Takeaways From The 11th Annual Global Fund Finance Symposium – Finance and Banking

On February 16-18, 2022, the Fund Finance Association reconvened
for its 11^th Annual Global Fund Finance Symposium
in Miami where market participants gathered to discuss the latest
developments in global fund finance and to consider the outlook for
the industry in 2022 and beyond. Below is a summary of our key
takeaways from the conference.

• Market Update — The year 2021 saw a
  record level of fund financing activity. The pace of fundraising on
  the sponsor side accelerated in 2021 and, with it, interest in fund
  financing solutions. Subscription facilities have become essential
  working capital products used by an ever-increasing number of
  private funds from their initial formation through and sometimes
  beyond their investment periods. Conference participants expect
  deal volume to continue to increase in 2022, particularly in
  subscription lines and NAV facilities. Fund structures are become
  increasingly complex, including from greater use of alternative
  investment vehicles, co-investment funds, “side pockets”
  for certain categories of investments (e.g., distressed), warehouse
  vehicles and series limited partnerships.In light of this
  complexity, sponsors and their legal counsel should seek to ensure
  that the fund’s organizational documents provide sufficient
  flexibility to obtain appropriate financing for these structures at
  the outset to avoid having to go back to investors for
  amendments.




• Effect of COVID-19 — The global pandemic
  gave the fund finance industry a chance to prove its resilience and
  flexibility. Conference participants agreed that, while some
  borrowers had difficulty obtaining funding at the start of the
  pandemic in early 2020, most lenders were able to deliver flexible
  and creative solutions to their borrowers’ liquidity needs,
  including temporary upsizes to existing facilities, the addition of
  qualified borrowers and NAV and hybrid facilities. By the end of
  2021, the fund finance market exceeded its pre-pandemic level and
  continues to grow with new entrants and more complex financing
  structures. On the lender side, competition has increased since the
  start of the pandemic, resulting in lower margins, higher advance
  rates and riskier structures, forcing lenders to consider what
  products they should focus on to set themselves apart.




• Alternative Lenders — Alternative
  financing sources, such as private credit funds and insurance
  companies, have demonstrated enormous interest in acting as lenders
  in fund financing transactions. Since they generally require a
  higher return than banks and have more flexible risk appetites,
  alternative credit providers will likely find their niche in more
  bespoke structures, including NAV and preferred equity facilities,
  rather than subscription lines. For sponsors, the entry of
  alternative lenders into the fund finance space brings both
  opportunities and risks.Sponsors should bear in mind the
  implications of sharing confidential information (such as the
  identities of LPs) with alternative lenders and should ensure that
  the loan documents provide sufficient notice and consent rights
  with respect to potential assignments and participations by
  lenders.




• “Fund Finance 2.0” —
  Conference participants discussed the evolution of the fund finance
  market from its origin in simple “bridge” subscription
  facilities to today’s variety of dynamic, solution-focused
  products. Several factors have driven the growth of non-traditional
  fund finance products, including the financing challenges created
  by the pandemic, increasing familiarity and comfort with fund
  financing on the part of sponsors and investors, greater complexity
  of fund investment structures and the entry of alternative
  financing sources. While many traditional lenders have been slow in
  offering these products, one panelist expects that, once these
  lenders gain confidence in their long-term durability, the growth
  will be exponential rather than linear. Some of these structure
  include:




• • Rated note feeders— This structure was
    designed to enable sponsors to raise capital from insurance
    companies in the form of rated notes (typically pay-in-kind) that
    are treated more favorably, as compared to equity investments,
    under capital requirement regulations applicable to insurance
    companies. A fund’s subscription facility must allow inclusion
    of the insurance companies’ commitments to purchase the rated
    notes in the borrowing base similarly to equity capital
    commitments. For lenders, these structures may carry some risk
    since the enforceability of the insurance companies’ note
    commitments in the event of a bankruptcy of the fund may be unclear
    or untested in the relevant jurisdiction. These risks may be
    mitigated by incorporating an investor’s note commitment into
    the fund’s partnership agreement or other organizational
    documents. As a result, it is crucial for fund managers to engage
    with subscription facility lenders early on in the process to
    ensure that an investor’s note commitments will be included in
    the borrowing base, including in circumstances in which the note
    commitment may convert into equity.

  
  

  • Hybrid facilities— Under hybrid
    facilities, borrowing capacity is based on both investor’s
    uncalled commitments and the fund’s net asset value (NAV),
    theoretically extending the term of the facility from “cradle
    to grave.” Despite their attractiveness to sponsors, many
    lenders struggle to provide these facilities given the bifurcated
    collateral packages, which are typically covered by separate credit
    review processes and underwriting teams. However, lenders that can
    successfully coordinate these teams internally are able to provide
    a flexible financing product that is well suited to every stage of
    a fund’s life cycle.

  
  

  • NAV facilities— The use of NAV
    facilities, which were traditionally utilized primarily by
    secondary funds, took off during the pandemic.  New to the
    product, private equity buyout funds began to use NAV facilities to
    provide liquidity to struggling portfolio companies in legacy
    funds, as well as to fund add-on acquisitions and even
    distributions. With a limited number of assets, these
    “concentrated NAVs” are often too risky for commercial
    banks and thus have been provided primarily by alternative lenders.
    In the secondaries market, the use of NAV facilities also
    skyrocketed in 2021, with these facilities still provided primarily
    by commercial banks and requiring a minimum level of
    diversification in the portfolio. With the growth of secondary
    funds sizes, lenders are being asked to write bigger checks,
    requiring banks to rely more heavily on syndication, including to
    insurance companies that have been entering the space in increasing
    numbers. Secondaries’ NAV facilities are also seeing greater
    interest from LPs and family offices that started to look into
    these facilities as a way to leverage their own portfolios.

