Fund Finance Yields Reach All-Time High as Non-Bank Lenders Take the Reins in 2023
Fund finance is dominated by banks — historically institutional capital has played a limited role in this asset class. 2023 presents a strong opportunity for non-bank lenders to gain exposure to this stable asset class at historically high yields. Why now?
Fund finance; no longer a niche asset class
One of the lasting effects of the Global Financial Crisis (“GFC”) of 2007-2008 has been the role of non-bank lenders to provide increasing levels of capital, including fund finance. Fund finance is set to reach record levels in 2023 as private equity investors and other private market GPs utilise subscription, net asset value (NAV) and hybrid financing lines in greater numbers.
Fund finance has grown not just in volume but also in its ability to provide ever increasingly sophisticated solutions, offering GPs a series of financing options. Fund finance now provides a valuable liquidity option for portfolio companies and investors at key stages throughout the fund life cycle. As such it has become a standard in the GPs toolkit across a spectrum of private market funds as lenders can now tailor individual facilities to bespoke or niche investment strategies.
Fund finance will increasingly engage with non-bank lenders
Funds are getting bigger. In the first half of 2022 several funds raised over $100 billion in commitment. Estimated fundraising is expected to surpass $1.3 trillion for 20221. This has meant bank lending activity and balance sheet capacity can no longer keep pace with the demand for fund finance facilities. There is now widespread recognition from asset class participants that there is a growing funding and liquidity gap. Demand for fund finance continues to grow and larger fund sizes require larger credit facilities that are too big for a single lender. Banks are increasingly looking for lending partners so they can continue to support their strategic clients
The key players in the fund finance market are global systemically important banks (GSIBs) which due to their pro-cyclical nature are required to hold increased capital buffers driving a tightening balance sheet. Many have now reached their internal lending limits. As the growth in fund finance lending portfolios has outpaced growth in other commercial lending books, creating disproportionately large fund finance portfolios. Bank risk managers are looking to correct this imbalance by distributing risk, and free up liquidity to allow them to continue to write new business. This has led to some banks needing to sell down a portion of existing fund finance facilities while other banks have a strong desire to share the origination of new loans. This provides a growing opportunity set of attractive investments for institutional private capital.
Fund finance loans offer stability and protection from credit risk in an uncertain macro-economic environment
Due to the floating rate nature of fund finance, ‘all-in’ yields are climbing higher. This should not be understood as a reflection of a deterioration of credit risk. Despite challenging macroeconomic conditions, the credit risk profile of fund finance remains stable. Subscription line loans are typically investment grade and the track record remains exceptional for these loans: there has been no known credit defaults. In addition, subscription line loans are short tenor assets where the credit risk is diversified across a large pool of high-quality institutional investors committed capital with substantial levels of over-collateralisation and first ranking senior security built into the structure. Being first in line in times of possible trouble is one of the best defences a debt investor can have.
The unique risk drivers and structuring of fund finance means that they have both: lower correlation to other major asset classes, providing vital diversification at a time when most public markets have moved in negative territory together; and lower volatility compared to other risky and long-duration assets.2
Fund finance in a liquidity squeeze
The majority of fund finance is subscription line facilities which are used by GPs to bridge investment activity. This finance provides certainty of funding, short notice access to liquidity and reduces administrative complexity: GPs use this finance to “batch” capital calls to avoid drawing down on investors too often, effectively “smoothing” the capital call process.
A squeeze on liquidity is a growing concern for LPs in this current environment. If LPs lack a clear and detailed understanding of how and when capital will be called, it increases the uncertainly around what is their optimal balance of illiquid and liquid assets to meet future liquidity needs.
During times of market uncertainty this balancing act is even more imperative as investors may be forced to sell liquid securities at a meaningful discount to meet capital calls. Additionally, increased deal volatility for private market GPs can produce greater uncertainty around the number and size of future capital calls.
The use of subscription line facilities helps provide greater clarity of the timing of capital calls to help investors manage their own cash flows. A useful tool to avoid liquidity squeezes or at least be able to better plan ahead.
Investors in fund finance loans can potentially benefit in a rising interest rate environment
In a rising interest rate environment, there is a strong case for a strategic allocation to assets that provide attractive yields combined with protect against duration risk. Fund finance is such an asset class.
Fund finance interest ‘coupons’ are reset in-line with a floating reference rate e.g. EURIBOR or SOFR. The frequent interest reset process means that floating rate loans have near zero duration. If these reference rates continue to rise so does the interest coupon paid on the underlying loan, increasing the income to investors.
At present, 3-month SOFR is 4.26%4 leading to all in yields of circa. 6.26% for an investment grade, short maturity subscription line facility.
A combination of relatively high current yields, credit protection, as well as a low correlation to other private credit and fixed income options, suggests not only that 2023 is a good time to consider this relatively new asset class, but also that a strategic allocation to fund finance loans in 2023 and beyond can potentially provide investor benefits in any market environment.
1Cadwalader - Behind the Numbers: The 2022 Fund Finance Market
2 Mercer 2022.
3 As at October 2022
4 Federal Reserve Bank of New York November 2022
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