Asset-backed loans in the funds finance market
November 2016 | PROFESSIONAL INSIGHT | BANKING & FINANCE
Financier Worldwide Magazine
There has been substantial growth in the funds finance market over recent years with more and more funds seeking subscription line or capital call facilities from lenders. These are debt facilities provided by lenders to funds where the recourse of the lender is to the uncalled commitments of the fund. The bank will generally provide a short term facility to the fund to effectively bridge the commitments of the investors of the fund. Therefore, the bank’s credit risk is on the investors of the fund and the likelihood of them honouring their obligations to provide monies to the fund when called upon to do so. This requires detailed credit analysis by the bank on the creditworthiness of the investors they are effectively lending against, usually carried out by assigning each investor a rating together with an advance rate against each investor. Many banks have been and are still entering this market. With the rapid growth of these facilities there have been substantial pressures on pricing as lenders compete between each other for this business.
More recently, there has been a significant growth in the market of NAV or asset-backed facilities. These are funds finance facilities provided by lenders to the fund or to a special purpose vehicle owned by the fund, that are not secured against the undrawn investor commitments, but rather the underlying cash flow and distributions that flow up from the underlying portfolio investments. Therefore, lenders under these facilities are ‘looking down’ for recourse against the underlying investments rather than ‘looking up’ to the investor commitments. The credit analysis needed to be carried out by the banks is very different from that needed for subscription line facilities. For pure asset-backed and NAV facilities, the creditworthiness of the investors of the fund is much less important than the value of the underlying assets.
For secondary funds, lenders will typically take security over the limited partnership interests that the secondary fund holds in different fund assets it owns or is about to acquire. It may be commercially and legally difficult to get direct security over these limited partnership interests and so often security is just taken by the lender over the shares of an SPV entity that will be set up to hold all of the limited partnership interests the lender is lending against.
For direct lending funds, the lenders will take security over the benefit of the underlying loan portfolio (not too dissimilar to the security that may be granted to a lender under a CLO warehousing facility). The banks will be analysing the underlying loan portfolio of the fund to understanding what level of loan to value ratio it can provide. There will be eligibility criteria that will need to be met for a particular loan to be included in the asset pool that the lender is lending against. This might be a requirement that the loan is senior secured, not subject to any default and is provided to a borrower located in a particular jurisdiction or geography. Some lenders structure these facilities as a loan facility, others as a note purchase facility not too dissimilar to a securitisation structure. Another important factor for loan to value ratio is the diversification of the underlying loan portfolio. Typically the more diversified the loan portfolio, the more favourable the loan to value terms the borrower can expect to apply.
For PE funds, the lenders would typically take security over the shares in the relevant holding companies of the PE fund that acquired the underlying investments. Quite often the lenders providing these facilities to PE funds may be structurally subordinated to other lenders that have provided finance that is secured directly against the underlying portfolio companies. These facilities generally carry higher risk as the portfolio of assets is not as diversified as the facilities provided to direct lending funds. These types of facilities may also be known as ‘holdco’ loans.
In some instances, lenders that are lending to a special purpose vehicle owned by the fund will require a guarantee be provided by the fund. However, lenders need to be careful and ensure that if this is the proposed structure, no borrowing limits of the fund are exceeded. Furthermore, if the fund has a subscription line facility, the terms of this will need to be reviewed to ensure there is no restriction on other financial indebtedness and that there is no negative pledge included.
In principle there is no reason why these NAV or asset-backed facilities cannot be provided to any type of closed ended fund that holds assets for a given period.
There are an increasing number of new lenders that are entering into this market as the returns are generally higher than the returns available for subscription line and asset-backed facilities. These new entrants into the market are not only the existing banks that provide funds finance facilities, but also credit and special situations funds that are searching for sufficient yields. A perfect example of where this product can prove highly desirable to a PE fund is when there is some sort of urgent liquidity required at the fund level but there are no imminent distributions from portfolio investments foreseeable. A fund may need to make distributions to its investors to, for example, ensure such investors can make new investments into the fund managers’ new fund.
Therefore, having access to this liquidity can ensure fund managers continue to fundraise successfully. Alternatively there may be a follow on expense or investment needed to be made by the fund. If its investor commitments are fully drawn the fund may have a desperate need for short term liquidity until distributions come up from the investment portfolio.
On the direct lending side, it is important that leverage is applied to the fund by way of NAV or asset-backed facilities to ensure that the fund is producing the rates of return promised to its investors. The challenge then becomes making sure these facilities are provided at sufficiently low margins to ensure that they can enhance the IRR of the direct lending fund.
There has also been a substantial increase in ‘hybrid’ facilities. These are facilities provided by lenders that look down to the value of the underlying assets, but in almost all cases, there will be covenants that ensure that there is sufficient headroom of undrawn investor commitments. These facilities are particularly useful to funds that are looking for long term financing facilities that are available from the funds first close, until the end of the life of the fund when all of its commitments have been fully drawn down and the fund is fully invested. A lot of banks have found it challenging to execute such facilities. This is mainly because different parts of banks will have expertise with respect to analysis of investor commitments and the value of the underlying assets respectively. However, some banks have been very successful in having their CLO teams and funds finance/financial institutions teams collaborate closely together to allow this offering to be put forward to their fund clients.
Finally, we have seen a very recent trend for some asset-backed/NAV lenders requiring second ranking security/recourse to the undrawn commitments of investors. If the fund has or is intending to also have a subscription line lender provide financing to the fund, this can give rise to detailed discussions on intercreditor arrangements with the subscription line provider and asset-backed lender negotiating to get the strongest position possible with respect to the fund’s assets.
We expect further significant growth in these types of facilities as the demand from funds increases and the lenders’ search for yield becomes more challenging. In particular, the hybrid facilities seem to be a perfect way for the lenders to develop strong relationships with funds and enables the lender to ‘stay with them’ from the start until the end of the fund life, increasing the chances of the lender picking up other ancillary business.
Leon Stephenson is a partner and head of the European Funds Finance Practice at Reed Smith. He can be contacted on +44 (0)20 3116 3594 or by email: email@example.com.
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