Fund Finance Update: FFA European Symposium 2024

It is impossible to divorce fund finance from the wider asset management landscape, and so unsurprisingly, a common thread that ran through most of the panels was the challenges that have been faced by that industry in recent years – particularly when it comes to fundraising and investment exits – thanks to inflationary pressures and the higher interest rate environment.

Fundraising

Early in the day Preqin's Market Update showed private capital fundraising falling for consecutive years since the record highs of 2021, with more funds than ever actively looking to raise capital but fewer funds closing in 2023. Across the same timeframe there has been a noticeable growing bias towards experienced and larger managers with multi-strategy platforms, leading to predictions of further GP consolidation and bifurcation of the market as the larger managers continue to successfully raise the so-called "mega funds".

Subscription Facilities

A theme that ran throughout the day is that subscription facilities remain a mainstay of mangers' liquidity and operational toolkits and that, whilst the higher cost of those facilities in the current high interest rate environment might have given some managers pause for thought, demand for subscription facilities remains strong.

The popularity of subscription facilities, and the increasing size of the largest funds, has seen the demand for subscription facilities outstrip supply for some time. A slower fundraising market was therefore touted as being something of a boon for liquidity, as over the last 12 months or so longer fundraising timelines have slightly tempered the immediate demand for subscription facilities. However, the implementation of Basel 3.1 (or Basel 3 Endgame / Basel IV, depending on your preferred terminology) is looming and with it comes tighter capital adequacy requirements, which will make the allocation of a large amount of balance sheet to subscription lines (or any further increase for those who already have significant exposure) a tougher sell for some banks. Certain subscription facility providers have already scaled back or withdrawn their allocation to subscription facility lending, having reached their manager or asset class concentration appetites and/or internal hold constraints – all of which, alongside the collapse of SVB, First Republic Bank, Signature Bank and Credit Suisse just over 12 months ago, has driven higher pricing and pressure on advance rates in both the US and Europe.

M&A activity and the ongoing need for liquidity

M&A deal flow has been similarly muted with exits (and as a result, distributions to LPs) also falling drastically since 2021. Funds have needed access to liquidity more than ever which has led to a burst of creativity and innovation across the industry, particularly around the use of NAV facilities and in the secondaries market (see "NAV Facilities: from bear to whale" below and "Secondaries" below).

A theme throughout the day was the importance of the relationship between GPs and their lenders. The subscription finance market has been relationship-driven for many years, with the lower margin product often viewed by traditional bank lenders as a relationship offering to managers designed to attract ancillary wallet and other adjacencies attached to a manager's investment activities. In the face of the widening gap between supply and demand for subscription lines, several banks have conducted detailed analysis of their books and rationalised their relationships to focus on the managers that matter most to them institutionally.

Interestingly, this came at a point when the failure of SVB, First Republic, Signature Bank and Credit Suisse referred to above meant that some GPs appeared to be favouring exactly the opposite approach, actively looking to expand their relationships to ensure that their borrowing arrangements were not over-exposed to any one institution. With larger facilities immediately swallowing up lenders' balance sheets, managers are now building relationships with not just one provider but a wider lending group which may include both bank and non-bank lenders.

As the range of products available in the fund finance market has increased in both number and popularity banks are now aiming to lend at the fund level throughout the fund's lifecycle, beginning with subscription lines before moving on to (the more lucrative) NAV facilities once investor commitments have been deployed and the fund has assets in the ground. The more bespoke nature of NAV facilities (see "NAV facilities: from bear to whale" below) does mean that winning that mandate in an increasingly competitive NAV lending market means that lenders can, and should, employ creativity and innovation to find genuine solutions for their customers' needs.

NAV facilities have long been on the agenda of both the Global and European Symposiums, with these products the focus of three separate panels this year. If in previous years it felt like NAV was a relative novelty that everyone was talking about far more than they were using it or seeing it in practice, it is now clearly cementing its place as a mainstay of the fund finance sector.

