Secondaries

• It’s been an area of significant growth which is particularly notable given:
  • there is no meaningful exit market; and
  • fund raising levels are down.

• Last year, LPs were liquidity constrained causing high quality portfolios to be picked up at a discount, which is not so much the case this year.
• Growth is being led by:
  • LPs striving for liquidity, and
  • GPs holding onto their prized assets to squeeze out more value from their investments.

• There are more secondary funds generally and more facilities available (be that subline, NAV or hybrid).

Motivations and drivers

• Liquidity, liquidity, liquidity. Liquidity needs have been the main driver for the market changes since last year.
• A move from zombie funds to trophy assets. As there is less liquidity and the IPO market has been falling (until recently), GPs want to keep their prized assets and so have been spinning out those prized assets into continuation vehicles.

2024 outlook

• The overarching takeaway is that it is high quality assets are and will be coming to the market and there are lots of opportunities.
• Overall, the panel participants have not seen stress within the market.

NAV Lending to Credit Funds

Key takeaways

• One of the key differences between lending to a PE fund vs a credit fund is the review of the underlying portfolio, and a lender’s approach to underwriting which is dependent on the fund’s strategy and the type of assets it holds. Typically for a credit fund, underwriting will be based on eligibility which may include metrics on leverage and seniority of the underlying portfolio loans. In the other hand, for a PE fund, a bottom-up approach is more likely to be applied with certain conditions for newly acquired assets to be considered within the borrowing base (‘BB’). If a lender effectively has a veto right for new assets, a borrower may be put in a situation where they have commitments or assets which cannot be used towards the BB calculation. For credit funds, given there is a diversified asset class, underwriting may be a quicker and smoother process.
• NAV facilities to credit funds may be attractive to borrowers as, given the more diverse underlying portfolio of assets and more predictable cash flows, leverage can be maximised. Additionally, NAV facilities are usually provided for a longer tenor and may be provided as a multicurrency facility (and indirectly enhance IRR).
• More alternative / non-bank lenders are being seen in this space and it’s predicted that more banks will partner with such lenders as the market grows.
• The overall outlook on this space was a positive one and certainly one to keep an eye on.

NAV 1.0

• Lenders continue to see demand for NAV facilities to be provided for a range of purposes, including to facilitate “defensive” (e.g. meeting covenant breaches, paying management fees and paying distributions to investors) or “offensive” (e.g. making follow-on investments or investing in portfolio companies) strategies. Whilst NAV facilities were historically mostly used by credit and secondaries funds, they are now common amongst all fund types.
• Whilst the term “NAV facilities” captures a broad spectrum of facilities, the typical collateral package includes security over (i) the bank accounts into which distributions from portfolio companies are received and (ii) equity interests over holding vehicles that own the underlying assets.
• Non-bank lenders in particular are often able to offer a collateral package limited to distribution accounts, whereas bank lenders typically press for equity interests to also be secured, unless they are dealing with a top sponsor. A common challenge from a lenders’ perspective is that the fund’s equity interest may be a minority position, which can be challenging for lenders to exit from and typically requires a sale in the secondaries market.
• There continues to be a good level of liquidity for larger funds, however mid-market to smaller funds have seen less liquidity from traditional banks, and are more reliant on non-bank lenders or new market entrants. Non-bank lenders are typically able to lend against a higher NAV than banks, and can offer covenant lite facilities.
• Concentrated NAV facilities and continuation hybrid facilities are expected to increase over the next year, as funds are increasingly holding on to investments for longer than anticipated and require additional liquidity. Hybrid facilities typically provide the lender with recourse to a combination of uncalled capital and asset-level security.

