Navigating the new subscription finance market

A banking crisis coupled with a hike in interest rates has significantly altered the rules of engagement for capital call facilities.

In the nine months since some of the most prolific players in the fund finance market went to the wall, CFOs have been forced to overhaul their banking relationships and rethink their approach to cash management.

Over half of CFOs have moved money as a result of the banking crisis, according to the Private Funds CFO Insights Survey 2024, conducted in partnership with Aztec Group. Indeed, the mantra appears to be: diversify your funding sources.

“Lessons have definitely been learned – most importantly, that it is vital to have more than one banking relationship,” says Zac Barnett, co-founder of Fund Finance Partners.

“The firms that were hurt the most by the regional banking crisis were those that had a single fund finance provider. When that lender failed, or appeared to be on the precipice of failure, they were forced to look for new lenders at a time when most were focusing on existing relationships. In the wake of what happened, private fund CFOs are prioritizing building multiple relationships with multiple different lenders.”

Jamie Mehmood, partner and head of fund finance advisory at Deloitte, says: “Borrowers are increasingly looking to move from a bilateral relationship – no matter who their lender – to one where not all of their eggs are in one basket, given the stark market experiences of spring 2023. Managers are also very much more aware of having good visibility on the underlying exposures for both sides of the balance sheet – deposits as well as loans.”

“The big lesson learned was to always have a backup plan,” says Benjamin Berman, partner at Latham & Watkins. “This was a scary situation, particularly for CFOs with money in accounts at the impacted banks. There was a definite sense of relief when the government stepped in and managed the process to ensure an orderly transition. Now CFOs are focusing on how to best position themselves in case anything similar should ever happen again.”

Relationship building

Forging new relationships is not straightforward, however, given supply-side constraints, says Barnett. “We have had a supply-side problem for 12 to 18 months now, and that is only going to get worse when increased regulatory capital regulations kick in in January 2025. It is a tough time for accessing subscription finance

The challenge, of course, is that many banks require deposits in order to provide fund finance loans. But there are alternative routes to relationship-building, including fund administration services and FX, for example.

Says Barnett: “There are lots of different lines of business that can be established with these banks so that, were we to have another crisis, or if your primary banking partner should fail for any reason, then at least you would have other contacts to reach out to rather than trying to start up something anew in what could be a challenging time for the market.”

“Building relationships with banks is certainly a challenge, particularly for newer managers,” adds Berman. “A lot of lenders view these capital call facilities as relationship-building tools and so we generally recommend that our clients go to their relationship banks first, because they may be able to offer better terms. That said, there are new players in the market.

“In the aftermath of the banking crisis, many great bankers have moved to different banks that are now growing their presence in the space. Those lenders too will want deposits, of course, or other forms of ancillary business, whether that’s hedging, M&A advisory or derivatives, for example, and so CFOs should be strategic about who they partner with.”

“The big lesson learned was to always have a backup plan”

Benjamin Berman,
Latham & Watkins

Meanwhile, some CFOs have taken the decision to stick with their regional banking relationships – even those that were among 2023’s failures. “We decided to stay with SVB, which has since been acquired by First Citizens Bank,” says John Cerra, CFO at Clearview Capital. “They are great service providers, and we are happy with our long-standing banking relationship. It was just an unfortunate situation and, to be honest, since then it has been business as usual.

“A few of our peers pulled the trigger pretty quickly but we felt it wasn’t prudent to jump into another relationship after a day and a half of diligence and we haven’t regretted our

Meanwhile, there are other steps that CFOs are taking to protect their cash, says Berman. “We are seeing clients ask for linked accounts so that deposits are kept under the $250,000 insured level. As cash exceeds that amount, it is then swept into other money market accounts to benefit from interest.

“It is important to exercise caution here, to ensure the necessary security remains in the collateral account, but we are seeing clients asking those questions, in order to maximize their cash position.”

Cerra says: “What happened with the banking crisis really highlighted the fact that it is extremely challenging for us as finance professionals to benchmark banks if even the regulators have difficulty keeping track of what is going on.

