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Liquidity in Fund Finance and Me

Published November 06, 2023
FFA NextGen spoke with Jeremy Cross to discuss how this sector has enjoyed stability and growth, largely unaffected by external economic and political events. However, recent shifts in interest rates, regulatory focus, and lender dynamics are reshaping the landscape. In this article, we explore the evolving nature of Fund Finance and how these changes are impacting both industry veterans and newcomers.

The times they are a changin'

The Fund Finance market has now been going and growing for a significant amount of time. Exact estimates as to the date of its origins vary, but a safe(ish) guess would be that it started in a significant way in Europe around the dawn of the new millennium. Many of the basic building blocks that we still see in the market (particularly Subscription Finance and NAV Finance) were present from the beginning. GP and Manager financing probably followed slightly later with others (particularly financing preferred PE structures) possibly following later still. For most of the last 20 plus years of its existence, the Fund Finance market has continued relatively undisturbed by outside economic or political events. It was minimally affected by the great financial crisis in 2008 and until recently, growth continued relatively unchecked.

Why was this? A combination of factors, but some that helped were a long standing and benign (low) interest rate environment as well as a focus on relatively low credit risk Subscription Financing, which in terms of amount and volume always formed the bulk of the Fund Finance market as a whole. Default rates remained (and remain, despite a couple of minor hiccups) extremely low. The regulatory environment for Lenders also remained relatively benign. As a result, the last few years saw many Bank and alternative lenders pile into the area.

A number of these factors however no longer exist. Interest rates have substantively increased and are forecast to remain "high" for an extended period. The regulators, particularly but not only in the US, have started to focus in on the state of Bank capital and in turn the Banks have had to focus on the actual balance sheet costs of keeping Fund Finance assets (particularly Subscription Finance loans) on their books. As a result, many Bank Lenders have had to reign in or refocus their lending activities. In some well publicized cases, Banks have in effect exited particular parts of the Fund Finance market (Subscription Finance) altogether. In others, some of the smaller Banks have found that their capital management policies are no longer sustainable in the higher interest environment and have had to seek the protection of (or in other words be acquired by) other Banks with larger balance sheets so that they can continue to effect Fund Finance business.

Plus, ca change...

If this article had been written this time last year, or even 6 months ago, the picture would have been very murky indeed. Major balance sheet readjustments were taking place. Banks were either by accident or design reducing exposures to the Fund Finance market in general or even exiting the market. Alternative lenders were (and are) on the rise but taken together did not have the firepower to make up the resulting shortfall in liquidity. On the other side of the coin, Funds were increasingly debating (and still are) whether it makes economic sense to take down Subscription Finance facilities in particular.

The picture today is however a little clearer. Here is where we are (with the usual lawyer's plea that this is from a personal perspective and based on what we see in the market so may not be 100% representative):

Subscription Finance facilities continue to be offered by Bank and alternative Lenders alike. While some Lenders have exited the market, refined their offering or changed ownership, the vast majority will still lend into this market. With very few exceptions the base of potential Lenders is still pretty much as wide as where it was a year or two ago. What has changed is specific Lender's appetite for the product. This will be conditional (and hedged) to a degree that was not the case certainly more than a year ago. Funds looking to this type of finance ,possibly other than the "jumbo" funds, need to cast their net far wider to find Lenders who will give them the right facilities on the right terms. Margins have generally increased somewhat and the base rates on which those Margins are based have also increased. The specific terms of Subscription Facilities however remain relatively unchanged. There has been relatively little tightening of terms (just as there was relatively little loosening of terms when market conditions were more favourable).

NAV facilities are now offered by more and more of the Banks and alternative Lenders. This is a change from the position two years ago. The change has to a great extent been dictated by the underlying market conditions for Funds seeking to make disposals and realize investments. As new fund raising and investment realizations have slowed the demand for financing facilities that enable Funds to accommodate these changes has increased. The same growth trend is apparent in other "NAV related" Fund finance facilities, such as preferred equity.

GP and Manager facilities are also on the rise, although the difficulties from a credit perspective for these facilities remain. However, for very similar reasons to the rise of NAV facilities (including issues with timely realisations of existing investments) the demand for these types of facilities has increased.

Overall, after a brief pause last year, Fund Finance facilities generally are in demand, many Fund Finance Lenders have survived (if not in their existing guise with the benefit of an acquisition), the demand is still there and the Fund Finance market still remains active. In many ways therefore you could say that the more everything changes (as the saying goes in the heading) the more everything has remained the same.

What lies beneath

While you could say that everything has remained the same, though, that would not be entirely accurate. Even less accurate if you look ahead. If the consensus is that higher interest rates are indeed now baked in for a longer period, the demand for and use of Fund Finance facilities will inevitably change, and is already changing. A Subscription Finance facility no longer always makes as much sense (as maybe it once did) as something for a Fund to have "in the back pocket" and almost as general working capital to help smooth its investments and investor demands. Better for a Fund to use these facilities in a more focussed way, possibly even deal by deal. At the same time the demand for NAV and NAV related Facilities is likely to continue to increase, as Funds' will continue to require more flexibility to manage existing investments and disposals, even after initial investment periods, while keeping their investors onside.

In many ways flexibility will be key for both Lenders and Funds. Existing and familiar structures will be strained by the new environment, and existing assumptions about how Fund Finance facilities work, and what they can do, will need to adapt in turn. The arrival of rating agencies (Fitch and KBRA) into the Fund Finance market will change (and may already be changing) the range of Lenders and the range of financing products to which Funds may have (and may demand) access. Funds, Investors and Lenders are becoming increasingly aware of both the possibilities of (and limitations of) Fund Finance facilities.

How does this impact me?

People in the market of a "certain age" will have spent much of their careers focussing more broadly on other areas of finance, not just Fund Finance. For those people (including me) that has been a considerable benefit as Fund Finance has come to incorporate more and more elements of these other Finance areas. As Fund Finance has grown the market has effectively moved towards people with broader specialisations in finance and enabled them to focus on Fund Finance as it expands into these other areas.

For those who are starting out in Fund Finance now or who are earlier in their careers in this space the  challenge (and the opportunity) is to ensure that you have as much knowledge over a broader range of "finance" as possible and are prepared to be flexible in applying that knowledge. We live in "interesting times" and there has never been a more exciting time to be involved in this part of the Finance industry. To take advantage of the opportunities requires curiosity, a willingness to be challenged and courage. I am confident that all who read this will have those qualities and use them to the full!

Jeremy Cross
Partner Addleshaw Goddard LLP