Much talked about, but still hard to elegantly define because of its bespoke nature, a repeated discussion point was that NAV facilities do not represent a single, easy-to-describe product but rather a varied and evolving liquidity solution – or, as it was described on the day, a bear that has now evolved into a whale! From primarily being used to lever acquisitions in the secondaries space these facilities are now used to defend, release, extend and restructure value across the wider private equity and asset management market, across strategies. The myriad of outcomes that can be achieved through their use, the different types of assets being lent against, and the diversity of the relevant portfolio impacts the approach that lenders take on a case-by-case basis with varying requirements as to the level of due diligence and security package, as well as pricing. Unsurprisingly, those representing borrowers were keen to push for unsecured, "cov-lite" structures with minimal reporting requirements – not least for ease of execution. There have even been instances of such facilities being provided on a "certain funds" basis in order to supports LBOS although these are few and far between. No matter the agreed-on structure, it remains crucial that there is clear communication between borrower and lender from the outset around exactly what each party requires from the facility, given the bespoke nature of the structures and terms available in the market.

"Looking down" to the assets of the fund (as opposed to subscription facilities, which "look up" to a fund's uncalled investor commitments) and typically (although, increasingly, not exclusively) made available once the fund has deployed a significant portion of its investor commitments NAV facilities are the natural antithesis of a subscription line, and this oppositional approach has tracked through to the availability of these products. Where the subscription line market has been actively constrained, a huge number of banks and alternative lenders (arriving from both the fund finance and direct lending space) now either actively offer NAV facilities and other structured liquidity options, or have voiced strong interest in entering the market. Only recently considered a more niche product, this influx of liquidity – together with the resulting competition in the market and increased familiarity and experience with the structures, terms and risks involved – is exerting downwards pressure on pricing.

However, this increased interest and popularity has been accompanied by increased scrutiny from regulators and investors alike, with concerns voiced in both national and trade press over the past year that (among other things) an uptick in the use of these facilities is leading the way for unrestricted overleveraging of funds and a focus on DPIs over absolute returns. This culminated recently in the PRA's letter to Chief Risk Officers of UK banks following a thematic review of private equity related financing, with NAV heading the list of concerns. It is clear there is still significant work to do on educating the market (and the investor community, in particular) on these facilities, with education being one of three core topics expected to be covered in ILPA's guidance on NAV loans, due to be released later this month, along with a focus on so-called "guard rails" such as transparency of usage and greater clarity in the LPA language.

The Travers Smith Fund Finance practice has recently advised on numerous NAV facilities across a range of strategies and will contribute a chapter on the topic to the upcoming publication, Private Equity: A Transactional Analysis, Fifth Edition. For more information, please contact any one of the team listed below.

Trailed in Preqin's Market Update at the beginning of the day, secondaries strategies have been a standout story in a somewhat stagnant market, with total AUM (both dry powder and unrealised value) in secondaries funds more than doubling in the period from December 2019 to September 2023. The dramatic fall in strategic M&A activity and an elevated bid/ask spread has made it a challenging period in which to exit investments and this has seen GPs hold on to assets for longer than expected, sometimes even beyond the life of the fund.

Secondaries were once thought the preserve of zombie funds: fund vehicles still loaded with overvalued assets that they could not sell, halting distributions and effectively making it impossible to raise the next vintage, trapping capital on a long-term basis. Now, however, they have (via continuation funds) become the tool of choice for maintaining investors' exposure to trophy assets and for providing sponsors with extended opportunity for follow-on investment to further grow the asset and the time to eke out increased value. It was suggested that single asset continuation vehicles used in exactly this manner formed circa 50% of the GP-led transactions seen by the panellists over the past year.

This use of continuation vehicles has created additional opportunities for lenders with a variety of subscription line, NAV and hybrid facilities being offered to these funds. Once again, there has been ample opportunity for lenders to show both their creativity and their commitment to the relationship in designing the most appropriate solution for each individual transaction, whether the intention is to bridge investor commitments or to finance follow-on investment activity.

The LP-led market has also been buoyant and has presented further opportunity for the use of NAV facilities in what is perhaps considered their "original" form: providing acquisition financing for sponsors seeking to purchase a portfolio of limited partner interests in the secondary market. Traditionally focused on distressed or regulatory-driven sales, there is now a sophisticated global market of secondary managers with acquisitions consistently featuring leverage in some form.

It remains a bullish outlook for secondaries, with a growing amount of dry powder and increased familiarity from GPs and LPs alike. As M&A activity picks back up and we move into 2025 and onwards to 2026, expect all eyes to turn towards some of the larger premium assets currently held by continuation vehicles, as investors wait to see if this strategy has been successful.

