Key takeaways and industry perspectives
- The general takeaway from the symposium is that the fund finance industry will continue to grow this year but, due to a slowdown in fundraising, there will be an increased emphasis on NAV, hybrid and preferred equity-type facilities, as well as rated note feeder structures.
- Lending capacity limits set against increased demand creates opportunities for regional and smaller banks to enter the subscription line field, while private lenders will seek higher value opportunities in NAV. Pricing will remain a challenge, with funds looking to standardization and efficiency in use of lines to offset higher costs.
- There continue to be constraints in the balance sheet of a large proportion of banks that can be deployed to subscription line facilities. Furthermore, fund raising is lower in 2023 than it was in 2022. This is driven by global uncertainty in the economic markets, inflationary pressures and importantly the so-called “denominator effect” which means that investors require distributions to be made from investments in existing funds before committing to new funds.
- Funds are expanding their banking relationships as they seek additional balance sheet from bank and non-bank lenders. There was a significant increase in sponsors at the symposium which supports this trend in the market.
- The effect of this demand for balance sheet is to create an upward pressure on pricing as this demand starts to outstrip supply in certain circumstances.
- There is a consequential increase in the demand for NAV and hybrid facilities and preferred equity, as funds are encouraged to offer asset level recourse to support their fund finance facilities. Many banks in the market that traditionally provided only subscription line facilities are now branching out and offering NAV and hybrid facilities.
- Our debt fund clients who specialize in providing NAV facilities have been inundated with requests for term sheets from sponsors. Interestingly, the large upper market direct lending funds that specialize in leveraged finance facilities are now prepared to provide NAV-like facilities to sponsors.
- However, upper mid-market and top tier sponsors continue to successfully raise funds and obtain balance sheet from their key relationship banks, although even these sponsors are now looking more at NAV facilities and widening their bank relationships. They are also looking to non-bank lenders to provide these facilities, a number of which are sitting on large amounts of dry powder.
- There was much discussion about banks and non-bank lenders combining together to provide a sort of term loan A facility and term loan B facility, or a unitranche facility (including use by non-bank lenders of back leverage arrangements with banks), that would have the term loan B lender incur the first loss on any default. The idea is that a more traditional bank would provide the term loan A facility or more senior debt (on enforcement), with the non-bank lender providing the term loan B facility or less senior debt, or providing back leverage. We believe this structure could be successful and will reflect to some extent the development historically in the leveraged finance market.
- In order to get around regulatory and capital retention issues, both bank and non-bank lenders are keen to explore obtaining a rating of the debt that they provide. This would facilitate a bank or non-bank lender’s ability to syndicate the facility to certain market participants such as insurance companies.
- For the first time, there were many rating agencies present at the symposium and a number of the people they have hired were previously bankers who specialized in fund finance.
Selected session breakdowns
Investing with purpose: providing capital and worker solutions to underserved communities
- This session included a focus on human capital risk – 40% of workers are living paycheck to paycheck today. Inflation is exacerbating this issue.
- SOFR is ~4.75% and is projected to go up to ~5.75%. Inclusive of applicable margin, the cost to borrow is almost 10% in some cases.
- Diversity is at an all-time high in our industry, which is extremely encouraging and, more importantly, shows that our industry is still in good shape.
- There is a general perception that U.S. workers are uneasy and unhappy. Expect to see a wave of new incentives for workers.
- When we factor in all these risks, we need to move back to lending with stronger covenants.
Titans in finance: the rise of private debt
- The private credit market has grown substantially over the last several years.
- The U.S. Fed is planning for a modest recession.
- A forward SOFR curve suggests that interest rates will decrease at the end of 2023.
- Pricing remains high and may decrease within the next 12-18 months.
- Deal flow remains steady – deals are being done more carefully, with better economics and to better companies.
Governance, underwriting and due diligence
- When it comes to underwriting, the relationship between lender and borrower is of paramount importance.
- It is best for the fund to have a broader relationship with the bank partners across the bank rather than just the subscription line team.
- Investor diligence is key; it is essential to address side letters early.
