The evolution of fund finance

Subscription finance has become a staple of the private capital industry over the past decade, catered for as standard in limited partnership agreements and used almost universally as a treasury management tool. These facilities help streamline back-office functions at both a manager and investor level, reducing the burden of capital calls for LPs and enabling sponsors to move swiftly to complete transactions. 

“Subscription lines are a critical tool for treasury management, enabling firms to act quickly to get a deal done, and often allowing them to pay slightly more,” says Ian Wiese, head of secondaries at Investec. “There is a real economic advantage.” 

“Subscription lines are a critical part of our working capital strategy,” adds Joshua Cherry-Seto, CFO at Blue Wolf Capital. 

“These facilities are largely used for cashflow management practice, and in that sense, they are highly effective,” agrees Carolina Espinal, managing director at HarbourVest Partners, where she focuses on fund investments.

Subscription lines also have the advantage of creating a positive impact on IRRs, by delaying the capital call, something that initially caused some controversy and certainly boosted uptake, as it left those not employing fund finance at an optical disadvantage. It is now widely accepted, however, that this is rarely the primary rationale.

NAV financing

While subscription finance may be the most pervasive form of fund finance today, it is far from the only game in town. The little-known world of NAV financing emerged from the shadows during the pandemic and is now poised for explosive growth.

While lenders look to the credit worthiness of the LP base and their undrawn commitments when providing subscription lines, with NAV financing, the collateral is the underlying assets themselves. When capital markets dried up during covid, sponsors looking for defensive capital to support portfolio companies found NAV financing to be a highly effective solution.

“Lots of lenders pulled back from lending during covid but NAV financiers remained steadfast because, while individual companies may have suffered as a result of the pandemic, we were able to look at the portfolio as a whole,” says Thomas Doyle, head of NAV financing at Pemberton. 

“Why would you not use a modest level of gearing against the portfolio to protect a business experiencing challenges?” adds Wiese. “Equally, if you have a fund where there is not a great deal of dry powder, but growth opportunities remain, why not consider a NAV financing line, which can give you that additional firepower to grow and far outperform the cost of that
instrument?”

Indeed, sponsors are increasingly recognizing that NAV financing is not only a defensive play. There is also the opportunity to draw on funding to make follow-on acquisitions and other value accretive moves, later in a fund’s life when undrawn capital has
dwindled. 

This has become particularly pertinent in a more challenging exit environment. NAV financing is also being used more to return capital to LPs before an exit has been secured. NAV lines against the marked-up value of the assets can be used to generate attractive distributions and therefore to bolster future fundraising.

“NAV has seen a huge evolution across all asset classes where it is being used to provide additional liquidity for follow-on investments, refinancing of asset-level debt, retention of future upside and re-caps,” says Samantha Hutchinson, partner at law firm Cadwalader. “We’re also seeing a significant uptick in investors, principally in the family office space, using NAV finance to generate additional liquidity and rebalance
portfolios.”

In many ways, the more challenging economic environment that is looming before us should only supercharge NAV financing demand. “Market volatility tends to slow down exits, increasing hold periods and placing more demand on temporary liquidity solutions inside a portfolio,” says Dave Philipp, partner at Crestline Investors.

Doug Cruikshank, founder and managing partner at Hark Capital, agrees. “There are a lot of tailwinds driving the NAV loan market right now, largely stemming from the high multiples that have been paid by private equity in recent years and the challenging conditions that now exist that are going to make it harder to achieve the returns that have been promised,” he says. “With war, inflation and supply chain disruption, there has been a general re-pricing of both debt and equity, and so sponsors are going to need to spend more time creating value within portfolios and they are going to need money to help them do that.”

Furthermore, NAV financing has now proved itself in a crisis. “The product held up through covid,” says Zac Barnett, co-founder at Fund Finance Partners. “It advantaged sponsors, lenders were protected, and these transactions worked out for everyone. As a result, the word is out, and sponsors see this as a highly attractive tool.”

