent the cost of subscription finance soaring, which means demand has been impacted as well.

“After years in a close to zero rate environment, base rates in Europe continue to tick up,” says Investec’s head of fund solutions Grant Crosby. “In the US, they are even higher at north of 5 percent. Margins have also increased, due to the withdrawal of certain players from the market. The consequence of that is that borrowers are using subscription finance less. But they are still using it, because of the administrative benefits it provides.”

That shift in sentiment was reflected in affiliate title Private Equity International’s LP Perspectives 2023 Study. Amid a worsening macroeconomic environment, the survey saw a significant change in sentiment towards subscription credit lines.

Only 31 percent of respondents expect GPs’ usage of subscription lines to increase, down from 51 percent last year. Attitudes among LPs vary, according to Alex Scott, a partner in the European private equity investment team at Pantheon, when asked to comment on the survey results. “There is no consensus and it very much depends on the investor’s attitude to leverage, and expectations or objectives in terms of risk and return.”

Key tool

A slow fundraising environment has also muted demand, but Ahmed agrees that the market has not collapsed. “Subscription finance is a key tool available to funds in order to manage cashflow. Year-on-year, demand is probably down somewhat because fundraising is down, but where funds are raised, the demand is still there.”

Smith is more bullish still on continued demand, despite market volatility and price rises. “It might be logical to conclude that demand for sub lines would go down because of increased costs, but in practice that is not what we have seen. Demand remains consistent. Pretty much every sponsor wants a sub line today and the amount they borrow will depend on what they have negotiated with LPs in their fund documents.”

Meanwhile, demand remains strong in the GP finance space as well, despite a depressed fundraising market. “We haven’t seen the same slowdown in demand that we have on the capital call side,” says Grant, “although the market is still being negatively impacted by the cost of finance.”

Ahmed says this sustained demand is unsurprising. “A challenging exit environment has led to extended timelines around the crystallization of carried interest. At the same time, where managers are still looking to grow, and with LPs continuing to demand strong alignment of interest, the pressure on GPs to gain access to funding remains. GP facilities are a way of bridging to the crystallization of carry in order to help GPs to meet their commitments.”

The rise of NAV finance

Meanwhile, the relatively nascent NAV finance market continues to evolve with use cases spanning fund-level borrowing, as well as loans to general partnerships and to LPs. Fund-level NAV lines are primarily being used to drive value creation through extended hold periods, given today’s challenging exit environment.

NAV loans are also being used to bridge drawn out fundraisings, in order to allow GPs to start taking advantage of investment opportunities before their fund has closed. Rising interest rates and tightening credit availability at a company level is creating additional opportunities to use NAV as a means to de-lever businesses, often coupled with a refinancing. NAV loans can also be used to accelerate distributions to LPs. However, rising interest rates mean the cost of financing often exceeds hurdle rates, increasingly making this use case uneconomic.

NAV financing appears to be an area poised for significant growth, nonetheless. While banks may be retrenching, new fund entrants continue to proliferate, emanating both from the world of private credit and from within the secondaries sphere. Institutional investors – insurance companies in particular – have also been active.

However, the continued growth of this burgeoning area will be heavily dependent on LPs’ evolving attitudes to the space. Investors will need to be convinced of the economic rationale for using NAV lines, and transparent communication will be paramount, particularly as fund documentation still typically precludes the use of fund-level finance.

However, the fact that LPs are able to borrow against the NAV in their portfolio to continue investing alongside their highest conviction managers and to rebalance their portfolios is helping them appreciate the value that NAV finance can bring to the broader private equity ecosystem, according to Dane Graham, North American managing director, investments, at 17Capital.

Certainly, with increasing adoption among brand name GPs and a proliferation of use cases throughout the private markets value chain, the potential for NAV finance appears to be immense.

“NAV finance has already been solidified as a standalone asset class and has proven itself as an all-weather strategy,” says Graham. “It served as bridge capital through the pandemic, protecting quality assets in an unprecedented market environment.

“Use cases quickly pivoted to opportunistic growth in 2021 and to driving further value creation in portfolios through 2022 as monetization alternatives were less attractive, all the while continuing to grow at between 40 and 50 percent per annum, despite a very different macroeconomic backdrop. This is a product with a myriad of use cases, whether the economy is going up, down or sideways, and we see huge potential for growth ahead.”