By Zachary Barnett, managing director at debt advisory firm Fund Finance Partners
Until the disruption covid-19 wrought upon markets and societies in early 2020, subscription finance had been (perhaps erroneously) thought of as commoditized, with terms and advance rates generally predictable and consistent for those regularly in the market. The impact of the pandemic on depository institutions and their respective reactions, however, has been anything but consistent. Many of us in the fund finance space anticipated the market would stabilize by now. It hasn’t.
Lenders have entered and exited the market, and there have been meaningful shifts in the terms and processes required to successfully obtain subscription-level financings. During this time, we’ve arranged transactions across a range of asset classes and sizes, from $10 million to $1 billion, but results have been uneven. Such conditions were, of course, expected in March and April after covid-19’s initial shock wave, but most did not expect them to persist. Activity and supply are beginning to normalize, but there has yet to be a return to “market” pricing or terms.
We are of the opinion that pricing and terms prior to covid-19 weren’t as standardized as many believed, but there is no question that six months into the ‘covid-19 market,’ terms and pricing are extremely variant, dependent on the sponsor, fund and facility structure, as well as the most intangible but, increasingly, the most important factor: circumstance.
Here are some of the things that fund sponsors utilizing (or thinking about utilizing) subscription financing should know, now that the covid-19 market is the “new normal.”
Restoration of lender primacy
As it was during the Great Recession, the “power stick” (the advantage in negotiating these facilities) is back in the banks’ collective hands. Given the steady slide downward on the credit continuum for these transactions over the last five to seven years, we think the correction is reasonable and probably warranted. The influx of new market participants and service providers precipitated an exciting (for sponsors) “race to the bottom” in terms of LPA standards, structuring, investor diligence, facility terms and pricing. As bitter as some of these recent market changes have been for our sponsor clients to swallow, we believe that some were probably necessary to continue the subscription finance product’s impeccable winning streak.
Covenant and collateral growth
One consequence that fund sponsors can expect is a tightening of terms and structural flexibility. Lenders are seeking at least one NAV-linked covenant in nearly every transaction we arrange. Aside from reassuring lenders that investors are incentivized to honor their capital commitments, portfolio-based covenants demonstrate that there remains a valid “secondary source of repayment” for lenders.
Tenors have also shortened. The three-year committed facility with extension options is now the exception, not the rule. The historically large lender commitments of the past five years have waned, and committed accordions are more difficult than ever to obtain. Bootstrap collateral in the form of US and offshore security packages is becoming more common, as are enhanced reporting obligations on borrowing base and investor pipeline conversion.
How valuable is your funds complex?
Lenders have always cross-sold other complementary services and solutions for fund sponsors, but with certain (even money center) lenders, it has become imperative to access a sponsor’s balance sheet. The prevalence of these considerations depends on just how meaningful of a customer your platform is. If you’re seeking a $35 million subscription facility with a high-net-worth investor base, you may be hard-pressed to secure a term sheet without committing other meaningful business. Lenders may require that you give them business in cash management/treasury services, foreign exchange, fund administration or custodial services, for example.
If you, on the other hand, have unlocked the irrefutable cost and operational savings of combining your subscription lines into an umbrella facility, you’re likely to not only secure more advantageous terms, but the importance of giving lenders ‘other business’ is less pronounced. We’ve observed lenders declining to issue term sheets unless, for example, a fund sponsor transfers its entire fund administration mandate to the lender. Less draconian business migration requirements are also typical, such as deposits, treasury services or other types of transactional activity. More than ever, there is a premium on what other types of bank products and services a sponsor will consume.
Money (spread) talks
Our principals have been in this market for nearly FFP’s entire 20-year ascendancy. Never have we seen such great disparity in the pricing of subscription credit facilities. As recently as February 2020, pricing was confined to a narrow band and was higher or lower depending on fund size, investor base and the prowess of the fund sponsor. Spreads for top-quartile managers and investor lists were typically confined to a 25 basis point standard deviation, with upfront and unused fees even more narrowly banded. Over the last 60 days, we’ve seen term sheets with spread differentials as high as 85 basis points for the same transaction. Upfront and unused fees have understandably widened, but the range of those fees has also never been so expansive. As if that variance wasn’t enough, mind the LIBOR floors. While some deals are closing with floors of as much as 100 basis points over LIBOR, other transactions are closing without floors at all.
Much of this pricing fluctuation is attributable to lender pullback and supply contraction. Whether motivated by credit management burdens, the need for enhanced yield on assets or regulatory capital concerns, lenders come to the table with unique perspectives, requirements and circumstances. It has never been more critical to have an understanding of these in order to find the right home for your loans. As you know, the more sizeable and reliant of a borrower you are, the more important your funds complex is to the lender. More than marginally, we find that borrowers can get improved terms, despite the “new normal” of the covid-19 market, by consolidating their lending relationships into an umbrella subscription line. The trend is continuing, and lender receptivity is accelerating the trend.