  
  

  • Preferred equity— Typically used as an
    alternative to a NAV facility, preferred equity may be issued at
    the fund or aggregator level. While preferred equity (unlike debt)
    does not have a fixed maturity or require regular cash interest,
    investors may obtain a preferred dividend “ratchet”
    and/or the right to force a sale if the preferred equity is not
    redeemed within a certain period. Preferred holders are entitled to
    receive a percentage of future distributions (e.g., when the fund
    sells an underlying portfolio investment) in accordance with a
    waterfall set out in the preferred equity documentation. Although
    more expensive, preferred equity may be preferable to debt given
    the longer horizon, PIK dividends and fewer restrictive covenants
    as compared to debt.

  
  

  • GP financing— GP financing, i.e.,
    financing secured by the GP’s capital and carried interests in
    the underlying funds, is used by GPs to get liquidity without
    selling their GP stake. Although panelists agreed that this type of
    financing is still very much in its early stages, at least one
    panelist made the bold prediction that the volume of GP financing
    transactions will surpass the volume of GP stakes deals in the near
    future.




• Single/Separate Managed Accounts (SMA) Funds
  — SMA funds (also known as “funds of one”) are
  becoming increasingly common as GPs seek to build relationships
  with large institutional investors, who are attracted to SMAs for
  their greater input into investment decision-making and tax or
  regulatory advantages (as compared to commingled vehicles). To
  mitigate the risk associated with relying on a single
  investor’s commitment, subscription lenders conduct greater due
  diligence and require enhanced documentation from investors, such
  as investor letters that give the lender contractual privity with
  the investor. Lenders also run lien searches to ensure that the
  investor’s limited partnership interest is not back-levered and
  tighten events of default and investor transfer restrictions in the
  loan documentation. Having been pressure-tested during the
  pandemic, the SMA and “fund of one” sub-line seem to be
  here to stay.




• Effect of Fraud Cases — As Ropes &
  Gray has previously discussed, the potential for fraud in fund
  finance transaction brought to light by the Abraaj and
  JES Global cases has ultimately had limited impact on the
  subscription finance segment. One lender-side participant at the
  conference mentioned attempting to run a more intensive due
  diligence process on an existing sponsor client after JES,
  only to be emphatically rebuffed by the sponsor. On the other hand,
  lenders are conducting more intensive diligence on new
  fund sponsors than they had historically, including verification of
  the identities of LPs and obtaining confirmation from LPs of their
  specific fund commitments. Notably, lenders report that LPs have
  been constructive in cooperating with this process, presumably
  because they have a shared interest in minimizing LP default risk.
  Ultimately, while panelists noted that while fraud will always
  remain a risk, actual instances have been exceedingly rare and the
  risk remains highly remote, particularly for established
  sponsors.




• ESG — Both sustainability-linked and
  “green” use of proceeds facilities have accelerated in
  Europe in the past two years though, even there, there is not yet a
  wholesale shift in incorporating these into fund financings. In the
  U.S., while these products are far less common, investors are
  certainly focused on ESG considerations. Nevertheless, as one
  panelist remarked, ESG-related finance is still in its “first
  inning” and investors and LPs remain focused on a fund’s
  ESG strategy and mission broadly rather than how that strategy
  plays into fund-level financing specifically. The risk of
  “greenwashing” remains a concern, especially as there is
  still no market standard for setting or measuring KPIs. However,
  panelists were optimistic that achieving such standardization is
  only a matter of time and that, as more comps come to market and
  participants as a whole become smarter on this topic, investors
  will embrace the advantage of potential savings in funds’ costs
  of capital. (For additional information on Ropes & Gray’s
  ESG practice generally, and sustainability-linked debt
  specifically, please refer to our ESG practice homepage and our podcast on ESG-linked debt.)




• LIBOR Transition — In the fourth quarter
  of 2021 and continuing into early 2022, lenders have been
  accelerating the process of transitioning their portfolios from
  LIBOR to alternative rates. While most lenders have adopted CME
  Term SOFR as the fallback, some lenders continue to explore various
  “credit-sensitive” rates or, in some cases, simply the
  “prime rate”.With the widespread transition to Term SOFR,
  the main point of contention has been whether to add a credit
  spread adjustment (CSA) on top of the margin. While the syndicated
  market has been increasingly adopting a no-CSA approach, lenders
  under bilateral and privately placed facilities have sought to
  maintain a CSA, whether tiered (as contemplated by the original
  ARRC “hardwired” fallback provisions) or flat.One
  panelist noted that, without a CSA, lenders may seek to limit
  borrowings to a one-month interest period while, if there is a CSA,
  they are more likely to be comfortable with one-, three-, or
  six-month periods. The lack of market consensus on spread
  adjustments creates complexities for asset-liability matching,
  particularly for credit funds whose assets and liabilities may use
  different benchmarks, or use the same benchmark but with spread
  adjustments. While the market is expected to move toward a
  consensus during 2022, the current lack of consistency is causing
  enormous frustration on the part of sponsors.

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