Just as the private equity secondaries market took off in the wake of the global financial crisis, so portfolio financing has been propelled into the mainstream by the liquidity challenges facing buyout firms during the covid-19 pandemic.

Nine months ago, lenders to private equity vehicles were already predicting a boom in fund-level credit as the market prepared for a downturn. In fact, since lockdown hit six months ago, some have seen a five-fold increase in enquiries as portfolios have faced unprecedented stress.

Portfolio financing provides capital to funds either in the form of a loan or preferred equity, using the fund’s net asset value as collateral. Where loans are made, they may either be made to the fund or to one underlying portfolio company with a fund-level guarantee.

Matt Hansford, head of origination and NAV financing at Investec Fund Solutions, says: “At the start of lockdown, we had a lot of calls from GPs looking to understand their liquidity options in the context of defensive capital for their portfolio. We went through a very quick education process with those GPs.”

Investec has seen more than £5 billion-worth of interest in NAV transactions since the start of lockdown, double the amount in the previous 18 months. Alternatives include putting in more equity, using co-investment or going back to LPs for more money. All options are on the table and are not mutually exclusive, but it is NAV credit facilities that are on the up, building on the growth of preferred equity in recent years.

“Following those initial calls, most of the GPs found solutions for that defensive need in the portfolio, either drawing on government schemes or securing loans from banks and credit funds at the underlying companies,” says Hansford. Then, somewhat surprisingly, those managers started coming back to make use of portfolio-backed credit as part of opportunistic strategies, using it as a means to quickly access capital for bolt-ons or even to get money back to investors.

“Those discussions are ongoing,” says Hansford. “This quarter a lot of bolt-on opportunities are coming to the fore and people are going into the execution phase. These are typically funds that are just outside their investment phase, which could take more debt on at the underlying portfolio company level, but is now really the right time for that? They could try and re-lever lots of their assets, taking a little bit out of each, but that means running a lot of processes simultaneously.”

‘Natural expansion’

17Capital was one of the first firms to offer preferred equity solutions to private equity GPs when it was founded 12 years ago. It expanded its offering to include a credit product that has taken off this year.

Thomas Doyle, partner and head of credit, says: “For us it was a natural expansion of our product range. Preferred equity is incredibly flexible and is often seen as an alternative to the secondaries market that allows GPs to hold on to assets. But there are many cases where funds said they needed lower [loan-to-value ratios] and without the equity-like flexibility of the preferred equity offering. Covid really demonstrated the value of being able to look at financing on a portfolio level, rather than just applying it to one company, and being able to blend good assets with troubled assets to come up with flexible capital solutions.

“We have seen five times the amount of enquiries – a lot of those are exploratory, but our pipeline is certainly multiples of what it was pre-covid”
Dave Philipp
Crestline

“If GPs had to raise capital by company it would have taken a tremendous amount of time, at a point where some of those assets were troubled and everyone should be focused on revenues, costs and the bottom line. This is quick, it’s efficient and it is often cheaper.”

Crestline, based in the US and doing deals in Europe, is another provider of portfolio financing. Dave Philipp, co-head of its fund liquidity solutions group, says: “We are not seeing a big difference in terms of the drivers, uptick and usage of these solutions between the US, Europe and the rest of the world. Covid is essentially providing the perfect storm for sponsors, with portfolio companies reaching out to them for money, the exit market stalled and denying them the opportunity to sell assets, and capital markets, secondary markets and fundraising markets still materially impacted.

“Before this, most of what we were seeing were situations unique to individual borrowers, there was still a bit of stigma about this, and there were difficult discussions when GPs asked their LPs to allow them to borrow against assets. Now, it’s almost proactive to reach out to LPs, explain liquidity issues and set out ways that those can be addressed. We have seen five times the amount of enquiries – a lot of those are exploratory, but our pipeline is certainly multiples of what it was pre-covid.”

The small number of players on both sides of the Atlantic can offer only anecdotal evidence on the volume of transactions getting done. 17Capital has done 56 NAV financings in its lifetime; Crestline has done 24 portfolio-backed deals to date, around two-thirds of them in the US and most of the remainder in Europe.

“There’s a reasonable amount of competition but it is still fairly nascent, so a lot of the deals tend to be proprietary and relationship-driven,” says Philipp. “Competition, while it is there, is not really the big hurdle. The limited number of players in this space all have pretty big pipelines right now.”

Liquidity is the key

Tom Smith is a partner in the London finance group at law firm Debevoise & Plimpton, with a specialism in fund finance. “Pre-covid there was a lot of talk about private equity funds thinking about liquidity at the fund level,” he says. “Lenders were talking about it; funds were just thinking about it. Since covid hit, the key for any private equity sponsor has been liquidity. The market has switched from lenders trying to sell to sponsors to now sponsors trying to access lenders, and a handful of lenders have stepped up.”

