Following a period of rapid growth, the fund finance market has reached an inflection point. Once considered a small, esoteric area of the lending landscape, fund finance—loan facilities secured against investor commitments to private equity (PE) funds and/or fund assets—has grown into a global market worth more than US$600 billion during the last decade, according to asset manager abrdn.
Managers and investors have become increasingly comfortable with fund finance, using it to manage cash flow and capital calls, unlock additional liquidity for portfolio companies and return capital to investors, among other uses.
However, after a strong run and steady expansion, fund finance stakeholders are assessing what new banking regulations and the collapse or forced sale of several active market participants mean for the future of fund financings.
Impact of tighter banking rules
On the regulatory front, new international capital adequacy rules for global banks (implemented by the Federal Reserve in October 2022) have directly impacted fund finance loans and will continue to do so.
Banks must now set aside additional pools of capital for risk-weighted assets to cover any potential losses. The tighter capital rules have affected, in particular, subscription line facilities (revolving bridge loans that PE firms use to finance deal investments), as banks will be obliged to hold more capital against these loans.
Subscription lines have historically been low margin products, offering spreads of 1.5% to 2%; the loans are seen as low risk with virtually no defaults. Banks have also used the product to build relationships with PE dealmakers, hoping to secure bigger M&A financing work.
Now that banks must hold larger reserves against subscription line loans, they will reconsider deployment of the product, as sustaining current levels of activity will effectively reduce the capital that banks have available to lend in other areas.
Rising inflation and interest rates have already affected spreads on subscription lines, which have edged higher to around 3%. The additional costs that come with setting aside reserves add a further expense to the subscription line package.
PE borrowers may reduce their use of subscription line finance as the debt becomes more expensive, making the space less attractive from a lender perspective. For example, Citigroup has scaled back its subscription line lending in anticipation of the new capital rules and plans to prune its US$65 billion subscription line financing book to around US$20 billion, with anecdotal evidence suggesting that other lenders are also stepping away.
Key providers exit market
In addition to tighter capital requirements, the supply of subscription line loans has decreased by the insolvency of multiple significant market participants earlier this year.
Buyers for loan books, which became available as a result of such insolvencies have been hard to find, with big banks choosing to either scale back or maintain their positions on current subscription lines, and not acquire additional portfolios. While private debt funds have historically stepped into markets not serviced by big banks, they typically target higher returns than what low margin subscription line loans can deliver.
The exit of the failed lenders left a large gap in the market, and while this will offer opportunities for new entrants to take up market share, it seems unlikely that this will be sufficient to replace entirely the lost capacity.
Moving forward
Despite current challenges, subscription finance remains a viable route to building ties with PE dealmakers, and we have seen an uptick in interest in NAV facilities and other types of fund finance. Fund finance credits have also proven resilient in the face of wider macroeconomic volatility. Defaults remain low and large institutions remain committed to the product, even when they may be tapping the brakes on new activity in the near term.
The market is also continuing to innovate in response to headwinds. For example, in February of this year, the market achieved a significant milestone when ratings agency Fitch published the first ever set of criteria for assigning credit ratings to subscription line facilities.
As rated debt instruments, subscription lines will be subject to lower capital reserves requirements, which will help to counter the effects of the recent regulatory changes, bring down costs and open the segment up to a wider set of investors. Assigning ratings also opens the door for trading the facilities on capital markets, providing lenders with more flexibility.
After a challenging period, the foundations are being put in place for fund finance to emerge as a more mature and sophisticated option in the debt market.