- Third-party services that provide investor analysis are good, but there is no substitute for the information you obtain in-house from your own experiences with the investor, doing your own diligence.
- Funds, lenders and law firms need to update their due diligence knowledge and procedures to cover note purchase agreements in order to ensure that they are diligenced to the same level as LPAs and do not include language which may be detrimental to a financing.
Syndication update
- 2022 was a dynamic year. The first half of the year had a record volume of deals, with a slower pace toward the end of the year.
- The syndicates swelled, with a number of deals in the $5 billion-$10 billion range.
- Pricing was very stable even into the end of the year.
- Lenders in the space began getting closer to their lending caps by Q3. That, coupled with the changing global economic environment, increasing rates and revised capital requirements for some of the largest banks, led to banks holding back in the U.S. at the end of the year.
- A strong U.S. dollar made it tough for European lenders, who notoriously were involved in U.S. syndicates, to lend stateside.
- As a result, in Q3 we saw prices increase, tenors shorten and commitment amounts shrink.
- The value of client relationships with lenders has never been more important.
- In somewhat of a silver lining, new lenders who could not do deals in the past were able to pick up the slack and move into the space.
New suppliers of capital in fund finance
With a pullback by larger bank lenders from fund finance lending for regulatory reasons, panelists anticipated difficulty in finding new sources of capital. Banks are viewed as remaining committed to fund finance, but with a need to be disciplined and selective. While long-standing bank customers and top funds will retain access to bank funding, funds with lower utilization of lines are the most likely to face non-renewal. Panelists believe that regional banks will fill the void in the subscription line market, but it will be alternative lenders – broadly stated as funds, insurance companies and pension plans – who are expected to meet the NAV market, offering longer terms but at increased spreads.
Rating agencies participating in the panel noted that insurance funding is driving an increase in rating requests for private fund and feeder fund ratings, with BDCs accounting for roughly 80% of private fund ratings. Insurance is viewed as favorable for long tenor availability, but has limitations on currency availability. Ratings for subscription lines will be based on qualitative analysis of the investor base, the covenant package, and past performance of the manager. Ratings for NAV products are very much on a deal by deal basis, but assets, structure and GP are three main areas of focus in the rating process. Regulatory scrutiny of ratings is anticipated, and it was noted that insurance companies are regulated not at the federal level but by each state’s own insurance commissioner, which makes ratings trickier.
Fund finance market update, ESG and macro developments
- There has been a longer execution time because it is taking longer to raise funds and deploy capital.
- Deals have been outstanding for longer, and funds are getting bigger.
- Lenders are trying to be forward thinking with the deployment of capital.
- The market is being creative in developing documents that include institutional capital parties.
- Lenders do not have a bucket for ESG deals, as they would need to check compliance documentation.
- ESG is relevant but has not provided a clear advantage. Pricing incentives are not significant and market players are being careful not to be accused of greenwashing.
NAV, hybrids and preferred equity: an international perspective
- It was acknowledged that even among the panelists there was not a shared understanding of exactly what NAV is. Some view it strictly as financing provided to the fund, based on a percentage of the value of its portfolio holding, net of debt. But others include loans to portfolio companies secured by the assets of the portfolio companies to be NAV as well.
- There has been a general uptick in interest and execution in NAV facilities across all asset classes, particularly PE, where the ideal structure is settling down.
- There is a definite feeling that diversified PE NAV is an area where subscription line banks are now starting to venture, but concentrated PE NAV and other asset classes see fewer banks and more investment banks and alternative lenders, particularly at the bespoke end of GP/co-invest deals.
- “Whole of life” hybrids are still rare, whether for borrower uncertainty about the blended pricing or lender uncertainty about the ultimate asset pool. Hybrids are still used to spice up pricing or quantum on subscription lines and NAVs (i.e., a touch of NAV technology added to a subscription line, or vice versa).
- Preferred equity can do everything that NAVs can do, but is particularly suited to solving tricky structural situations where debt fears to tread. And there are fewer documents to draft and negotiate.
- Broad predictions for 2023 include an increase in all these products and more alternative lenders arriving in this space.
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