Capital call facilities

• Slowdown in the fundraising and its impact on the management and negotiation of capital call facilities: The panellists considered the slower environment in terms of timing. The capital providers/lenders are more open to discussion, suggesting interesting solutions – for instance offering further insight into how the banks look at borrowing base. This includes offering to support a smaller closing at the beginning and consider looking into how they can lend more on the following closings. The panellists also noted that slower fundraising has created issues in terms of operations. The different levels of closings are happening throughout the fundraising period of the fund, which in turn affects things operationally from bank’s point of view. Finally, the panellists noted that the pricing for original lenders could be different from the pricing of the lenders that ‘conveniently’ join the facility at the later stage.
• Capital call facilities vs simple bridge facilities: The panellists pointed out that there are some asset classes that lend themselves to more term-like structures. Generally speaking every fund will at some point consider putting a subline in place, and in its simplest form it’s just a tool in the toolkit that’s been around for a long time. It is also worth noting that the LPs are happy with these too (in spite of the prices involved). Another advantage of these tools are to avoid exposure to the new deals, as longer period of time that is involved in launching a new deal isn’t always helpful. These facilities are a key in those situations.
• Liquidity: After March 2025, when Basel IV will become effective, some of the solutions that will be used more widely will be: ratings and securitisation. Banks are currently experimenting to find the solutions that work and capital call finance is largely relationship driven so strong relationships will continue to be important going forward.
• Rating, acceptable/good levels for capital call facilities: Although the panellists have seen large facilities close without any ratings, lenders are generally comfortable lending with ratings in place, including for syndicated loans. At the time of Basel 3.1 there were a number of lenders who were unable to lend without a rating in place. There is a clear development in respect of high net worth individuals, as historically the rating agencies have considered them high risk. There still remain some institutional lenders that absolutely require a rating.
• ESG – challenges: The panellists appreciate the significant amount of work on ESG done by the FFA and LMA. They noted that at portfolio company level meeting ESG standards is straightforward but more difficult at a fund level – mostly because it is frequently unclear what the strategy of the fund is. The panellists agreed that ESG standards need to be achievable with the right attention and focus.
• ESG requirements coming directly from LPs: LPs are more focused on the underlying asset level, the policy and aspirations. But it’s only a matter of time (3 to 5 years perhaps) before they start asking questions about whether funds are linking other aspects of the fund to the sustainability policies. Therefore, it is important to look at both the asset level and the fund level. Initially, the focus was on what the LPs needed, and requirements were not sophisticated. Meeting net zero targets in the next 10 years or so will become more and more important to the LPs. ESG focus has increased not only on the LP side but also the lender side. One of the solutions according to the panellists needs to come from the regulator, more specially, the regulator could produce capital relief for ESG/sustainable loans which could be a turning point.
• Challenges in capital call facilities: Communication with GPs, collaboration, and making sure that capacity is available will be key.

NAV 2.0

Following the pandemic, sponsors have been increasingly looking to NAV facilities to provide liquidity to funds in a challenging environment.

Sponsors identified the following items as key drivers behind the increased demand for NAV financing:

• the ability it provides to clear out asset-level debts;
• the flexibility it affords as an intermediary between subscription lines and "pure" asset backed lending; and
• that it is agnostic as to the stage in the fund's lifecycle at which it is provided, which, in a challenging macroeconomic environment, allows sponsors to hold on to investments for longer, make follow-on investments, or acquire new investments, as is most opportune, before realising them, rather than traditional drivers such as to finance dividend recapitalisations.

The panel also noted a disconnect across the fund finance market in its understanding of NAV financing. An important distinction was made between "traditional" NAV facilities and newer, more "sophisticated" NAV products. While there was a consensus that all NAV financings look downstream at the underlying portfolio of assets, newer NAV facilities are more sophisticated products, defined by more bespoke covenant and security packages with a more intense focus on the underlying asset classes and asset-level due diligence. As a result of this shift from traditional NAV products with more cookie-cutter terms to more sophisticated products, sponsors have been increasingly looking to specialist NAV financing providers and practitioners.

Traditionally, the higher pricing of NAV financing was a drawback for sponsors. The panel agreed that greater innovation in the structuring of NAV products was required to enable lower cost financing. The use of back-levered structures and ratings, allowing more beneficial capital treatment for bank lenders, were identified as key to drive down the pricing of NAV facilities. The increased use of ratings also holds the promise of more covenant-lite approaches to NAV financings to allow for greater ease and speed of execution of the financing is particularly attractive to funds with a capital markets focus. Lenders also saw syndication as an important risk-reduction tool and to enable greater accessibility of bespoke NAV facilities.