GP financing 

In addition to fund level financing, sponsors are also frequently turning to the lender community to secure funding for the general partnership itself. These loans are made against management fees and co-invest and can fulfil a number of objectives. As fund sizes have grown in leaps and bounds, and as fundraising cycles have accelerated, it has become increasingly challenging for GPs to meet their personal commitments to the funds they manage, which have, in many cases, risen way above 1-2 percent historical norms. The situation is particularly acute for firms using a European carried interest waterfall model.  

GP financing can also be used to support geographic or product expansion, and to facilitate succession planning by buying out founding partners. It has advantages over another trend that has gained popularity over the past decade, the sale of an interest in the management company, in that it is temporary, and the loan can be repaid. In fact, in some instances, GP financing is being used to buy back ownership stakes that have previously been
sold.

“Management fees tend to be sticky in nature and can be fairly substantial in terms of providing interest coverage. For lenders that provide lines secured by management fees, the risk reward equation can therefore be compelling,” says Khizer Ahmed, founder of Hedgewood Capital Partners. “GPs requesting between 10 and 20 cents on the dollar by way of revolving lines of credit at a management company level, secured by management fees, use these to manage their corporate cashflows more efficiently and to support the firm’s growth.”

There are strong secular trends that have been driving the growth of all three forms of fund finance, including the overall explosion in private markets assets under management and increased education and sophistication among stakeholders. Meanwhile, Weiss points to the evolution of capital markets teams within private capital firms as another contributing factor. 

“Ex-bankers that once provided debt are now tasked with ensuring that funds achieve optimal financing,” says Weiss. “In the past, this work would have been carried out by deal teams on an ad hoc basis. Now you have dedicated experts whose job it is to find the best financing at an opco and fund level, whether that is subscription finance, NAV finance or anything in between.”

Investec Fund Solutions’ head of relationship management, Jonathan Harvey, adds that the role of the CFO has also changed dramatically as the industry has matured, moving from an administrative function focused on reporting and audits to a more strategic position. “That shift has been accompanied by an increased willingness and ability to understand the financing options available at a fund level. We are educating people about fund finance today, that didn’t previously have the time or breadth of role to want to be educated. That is all feeding into the exponential growth we are seeing in this industry.”

Q&A

Carolina Espinal, managing director at HarbourVest Partners, says leverage can be a sensitive issue for LPs

How widespread is the use of fund finance today?
Subscription finance lines are largely used for cashflow management practice and have become increasingly prevalent in recent years. These lines also have a positive impact on IRRs to the extent that you are, on the surface at least, disadvantaged if you don’t have a fund finance facility. 

NAV financing is a developing trend. It is more common in the secondaries space, and we have still only seen a handful of examples in the primary market. NAV financing is a tool used to generate liquidity ahead of a full exit. 

How do LPs view the use of subscription finance?
Leverage is a sensitive topic and not all investors have the same risk appetite. 

I do believe, however, that subscription lines add value when it comes to cashflow management. Being able to affect those calls in a systematic quarterly or semi-annual basis offers LPs clarity.

How do you view NAV financing when compared to the potential for a GP-led secondary?
There are similarities between the NAV finance and GP-led secondaries in that they both offer liquidity solutions, as well as distributions to investors. Managers today have choices in terms of how they continue to support their strongest performers. Continuation vehicles have arisen as a way to roll over or extend the investment horizon, while NAV facilities offer an alternative way to unlock liquidity, without having to go through that whole continuation vehicle process. 

How are you seeing ESG impact the fund finance space?
As managers develop their reporting standards and their ability to measure the results of ESG initiatives, I think we will see more ESG-linked facilities being issued. And in a rising interest rate environment, any opportunity to get a discount on margins by meeting agreed-upon metrics is going to seem extremely attractive. It is also a useful way for managers to differentiate themselves based on their ESG journey. I see this as an exciting innovation in the credit markets with plenty of room to develop.