Banks continue to be the dominant source of fund finance, cited by 86 percent of respondents to the Private Funds Leaders Survey 2022, conducted in partnership with MUFG Investor Services. Only 10 percent habitually use private funds, while a mere 4 percent turn to insurance companies. Meanwhile, capital call facilities are the mainstay of the fund finance market, used by 81 percent of those surveyed.

The use of capital call facilities today is ubiquitous, but that does not mean fund finance is without controversy. “The only reason fund finance exists is because of the 8 percent preferred return hurdle,” says Phoenix Equity Partners CFO Steve Darrington.

“Over the last 15 years, the risk-free rate of capital has been less than 1 percent. It doesn’t take a rocket scientist to realize that it doesn’t make sense to draw down money from LPs at 8 percent if you can go to market and buy money at 2 percent. Any CFO that didn’t wake up to that delta 15 years ago was probably fired.”

Indeed, while capital call facilities were originally used because managers had to give investors 10 days’ notice to call down money, these bridges have since become increasingly extended. According to Darrington, some US funds are said to be using facilities that bridge the whole of their investment period, enabling them to “turbocharge” their IRRs.

“It is basic financial engineering. Why wouldn’t you? It is not within the spirit of the way LPAs are written but economic circumstances have made it a no-brainer,” he adds. “We fund all our activity on a six-monthly basis and then clear it completely. That puts us at a disadvantage to many of our competitors.”

Unease from investors

Of course, there has been pushback from investors over the years. Investors have wanted more clarity on the impact of capital call facilities,” says Joshua Cherry-Seto, CFO at Bluewolf Capital Partners.

ILPA, in particular, has advocated the publication of track record both before and after leverage. “The industry, however, responds by saying that this isn’t leverage and that we are simply doing it to reduce the administrative burden on our investor base,” Darrington counters.

“Investors have wanted more clarity on the impact of capital call facilities”

Joshua Cherry-Seto, Bluewolf Capital Partners

Bluewolf Capital Partners’ Darrington believes, in any case, that the popularity of fund finance may be set to wane as interest rates begin to climb. “The return of interest rates to long-term norms might clip the wings of this market,” he says, although he adds that for banks, the fund finance proposition will remain compelling. “Banks will want to keep on lending because of the credit worthiness of the counterparties. If that population of capital hits a major problem, then I suspect the banks will have much bigger issues elsewhere.”

Of course, the fund finance industry is also evolving to meet the shifting interests of industry stakeholders. There has been a proliferation of ESG-linked credit facilities issued over the past couple of years.

These facilities are seen as a way for firms to align their financial goals with environmental and social objectives. KPIs are put in place so that if a manager meets a pre-designated checkpoint during the lifespan of the facility, they will receive a discount to the market margin. Conversely, penalties may be added if those indicators are not met on time.
Darrington, again, is a skeptic, claiming that managers are only taking on ESG-linked facilities associated with KPIs that they know a company can easily reach.

“I think there is an element of greenwashing that goes into these facilities,” he says. “I don’t think they are going to have any significant ESG impact, although they are, of course, a step in the right direction.”