Over the past two decades, commercial banks and insurance companies have enjoyed a growing, relatively safe and steady business: fund finance. The fund finance department at a global bank lends to alternative investment funds managed by professional general partners – typically these funds invest in illiquid investments, such as private equity, infrastructure, private credit or real estate. These closed-end funds usually have a defined investment period, during which they draw capital from their limited partners in order to make investments. However, the landscape of fund finance is changing, and the need for more complex solutions has grown.
The plain vanilla product in fund finance is the subscription or capital call facility. In a subscription facility, the lender is secured by the right of the GP to call capital from its LPs. Accordingly, the creditworthiness and reputation of these LPs (typically large pension funds, endowments, sovereign wealth funds or family offices) is of primary concern to the lender. Typically, funds use subscription facilities for short-term working capital purposes.
Obtaining and using a subscription facility serves a variety of benefits for both closed-end funds and their LPs:
- they can consolidate multiple capital calls to a periodic time (say once a quarter), benefiting LPs who are overburdened with managing hundreds of fund investments;
- funds no longer need to hold significant cash on balance sheet, lowering the “drag” on investment returns;
- whereas LPs often have 14 days to fund capital calls, a subscription line can typically be drawn in less than 24 hours, lowering the operational complexity of closing investments in a timely manner.
Subscription facilities have accordingly become enormously popular: the Fund Finance Association, an industry trade group, estimates that existing subscription line commitments have grown to approximately half a trillion dollars. However, a limitation of a subscription facility is that it is only available during a fund’s investment period.
A more permanent leverage solution is also available: the Net Asset Value facility, which is secured by a pledge of assets from the fund. Lenders underwrite NAV facilities by assessing the value, liquidity, diversity and volatility of a fund’s assets. A NAV facility offers a solution for borrowers – such as private debt, real estate or infrastructure funds which require more permanent leverage in order to execute their strategies.
But what if a fund borrower needs both a subscription facility as well as a NAV facility? A lesser-known option for funds is a hybrid facility, which offers cradle-to-grave financing for both closed-end and sometimes opened-end funds. Hybrid facilities are secured by both unfunded LP commitments as well as a fund’s investments.
A hybrid facility offers a seamless solution for clients who desire both a subscription facility (for transitional, operational leverage) as well as more permanent NAV-style leverage in order to execute their strategies. Hybrid facilities typically require more structure and complexity in borrowing base formulas and covenants. They can sometimes be challenging for banks to underwrite, as the analysis for asset-based or NAV lending and subscription financing is often undertaken by disparate specialists working in different groups at the lender. An experienced capital advisor can be of assistance in navigating both the institutional dynamics and the structural complexities of the financing.
Though hybrid facilities are a smaller part of the fund finance market, they can be useful for more complex situations, including those funds which have non-standard structures or which have some open-ended characteristics. We view hybrid facilities as one more tool that a smart fund manager can employ to better serve its LPs and optimize its funds’ capital structures.
The author is managing director of Citco’s capital solutions team.