Lenders landscape

The lenders are seeing slower fundraising activities and funds wanting liquidity in early fundraising stage, which is likely to result in the borrowing base becoming more concentrated. Combined with the tough exit environment, funds need flexible solutions relevant throughout the funds’ whole lifecycle. Traditional lenders will need to adapt to the needs of their clients to maintain competitiveness as non-bank lenders are able to provide more bespoke debt solutions. Banks will still have to comply with their policies and credit requirements but they are finding ways to service clients’ need by putting in more mitigants and conditions. Financial guarantees also offer a possible solution for banks to provide more flexibility. Sponsors may be concerned about disclosure of LP information to insurers but ultimately it is important to sponsors that the lenders understand the sponsor’s business and have appropriate protections (including financial guarantees) in place to ensure that they will be able to provide funds as and when required.

Whilst subscription lines remain the cornerstone product of the funds finance industry, the market is evolving and there is more diversification in debt products. From a sponsor’s perspective, it is a welcome change and they hope to see more “non-mainstream” products. It is envisaged that the space for credit funds and insurers will continue to grow in the next 3 to 5 years. There will also be growing demand in borrowing and liquidity so there is room for plenty of players in the market.

Legal update

The panel touched on several topics during this session including, amongst others, the introduction of AIFMD II, ESG financing and fund documentation. Beyond this, a prevalent theme of the panel was the rise of NAV financing in the private equity market. On this topic, the panel observed:

• NAV financing has been a feature of the real estate finance and secondaries markets for some time. However, in the past year, there has been a significant increase in attention surrounding NAV financing, particularly in the private equity market. Despite this increased interest, the market has yet to adopt terminology to categorise the various NAV financing products and their specific characteristics and risk profiles.
• Typically, a fund looks towards NAV financing at the end of its lifecycle. Difficulties can arise where fund documents have not envisaged the use of NAV facilities. Divergent approaches are being taken to this issue: some take the view that they may proceed with the financing on the basis that the fund documents are silent on the matter, while others actively seek consent from LPs. Moving forward, the tightening fund raising environment may present obstacles to incorporating sponsor-friendly financing provisions into fund documents.
• Guidance on NAV facilities in the private equity market is expected to be published by the Institutional Limited Partners Association (ILPA) soon. This guidance may help to steer the future decision making of LPs in relation to NAV based facilities.

Other items of note included:

• The final text of AIFMD II is now available and despite its "grandfathering" measures, it is expected to have a swift impact. Specifically, AIMFD II will be of particular relevance to AIFs undertaking loan origination activity. The market will be paying close attention to any guidance that is provided and ultimately how the directive is implemented.
• LPs are becoming increasingly sophisticated in relation to fund finance. It was noted that some LPs have begun instructing specific fund finance counsel.

GP Focus

The key takeaway from this panel discussion was the need to structure subscription line facilities more innovatively. In the bank-dominated subscription facility market, continued macroeconomic pressures and more stringent regulatory capital requirements for banks has seen subscription line tenors steadily decrease since 2022. Shorter tenors have led to more frequent and regular refinancings of subscription lines and the sponsor-side sentiment is that bank-provided subscription lines have become an unsustainable source of financing. As a result, sponsors have been increasingly looking to private credit lenders, who are able to provide financing on more flexible terms due to their more relaxed regulatory capital requirements.

At the same time, sponsors stressed the need for a more standardised approach to subscription line facilities to reduce the administrative burden on GPs and for greater speed and ease of access to financing. The increased use of SMA strategies by sponsors has compounded these issues: whilst borrowers would have previously been in the market for only one or two subscription line facilities for a small number of funds, they will now be in the market for multiple subscription line facilities across numerous SMAs simultaneously. Without further standardisation between lenders on financial indebtedness criteria, covenant packages and reporting requirements, the administrative burden on GPs is not feasible. The use of umbrella facilities under which each borrower effectively has its own subscription facility was identified as a key tool to help standardise the credit lines of the SMAs and funds managed by GPs.

