After rapid expansion, LPs turn cautious on fund finance

As debt markets tighten, LPs are becoming more particular about how managers use subscription credit lines and NAV finance, writes Nicholas Neveling.

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The evolution of fund finance – from simple bridging loans into a wide range of financing products at fund level – has driven significant growth in the market in recent years.

According to fund finance lender 17Capital, which closed a new NAV loan fund on €2.6 billion in April 2022, the NAV financing market alone was worth $100 billion in 2022 and forecast to increase sevenfold by 2030 to $700 billion.

GPs and LPs have become more familiar with the product and more comfortable with tapping fund finance lines to provide additional liquidity through the fund life cycle, and even  to enhance IRRs by delaying drawdowns. Providers have also expanded market reach by spreading the offering across a broader span of private market funds and structuring fund finance packages to match the requirements of private credit, secondaries and real estate managers, in addition to the core buyouts client base.

Through the second half of 2022, however, as interest rates have climbed and debt markets have tightened, there are signs that sentiment may be shifting.

Private Debt Investor’s LP Perspectives 2023 Study shows a decline in the number of LPs expecting the use of subscription credit lines to increase during the next 12 months. In the 2021 and 2022 studies, 51 percent of LPs predicted an increase in the use of subscription lines, but there has been a 20 percentage point drop in the 2023 study, with only 31 percent expecting usage to increase next year. Just under half of respondents (43 percent) expect usage to hold steady but more than a quarter (26 percent) see usage decreasing.

LPs also appear to be paying more attention to how managers are using fund finance credit lines to fund portfolio investments. In the 2021 study, only 42 percent of the LPs polled said they were concerned with the extent to which their GPs were using credit lines to fund portfolio investments. This climbed to 51 percent the subsequent year and now stands at 55 percent.

Investors are also demanding more transparency from managers on how they are using NAV financing across the portfolio, with the majority of respondents to the LP Perspectives 2023 Study highlighting the importance of including restrictions on GP use of NAV loans in fund documentation. Just under a fifth (19 percent) say this is very important, with more than half (55 percent) saying it is it somewhat important. Only 3 percent believe it to be somewhat unimportant or not at all important.

“It is really important that the GP communicates with its LP base… and we always encourage complete transparency,” 17Capital managing director Stephen Quinn said in an interview with affiliate title PEI in November. “If LPs understand the rationale for using NAV finance and if the manager can demonstrate how its use will add value for them as well, then we see very little pushback at all. That communication is absolutely critical.”

But although the LP Perspectives 2023 Study suggests a pivot in the investor community to a more cautious position on fund finance, the product does have the potential to help GPs hold on to assets longer in a flat M&A market and find additional funding for portfolio companies when investment periods have expired.

Alex Scott, a partner in the European private equity investment team at Pantheon, says that as the fund finance market has grown, a spectrum of LP opinion on how GPs should use the product has emerged: “There is no consensus, and it very much depends on the investor’s attitude to leverage and expectations or objectives in terms of risk and return for their private equity allocation.

“Some are positive towards GPs using subscription lines because they are aligned with the GP and remunerated according to IRR achieved, or are simply happy to see managers using the full range of fund and company financing tools available to maximise capital efficiency. On the other hand, some investors are more negative on this because they like to see a ‘pure’ return or have a general antipathy to loans and leverage relating to perceived risk.”