Travers Smith's multi-disciplinary Secondaries practice advises sponsors, investors, lenders and other market participants on their secondary market activity with experience across all asset classes.

One (partial) solution to the liquidity crunch detailed above has been provided by the emergence of non-bank lenders including private credit funds, pension funds and insurers. These lenders often find subscription lines challenging given their traditional structure as multi-currency, revolving credit facilities with relatively low pricing. Whilst there are certain non-bank lenders who can overcome these operational hurdles and are active in the subscription line market, so far this has mostly been achieved by institutional capital either lending through a series of term loans, or being introduced via back-leverage, sub-participations or similarly structured intra-funder arrangements.

Whilst subscription lines mostly remain the preserve of bank lenders (at least for now), the interest in NAV facilities has been widespread as these institutions are better placed to hold term debt and are attracted by the comparatively high returns and diversification in the NAV lending market. The funding costs of these non-bank lenders are also de-linked from benchmark rates, and they may be able, in some cases, to provide more attractive rates than banks – especially where the capital being deployed is ultimately insurance money.

In the private credit space, there are now several dedicated NAV lending funds active in the market and, much like the criticism of NAV facilities that is covered above, the increasing popularity of private credit has not been without scrutiny. The market has grown exceptionally quickly since the Global Financial Crisis and the combination of its detachment from bank regulators, the attraction of higher-than-usual returns, and its interconnectedness with the broader financial system has resulted in increased focus from regulators.

Whilst from an operational perspective it is not yet universally easy to introduce the entire universe of non-bank lenders into the fund finance market, there will certainly be more thought on how best to incorporate them into the space to continue to meet demand in the context of upcoming regulatory changes. The fund finance community has always been adept at working together in an extraordinarily collaborative manner in order to find creative solutions to potential roadblocks - is one such solution the introduction of credit ratings?

A reasonably nascent but much-discussed topic was the rapid rise of the rating agencies in the fund finance space, particularly in relation to their involvement in the subscription line market. The commercial drivers behind this rise, along with more detailed consideration of the legal elements that are of interest to the credit rating agencies, are explored more substantively in our chapter in GLI Fund Finance 2024 – Rated subscription lines: An emerging solution to the liquidity crunch? here.

Numerous credit rating agencies are now active in rating subscription lines - and their teams were very much out in force at the Symposium - with Fitch and Moody's having published bespoke criteria specifically tailored to the market. KBRA, the first to move into the fund finance market, continues to apply its Investment Fund Debt Global Rating Methodology which can be used for rating subscription lines, NAV facilities and hybrid facilities as well as other debt products used by funds.

Obtaining ratings for subscription facilities should enable certain bank lenders to access more favourable capital treatment for those facilities (which will become particularly important following the implementation of Basel 3.1) which should go some way to easing the bank balance sheet constraints and the upwards pressure on subscription line pricing. Panellists did point out that this is something of a zero-sum game, potentially doing not much more than returning the market to its earlier position, and also that, given the longer-term capacity constraints faced, it is unlikely to be a total solution to the liquidity crunch.

Lenders may also increasingly seek to securitise their positions in both subscription line and NAV facilities by repackaging, tranching and transferring risk to third party investors – albeit as noted above, the challenges are greater in the subscription facility market given the revolving nature of the facilities and the relatively tight pricing.

Banks in particular are structuring transactions designed to achieve significant risk transfer (or SRT) treatment, which allow banks to move facilities off balance sheet and thereby help with risk weightings and limits. Individual fund finance facilities (particularly NAV facilities to credit funds) may also be structured as securitisations, permitting better capital treatment for lenders from the outset and (from a sponsor perspective) often achieving more favourable pricing. However, securitisation comes with its own regulations, costs and structuring considerations, including enhanced diligence and reporting requirements. Much of the market for securitisation debt is also bank-driven, and so banks struggling with demand for liquidity may not be significantly better placed to take securitisation debt than fund finance debt. Which brings us back neatly to the introduction of institutional capital. Much like the banks themselves, many institutional investors are from regulated industries and, as such, have their own capital reserve and risk-based capital requirements, which can be much lower when investing in rated debt instruments. Obtaining a rating will therefore make a subscription line a more attractive investment to these investors (particularly insurers) and increase the marketability for banks relying on selling down a portion of the loan to non-bank lenders to manage their own capital constraints as part of emerging ‘originate to distribute’ strategies.