The panel also noted an increased demand for liquidity from GPs themselves. Lenders in the subscription line market have increasingly stringent requirements to make financing available; crucially, lenders now require GPs to have more 'skin in the game', demanding greater commitments from GPs in funds. In a liquidity-depleted environment, there is now a greater demand for GP support facilities to allow GPs to finance their commitments.

Securitisation, Risk Transfer, Ratings

• Globally, capital call facilities are valued at about $700-$900 billion whilst NAV facilities at about $100 billion
• In Europe, the applicable risk limits on banks have become an increasing concern in funds finance with the rapid rise of NAV financing. The existing size of sub-line facilities and upsurge in NAV lines, has led some banks to operate close to those limits and markets may not be able to absorb such capital growth
• One way to deal with risk limit issues for European banks are SRT (Significant Risk Transfer) securitisations. An SRT is a private arrangement between the bank and the relevant investor, thus there is no disclosure to the underlying GP or LPs as to the SRT. Under an SRT, one is taking a reference portfolio, tranching it, and passing each tranche to third party investors (a first loss tranche, mezzanine tranche, or other tranche depending on the structure).
• Depending on the origination and the investors, SRTs may have to comply with more than one regulatory framework. The most common examples of jurisdictions with their own securitisation regulatory frameworks are the US, the UK, Europe and Japan. Such regulations may require risk retention ('skin in the game' by the originator), regular reporting and due diligence.
• With fundraising becoming more and more difficult as well as potential leverage required at LP level, CFOs (Collateralised Fund Obligations; i.e. securitisation of LP interests) may become a useful tool.
• Reasons for rating of funds include: (i) capital benefits for banks and regulated institutions, (ii) distributions i.e. to bring in more (institutional) investors and thus support fund-raising, and (iii) the need to increase transparency between Lender and Borrower (especially for syndication purposes).
• Rating methodologies vary between agencies, however, there are common themes. For NAV rating, agencies consider the leverage of the fund (i.e. asset value in stress scenarios against recourse liabilities), size and liquidity of fund, and quality of GP and track record. For sub-lines, agencies consider each LP's credit quality, measure potential losses, review qualitative aspects (such as constitutional documents and managers), and consider the alignment of interest between the LPs, GPs and Lenders.
• Disclosure for rating purposes, whilst thorough, does not require esoteric information that the fund would otherwise not provide. The primary information would include financial statements and talking to managers individually (to understand their strategy, and review previous profits and losses). Given that rating agencies may not know the assets that the fund will hold, they are able to take a forward-looking approach by relying on the fund's track record and history.
• For rated feeders, rating agencies will look through to the fund (i.e. the share of assets of the fund that would relate to the feeder) and check recourse at fund level plus that of the feeder. Agencies would also compare cash flow at feeder level i.e. what they are receiving against what they need to pay.
• Proposals on future developments for banks: (i) for sub-lines, more standardisation of terms and information deliverables (i.e. information required from each bank), (ii) for fund-raising purposes, bridge facilities to be able to warehouse primary fund units, and (iii) for NAVs, given the relatively early stage of the NAV markets, greater consistency in the approach of the banks to be more readily used by GPs.

Surviving and thriving in the private capital world of the future

A diverse panel of entrepreneurs and senior management in banks spoke about their career journeys and how they adapt to the ever changing capital market. Within the panel there were panellists with drastic career changes, for example one panelist told the audience how he identified a gap in the market and went from being a funds formation lawyer to the founder of a large sharia fund management company.

It is important to adapt to the pace of changes in the market by identifying emerging trends. Another panelist noted that there has been a big growth in secondaries assets but the private and retail markets are still evolving. It is echoed by the head of fund finance at a global bank who predicted that the retail and pension industries are potential areas of growth. The rise of mass affluences means that there may be room for new funds to emerge to bring in new capital into the current private market where traditional fundraising activities are slowing down.

