Introduction
The fund finance market represents a large segment of the loan markets and is currently estimated to be worth around $1 trillion. In this briefing, the LMA provides an overview of the rapidly evolving fund finance space and its impact on the loan markets along with how the LMA aims to support the sustainable growth of this segment.
Key trends
Liquidity challenges for limited partners (LPs)
Limited Partners (LPs), including institutional investors such as pension funds and insurance companies, often face liquidity challenges. Capital committed to private equity funds is typically locked in for several years, limiting their ability to respond to new investment opportunities or meet other financial obligations. In 2023, the private equity market witnessed a ten-year low for exits, signalling potential shifts in investment strategies and market conditions.
Against this backdrop, fund finance products such as subscription lines and NAV lending have become essential tools, providing LPs with the liquidity they need while maintaining their commitments to long-term investments.
NAV financing is a growing part of this market and is on the point of becoming mainstream. The LMA sees the following as key success factors in this transition: increased transparency, some level of increased standardisation of documentation (acknowledging the bespoke nature of such transactions), and enhanced risk management.
Role of fund finance lenders in capital management
Lenders play a crucial role in providing liquidity solutions for private markets managers. They offer various fund finance products that help managers optimise their capital structure. For example, subscription lines of credit allow managers to draw on committed capital from LPs at set intervals which assists in managing cash flows and taking advantage of investment opportunities without waiting for capital calls from LPs.
Innovation in capital markets structures
Innovation in capital markets structures is another significant theme in fund finance. Financial institutions are developing new products and financing structures to support private markets managers and their funds. These innovations are designed to offer greater flexibility and efficiency in managing capital and investments. For instance, preferred equity products, and even securitisation are regaining popularity. We expect to see more CFOs in the rest of 2024 and going into 2025. These products help managers raise capital more efficiently and provide LPs with diversified risk-adjusted returns. Such innovations are essential for maintaining competitiveness and addressing the evolving needs of the market.
Regulatory oversight and risk management
The Federal Reserve, in its Non-Bank Financial Institutions (NBFI) document, and the Prudential Regulatory Authority, in its communication to Chief Risk Officers, have highlighted the need for enhanced risk management and transparency in fund finance activities. These regulatory cautions are driving changes in how fund finance products are structured and managed, ensuring that they meet high standards of risk management and regulatory compliance.
$514 billion raised in the first half of 2024
Trends in private market fundraising
The private markets saw $514 billion raised in the first half of 2024 alone, with an average fund size of $500 million. This trend towards larger fund sizes reflects an increasing concentration among sponsors. Larger, well-established sponsors can attract more capital, leaving smaller and newer players to compete for a shrinking pool of available funds. This concentration can lead to a more stable market, as larger sponsors typically have more resources and experience to manage funds effectively. However, it can also reduce diversity in investment strategies and increase systemic risks.
Insurance money flow into asset management funds
There is an unprecedented flow of insurance money into new asset management funds. Insurance companies, seeking higher returns in a low-interest-rate environment, are increasingly investing in private markets through fund finance products. Insurers and private capital firms have completed over $900 billion in transactions acquiring life and annuity liabilities worldwide. In the United States, insurers backed by private capital firms gathered nearly $700 billion in assets in 2023, according to McKinsey.
This influx of capital is reshaping the fund finance landscape, providing substantial liquidity to managers and influencing investment strategies. The involvement of insurance money also underscores the importance of robust risk management practices, given the stringent regulatory environment of the insurance sector.
Capital management strategies by private markets managers
Managers continuously develop new capital management strategies to enhance the performance and stability of their funds. These strategies often include the use of fund finance products to manage cash flow and leverage investment opportunities, whilst maintaining an alignment of interests between the fund managers and investors. By using products such as subscription lines, NAV lending, and preferred equity, managers can optimise their financial operations, ensuring that they have the necessary liquidity to take advantage of investment opportunities and manage the fund efficiently.
Increasing attention from commentators
Historically, fund finance has had a lower profile compared to public leveraged loan markets and private credit. However, this is changing, as more commentators focus on this sector. A number of leading media outlets have recently published articles highlighting the complexities and growth of fund finance, bringing this area of the market into the spotlight.
Investor concerns
Investors have publicly raised some objections to certain fund finance products due to several concerns.
Firstly, the cost. Products such as NAV lending are sometimes viewed as an expensive liquidity solution as some investors believe that they can secure financing at lower rates through alternative means.
The structural complexity of fund finance instruments, such as preferred equity or a CFO structure can also prove daunting for some. These products often involve intricate financial structuring, making it challenging for investors to fully understand the associated risks and returns.
Risk management is another area of concern. The fluctuating values of the portfolio which supports a NAV loan could lead to concerns on the impact of a decline in valuation on the continuance of the financing.
Finally, some are concerned about the alignment of interests between managers and their investors. Fund finance products often provide GPs with liquidity and flexibility that may not always align with an investor’s long-term investment goals, leading to potential conflicts of interest.