This is a quickly evolving segment of the market and there remain several questions about how ratings will work in practice. To date, there has been a heavy weighting towards private rather than public ratings and understandably, some GPs have been nervous about handing over the details of their LPs, with the quality of the LP base being given significant weighting by rating agencies when formulating a rating. The largest fundraises require several closes resulting in a shifting and growing investor base, which alongside a booming LP-led secondaries market requires a constant stream of reporting between GP, lender and credit rating agency. With more dedicated capital markets teams at sponsors focusing specifically on fund finance, perhaps this will not become the administrative burden that it seems, and ultimately may become a necessity for access to the best-priced capital.

So, whilst non-bank lenders, ratings and securitisation strategies are in and of themselves not yet a solution to the liquidity crunch, it seems like that their combined efforts could provide something of a power-up to the industry and help propel it to new heights.

A rare sight – when compared to recent years – was an agenda devoid of a dedicated ESG panel. It could be considered a surprising omission given the recent guidance published by the Loan Market Association and the FFA on the application of sustainability linked loan (SLL) principles in fund finance, but it is perhaps reflective of a waning in the buzz that initially surrounded these facilities.

Various panels did however touch on ESG issues. A key theme was the well-documented difficulties with agreeing KPIs that are meaningful, measurable, and challenging enough to result in real change (i.e. to ensure any accusations of green-washing are avoided) whilst remaining achievable. Managers are increasingly leading the discussions around ESG with their lenders, and with that has come a pressure for lenders to step away from a "one size fits all" approach and adapt to their borrowers' specific goals (and portfolios), which is more challenging as well as more time consuming. Once again, it suggests that the lenders who will have the greatest future success are those who have the strongest understanding of, and relationship with, their customers.

Pressure from LPs to implement SLLs has not yet arrived, with investors instead focusing more heavily on ESG elements at both the house and asset level, particularly with the implementation of regulation such as the Sustainable Finance Disclosures Regulation (SFDR). GPs do seem to expect this pressure to emerge and so it remains to be seen) whether there will be a renewed interest in SLLs at fund level and ii) how KPIs evolve in response. The regulatory appetite to reorientate private capital towards sustainable business is already evident and one suggestion from panellists was that, in time, some capital relief could be granted for SLLs.

As some of the earlier SLLs in the subscription line market come up for refinancing, they do so in a very different ESG landscape from when they were initially established. An increased focus on greenwashing alongside increasingly detailed guidance on the application of SLLs means there is likely to be real consideration of the recalibration of the KPIs to ensure these loans remain fit for purpose.

Private equity is expected to bounce back with the recent slight rebound of exit activity sparking hope for M&A activity picking up as the year goes on, leading to a raft of long-anticipated exits and distributions towards the end of 2024. Alongside this, the necessary creativity that led to liquidity solutions and particularly the boom of the secondaries market is unlikely to abate and the use of single asset continuation vehicles to extract maximum value for trophy assets will continue to be an option for managers.

The implementation of Basel 3.1 draws closer, with the pressures of amended capital adequacy requirements for banks leading to new products emerging in the form of ratings and structured solutions such as securitisations, whilst also opening the door even further for alternative lenders to take their seat at the table.

The fund finance industry remains a genuine community and is at its best when GPs, lenders, investors, lawyers, other advisors and all other market participants come together and collaborate to create innovative financing solutions. That spirit of creativity has kept the industry consistently buoyant through a challenging period but is also what makes the positive headwinds for the coming months a particularly exciting prospect. It should be a busy and brighter year ahead, in which in the fund finance market will continue to do what it does best: iterate and evolve.

Creating this summary of the day was a true team effort from our fund finance practice and only possible thanks to contributions from Charles Bischoff, Danny Peel, Laura Smith, Adam Burk, Alix Carpenter, Paris Taylor, Alastair Lowson, Hannah Ramsey, and Helena Brandon. Financial Services & Markets Senior Associate Loïc Bacquelaine appeared on the Legal Update panel at the Symposium, offering his perspective on recent regulatory developments. To discuss any of the topics covered in this briefing note in more detail, please contact a member of the team, listed below.