Doyle says: “What’s been pleasing and surprising is the number of very large GPs doing this. It has seen a high adoption rate among first-tier GPs straightaway. Demand has stayed strong through the peak of the crisis, into the summer, and now going into Q4.”

Furthermore, this is not the usual story of a trend developing in the US and migrating to Europe. “Our sense is it is more developed in Europe,” says Smith, whose colleagues in the US are also working on similar deals. “The teams at many of the bigger lenders are primarily European and some of the initial transactions were run out of Europe and were Europe-focused. But the same trend is taking off in the US and deals are certainly being done in the US.”

“In some cases, a plaster has been put on issues. But at some point, that plaster will have to come off”
Matt Hansford
Investec Fund Solutions

For lenders, putting these transactions together is not easy. Smith says the challenge is to expand how they think about financing. “You have a group of lenders who provide capital call facilities and that market has grown, with the credit analysis there based on the creditworthiness of the investors,” he says. “Then you have lenders financing leveraged transactions, looking at the creditworthiness of specific portfolio companies. NAV financing is a mixture of the two, which means lending at or just below fund level but looking at a downstream portfolio of companies and trying to get comfortable with that structure.”

Philipp at Crestline adds: “These are complicated transactions that have a lot of moving parts and need to be staged and sequenced properly so that you can deliver the resources required for the deal. They can fall apart because the end investors aren’t supportive, or because the underlying transaction falls apart. The biggest hurdle is really just managing a team dedicated to this strategy and having enough expertise to know where to allocate these sources of capital directly.”

Leverage debate

One criticism levelled at the market is that it is layering leverage on leverage. Doyle says: “That is a bit of a red herring. We are looking through the portfolio, so it is not as if the GP can put lots of leverage at fund level without anyone looking at the leverage at the asset level. The point is also often further negated by the fact of the stage in the lifecycle of the fund when we are investing, which is when these assets are typically five or six years in. So, the leverage at company level is often down significantly from what it was at the point when they were acquired.”

Katie McMenamin, a partner in the finance group at law firm Travers Smith who specialises in fund finance, says the LP community also has a journey to go on to get comfortable with fund-level credit: “Years ago, there were certainly LPs who were very suspicious of subscription lines and it took a while for LPs to understand those. We are now starting a similar process with LPs getting up the curve with portfolio finance options and starting to form a view.”

One issue is cross-collateralising: “You are essentially granting security somewhere in the structure over all the equity interests that the fund holds,” says McMenamin. “If you default under that NAV facility then, in theory, ultimately the lender can take the keys on the whole portfolio.”

Getting deals over the line requires a focus on protections, carve-outs and negotiated positions so that if something does go wrong there are grace periods, consultations and other mitigants before the lender gets close to enforcing against all the assets.

For now, the appetite to do deals shows no sign of abating. Although many GPs have got through the first phase of liquidity issues by drawing on credit providers at portfolio-company level, lenders expect a wave of further challenges. “In some cases, a plaster has been put on issues,” says Hansford. “But at some point, that plaster will have to come off. We are expecting another wave of these defensive conversations as either the macroeconomic picture changes or the underlying picture in the portfolio companies is still not healthy and more needs to be done.”

With more and more fund-level lending being discussed, it looks like it’s here to stay.

Fund finance: Three key developments

In a conversation with Private Debt Investor earlier this year, Richard Wheelahan and Zachary Barnett of Chicago-based fund finance specialist Fund Finance Partners identified three key dynamics in the current market

1. Fund sponsors are drawing down or extending their fund level credit lines

This would include subscription facilities, net asset value and hybrid lines of credit, as applicable. The proceeds are being used to either shore up portfolio investments or position for offensive capital deployment.

2. Credit fund balance sheets are being tested for the first time in a decade

Deterioration of borrower earnings is leading to requests (or demands in the case of unfunded commitments) for supportive follow-on investments by the fund. At the same time, as earnings decline, valuation adjustments at the end of Q1 and Q2 will stress fund liquidity when NAV-linked covenants are breached.

3. Attention bandwidth among fund finance providers is being stretched

Although everyone is getting accustomed to new work routines, lenders are still plugged in and deals are getting done.

In a client note, FFP said it had been in discussions with several debt fund managers with a view to developing finance-based or stopgap liquidity solutions to temporarily or indefinitely refinance credit facilities in danger of being pulled.

Also being looked into are partial refinancings, in which performing loans are left in place; securing the existing credit facility: and the use of fallen angels to collateralise new, rescue or curative financing.