Finally, another panellist spoke about his experience of being on the seller end of a deal with a PE fund and noted that advance preparation for exit with multiple advisors and potential buyers lined up is important.

Emerging and continuing themes in fund finance

The market is seeing a slowdown in fundraising activities in smaller funds, difficulties in deployment, and assets are being held for longer. Banks and sponsors are tackling these issues in an innovative and strategic way by tailoring facilities to the funds’ need, in particular using concentrated facilities and building in features to account for future diversification of the funds. One of the panel also observed that the increasing use of SMAs may be attributable to AIFMD II being a fairly restrictive legislation.

The NAV facility remains another solution for liquidity. Whilst the use of NAV in Europe is becoming more regular and prominent, the US market is still catching up with the European market due to tax and investor education issues. However there are alternative solutions (e.g. equity commitment letters) and non-bank lenders have been actively designing products that suit the funds’ particular needs, blurring the lines between strict subscription line and leverage finance solutions.

Ratings remain a continuing theme in the industry. Whether a rating is required or not depends on the banks’ policies – it may be mandatory or the funds may benefit from a bigger facility size if a rating is provided. Funds are less open to public ratings due to disclosure issues – the ratings will be visible to other parties who are not credit providers. There is also more sensitivity around the timing of the rating, e.g. if public rating is given on a subscription line which is put in place at the beginning of fundraising, the rating may be lower to reflect the concentration issue even if more investors participate in the fund later on. Notwithstanding the above, a private rating is trending in the past 18 months and it is increasingly common to see a private rating being a CP to closing.

CFOs and Rated Notes

• A basic RNF (Rated Note Feeder) looks like a regular feeder except that it issues debt alongside the LP interest in a vertical strip to the investor. This concept evolved to allow for multiple tranches to be built or having certain entities holding the equity and separate entities holding the debt.
• There is strong interest from investors for rated structures to drive better capital efficiency. A highly diversified fund coupled with RNFs can create significant synergies.
• Unlike RNFs, CFOs (Collateralised Fund Obligations) have less use in private credit funds where investors already have access to cash from the private credit fund.
• There are three main jurisdictions where RNF interest comes from (i) the US; insurance clients look to benefit from a reporting angle or capital benefit angle, the most important element being the debt to equity ratio in the feeder (90/10 being optimal going down to 70/30), (ii) in Europe; due to Solvency II which requires a look through approach to underlying assets, there is less use of RNFs however a rated structure lets insurance clients get better cost of capital for the non-cash part of portfolio – for non-insurance clients who are subject to VAG there is potential arbitrage which allows them to unlock further capital, (iii) in Korea; the regulator is more cautious and makes it difficult for CFO type products to exist but not for single-fund RNFs. However, a structure that does not hold equity underneath can cause issues with the Korean registration office, thus creating structural problems.
• In the US, if regulated insurance companies invest in a private fund by way of an equity investment, there is a 30% capital charge, thus it will optimally invest via a 90/10 (debt/equity) holding in a feeder.
• In Europe, Solvency II applies thus a regulated insurance company will need to adopt a look through approach to the underlying assets. As such, there is no reason to invest via an RNF instead of directly (albeit, there may be reasons beyond Solvency II).
• For some anchor investors, two ratings may be required. The ability of NAIC to challenge the note exempt status depends on whether there was a reasonable assessment of the risk (in which case, two ratings over the RNF should limit such risk and may be required by some managers).
• A concern for the Lender is whether it should count the RNF in the borrowing base. If a feeder becomes insolvent, then one cannot force a draw on its loan thus creating a risk as to its commitment. Some Lenders get comfortable by allowing the note to flip to an equity commitment.
• Mechanically, it is a requirement by rating agencies that only principal repayments be red-drawable, not the interest. Also, given that the unused LP commitment may be returned and re-used, the note must be a revolving note. Finally, despite any distributions made during the life of the note, mechanics must allow for the debt side of the note to be preserved.