These objections highlight the need for transparency, cost-effectiveness, and risk management in fund finance to meet investors’ expectations and align with their investment strategies.
Types of fund finance
Subscription lines
Subscription lines are the most common form of fund finance, accounting for the vast majority of the fund finance market. They have a relatively simple structure and are used principally for cash management purposes which benefits both the manager and their investors.
Management/GP lines
Management or GP lines are credit facilities extended to fund managers rather than the entire fund to support their commitment to a fund. These products occupy a rather small portion of the market but can be particularly useful for liquidity where, for example, younger members of a management team may not have sufficient liquidity.
Preferred equity
Whole-fund preferred equity solutions are gaining traction as an option for private investment funds. This form of equity helps address uncertainties over valuation and challenging exit environments, offering more flexibility in fund management.
NAV lending on its own could represent a $1 trillion market by 2026
NAV lending
NAV lending allows funds to borrow against the value of their investments, providing additional liquidity and investment opportunities. Some investors see this as an expensive option and see other liquidity options as preferable, with an opposing view from other investors seeing this as benefitting their interest and supporting the portfolio. NAV lending on its own could represent a $1 trillion market by 2026, according to Deloitte However, the use of NAV loans to pay dividends fell by about 90% during the second half of 2023 following heightened criticism from investors, according to 17Capital, a New York specialist later quoted in the Financial Times. 17Capital said that just 3% of the private equity industry’s NAV loans was used to fund dividends in 2023, down from a quarter in 2022.
Regulatory and market changes
Greater regulatory scrutiny
The broad range of activities funded, including private equity and both public and private credit, has attracted the attention of regulators focusing on transparent risk disclosure. Regulatory bodies such as the Securities and Exchange Commission and Financial Conduct Authority have issued new guidelines to improve transparency and risk management in fund finance.
Capital treatment and Basel 4/CRD6
Changes in capital treatment, particularly under Basel 4 and CRD6, will impact lenders by potentially increasing capital requirements for fund finance loans by up to 35%.
Non-bank lenders
There has been a shift in the lender landscape, with greater syndication of funding lines and more institutional investors financing funds. Non-bank lenders such as pension funds, insurance companies, and other asset managers are offering flexible financing solutions, increasing competition for traditional bank lenders.
Impact on loan market participants
Diversified lending portfolios
The growth of fund finance allows loan market participants to diversify their lending portfolios, spreading risk across various types of funds and financial instruments.
Enhanced risk management
With greater regulatory scrutiny, loan market participants must enhance risk management by adhering to best practices for transparency, risk disclosure, and valuation methodologies.
One of the key benefits for private markets managers is the optionality and relatively low-cost option value provided by fund finance products. This optionality is crucial as it offers managers flexibility in managing their investments, whereas Limited Partners (LPs) may find themselves at a disadvantage, or “short,” due to the increased complexity and cost structures involved – albeit not that expensive versus the cost of debt at the asset level holdco.
Competitive landscape
As mentioned above, the entry of non-bank lenders and institutional investors into fund finance has intensified market competition. Non-bank financial institutions (NBFIs), including insurance companies, pension funds and other asset managers, are increasingly important players, offering flexible financing solutions and increasing competition for traditional banks. This competition benefits borrowers, who are likely to receive better terms and more efficient capital allocation. The presence of NBFIs has reshaped the competitive landscape, prompting traditional banks to innovate and provide more flexible financing solutions.
The trend towards larger deals encourages strategic investments and partnerships between lenders
Strategic investments and partnerships
The trend towards larger deals encourages strategic investments and partnerships between lenders, providing capital for significant investment opportunities and expanding the market. Such partnerships are essential for supporting large-scale investments and fostering a more integrated financial ecosystem.
What the LMA is doing
Addressing sector challenges
The LMA aims to support consistency and transparency across the loan markets and in this case fund finance, by establishing guidelines focusing on documentation, reporting, education, and support – if necessary. Any such guidelines will help define best practices and reduce risks in the sector.
Collaboration with other associations
The LMA will continue to work with the Loan Syndications and Trading Association and the Fund Finance Association to address common issues, ensuring a coordinated approach to enhancing market standards.
Education and regulation
Given the innovative nature of fund finance products, investors can benefit from additional education in this area.
Regulation under frameworks such as CRD6 (Capital Requirements Directive) and CRR3 (Capital Requirements Regulation) regarding the treatment of risk-weighted assets (RWA) is also crucial. Ensuring that the purpose of these regulations is correct and aligned with industry needs is essential. Potential guidance could include detailed instructions on events of default (EODs), covenants, mandatory repayment terms, along with the ability to challenge valuation methodologies.
Establishing working groups
The LMA plans to establish several working groups to shape the future of fund finance by focusing on key issues and developing solutions. Interested parties are encouraged to contact Scott McMunn, CEO of the LMA, to take part.
Conclusion
The fund finance market is evolving rapidly, becoming more complex, and attracting greater scrutiny from regulators and the media. The LMA is committed to supporting the sector through guidelines, education, and collaboration to ensure a transparent and consistent approach to fund finance.