“It has also taught us to better monitor our cash controls. For example, we have implemented insured cash accounts with other banks, sweeping cash out of any account with more than $250,000, the amount that is currently insured.”

Cost of capital

In addition to managing the banking risks that are now apparent, the cost of fund finance has meaningfully increased. “I think there has been some frustration among CFOs as the banking crisis has led to higher rates for borrowers,” says Berman.

“A number of firms had to refinance because one of their banks was impacted, leading to additional costs for their investors, despite the fact that they themselves had done nothing wrong. It was the banks that got themselves into trouble. That said, the bigger challenge right now is probably this high interest rate environment. It is not an easy time to be a CFO.”

There has been a marked shift in the usage of subscription finance facilities reflecting these increases in cost, says Cerra. “When rates were at 2-3 percent a few years ago, we would use our credit facility to reduce the number of capital calls to two or three a year and potentially keep the line out for 90 to 100 days.

“Now that rates are at north of 8 percent, we are using the facility to bridge capital calls and then calling capital as quickly as we can – with generally around 10 days’ notice. We are very cognizant about not incurring interest expense for our investors.”

Jason Snider, CFO at Gauge Capital, says: “Interest rates are driving up the cost of borrowing, so as GPs we have to be mindful of that cost, which is being borne by investors.

“Many subscription lines are used as a bridge. They are more of a convenience factor than anything. But if a GP is using subscription finance to enhance performance, then I imagine they are reviewing that strategy in the wake of the price increases that we have seen.”

According to Barnett, there has been a reduction of subscription facility usage of anywhere between 10 and 30 percent, as costs creep closer and closer to hurdle rates. But he maintains that these are still valuable tools, allowing funds to be nimble and execute on transactions at speed.

“The ability to smooth out capital calls over a quarter is also advantageous,” Barnett says. “We have yet to reach a cost where firms are starting to think this is something they can do without. Rather, the impact is being felt in the volume of dollars borrowed and the length of time the borrowing stays out. This has also coincided with banks’ desire to lend smaller facilities due to pressures on their balance sheets.”

Barnett is optimistic that the situation is temporary. “If you believe the interest rate curves, the market expects interest rates to be cut in 2024 and so the cost of financing is poised to come down. Most people are predicting a reduction of somewhere between 125 and 175 basis points over the next 24 months and so these loans are likely to be used more extensively once again.”

Alternative lenders

Meanwhile, the prospect of non-bank lenders injecting much needed supply into the market is raising its head once again. According to the Private Funds CFO survey, the vast majority of respondents are still using banks for their fund finance needs. However, 30 percent are also tapping into institutional investor capacity and 10 percent have borrowed from private debt funds.

“There has been a lot of talk about private capital entering the space, but there still seems to be a pricing mismatch,” says Barnett. “Those lenders need a higher return than borrowers are willing to pay for subscription facilities. Insurance companies coming in to solve subscription finance’s supply-side issues has been the great hope for the past 10 years or more, but it remains a very small part of the market.”

Berman agrees: “We are not seeing many non-banks in the straight capital call facilities market, but they are definitely involved in NAV loans and hybrid deals.

“I wouldn’t be surprised if we saw more non-banks coming into the subscription facilities space. There has been some momentum building behind efforts to get certain subscription facilities rated, and that could really help bring in new entrants.”

Mehmood says: “We are seeing external ratings becoming an increasingly important consideration for certain lenders as a condition for providing subscription line finance, which we anticipate will become more widespread and increasingly standardized over the short to medium term.”

Dave Philipp, partner at Crestline Investors, meanwhile, says more syndicates are being formed between banks and non-banks in order to collectively provide fund finance solutions to borrowers.

“This option gives CFOs a more stable lending base with more diversified look-through capital sources to support further growth in times of market volatility,” says Philipp. “Having both banks and non-banks in the same facility can provide an attractive combination of pricing and structure not available from either group in isolation.”