United States:
Takeaways From The 11th Annual Global Fund Finance Symposium
To print this article, all you need is to be registered or login on Mondaq.com.
On February 16-18, 2022, the Fund Finance Association reconvened
for its 11th 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.
- Rated note feeders— This structure was
- 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.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
POPULAR ARTICLES ON: Finance and Banking from United States
https://www.mondaq.com/unitedstates/financial-services/1164986/takeaways-from-the-11th-annual-global-fund-finance-symposium