At the dawn of 2020, the private debt community was looking forward to an unprecedented 11th year of expansion and opportunity since the global financial crisis. However, the public health and economic crises that permeated every aspect of life during 2020 evaded even the most prescient in our industry. Although there were laudable success stories and capital formation achievements, perhaps the most lasting impact to our private debt industry will be the lessons learned in balance sheet management.
At the dawn of 2021, and the beginning of an unprecedented vaccination effort, the consensus among the private debt community is that there will be a restoration of ‘normal’ – that is to say, growth, leverage and ‘risk on’. Throughout last year, we observed changes to all the fund financing products our market relies on. Let’s examine what debt fund sponsors, lenders and their advisors will face with each of those products this year.
Managers’ use of subscription facilities continues to evolve
Subscription facilities are the core leverage solution for private debt funds, and they continued to gain acceptance in 2020. The unfounded criticisms of subscription lines – remember those 2018 Financial Times op-eds, penned by some of the most established sponsors? – are a memory. Private debt fund sponsors have reliably used subscription lines to enhance returns, ramp early portfolios and, of course, bridge capital calls.
Last year proved how valuable subscription lines can be to fund managers in need of liquidity. Managers used them to support challenged assets with the required liquidity, while certain investors asked for capital call reprieves during the early phase of the pandemic.
Their importance was never doubted, but their availability was not widespread. Several lenders were conspicuously absent when called upon by sponsors with which they did not have deep, pre-existing relationships. Others were opportunistic and onboarded lucrative new private debt relationships.
One of the most sensible subscription finance trends continuing into 2021 has been the proliferation of umbrella subscription facilities. These simplify subscription facility documentation and utilisation, and unlock pricing advantages for borrowers by combining multiple subscription facilities with one commitment, under one set of documents. Lenders increasingly offer them, and managers with multiple private debt funds under management drastically simplified their liability structures in 2020 by installing them.
Separately managed accounts constitute a growing share of private debt managers’ assets under management. Advisors to private debt SMAs are increasingly seeking subscription facilities for both return-enhancing and capital call bridging purposes. Sophisticated lenders are increasingly comfortable with single-investor SMA subscription lines, and private debt managers with multiple SMAs have even installed SMA umbrella subscription facilities.
Hybrid facilities continue to finance early-stage credit funds
As valuable as subscription lines are to private credit funds, hybrid credit facilities are a compelling alternative as private credit vehicles ramp their portfolios. Unlike certain overreaching subscription line collateral packages extending to the loan portfolio, hybrids lend against both uncalled commitments and the loan portfolio.
Hybrid credit facilities are particularly beneficial for credit funds investing in loans that may not be ‘down the middle’ for the most typical portfolio leverage facilities. In addition to market advance rates against uncalled LP commitments, notwithstanding loan concentration or underlying industry issues, the credit fund will also get a modest advance rate against its assets. Portfolio-level leverage may not be available when closing the fund, though after a year or more of performing loans in the hybrid collateral pool, the incumbent lender may migrate to an acceptable portfolio leverage facility.
Private credit portfolio-level leverage trends for 2021
Private Debt Investor readers understand that private credit’s growth is a direct consequence of depository institutions’ regulatory-driven withdrawal from leveraged lending. Collateralised loan obligations would never be able to purchase enough product to meet the mid-market’s needs. Private credit in the form of BDCs, commingled funds and SMAs would ultimately satisfy the economy’s demand for debt capital. Depository institutions, though, are still financing much of the economy because they are financing private credit.
Relationships rule: your collateral looks different to different banks’
Portfolios with a critical mass of tradable bank loans can obtain attractive advance rates and pricing from bank credit facility providers. They may even use total return swaps, obtaining the economic effect of efficient and cheap leverage.
Private credit funds withstood the same dislocation in the portfolio financing market as with subscription lines. As private credit matured, many portfolio financing businesses grew as dramatically as the largest private credit firms. Ten years ago, certain banks agented $50 million-$100 million credit fund facilities that now only seek portfolios of more than $150 million. Others only accept collateral in which the portfolio company’s trailing 12-month EBITDA exceeds a threshold.
In the absence of an existing lending relationship with the bank, credit funds finance lower mid-market, or under-$150 million, loan portfolios differently than they did as recently as five years ago. A few emerging providers are open to relationships with new credit managers, smaller portfolios or SMAs, or in lower mid-market collateral, but the terms diverge from those prevalent for ‘household name’ credit managers.
In addition to upmarket migration, lenders to credit funds last year made decisions to accommodate certain credit fund managers’ short-term portfolio distress with amendments and restructurings, thereby preserving the relationships. However, those same lenders also declined to extend such accommodations to other credit fund managers. The distinctions seemed compatible with the lenders’ directional ‘upmarket’ moves more than the type of loans in the underlying portfolios.
Multi-tranche vehicles: imperfect, but valuable capital formation solution
Multi-tranche credit vehicles, in the form of CLOs, have existed for decades. BDCs have administered joint ventures featuring equity tranches (mostly owned by the BDC) and a subordinated debt tranche (mostly owned by a JV partner) beneath JV credit facilities.
Investors with regulatory capital requirements, such as insurance companies, seeking private credit exposure have expanded that multi-tranche approach to SMAs. These capital structures may have several subordinated debt tranches between the equity and the credit facility. Depending on the respective tranche sizes, inter-tranche terms and the type of portfolio, the subordinated tranches’ credit ratings allow the investor to risk-weight each tranche size. Further, the SMA’s strategy (for example, lower mid-market, mezzanine or second lien loans) and its subordinated tranches’ pricing dictate how accretive the SMA’s subordinated tranches are to the equity before taking the senior credit facility into account.
Life insurance companies will take credit fund financing market share
One of the most exciting developments in private credit is the emergence of life insurance companies as lenders to private credit funds. These may resemble traditional or simplified bank-agented credit facilities or are executed as private placements. Investment grade credit ratings on the borrower (or on the credit facility) or issuer (or the notes) are the key to unlocking attractive pricing. Otherwise, the regulatory capital cost is closer to that of a fund partnership commitment or SMA ownership.
Insurance companies are already active in the subscription finance market (especially in Europe) but they are increasingly active (and most valuable) as portfolio-level lenders. Whether leading a bilateral transaction, or contributing significant capital alongside alternative lenders, the emerging role of insurance companies in financing loan portfolios is notable.
Managers are positioning their management company and GP financing facilities for platform growth
Management company lines
The prolific growth and maturation of the private credit industry has led to the corresponding growth and maturation of management company lines. Management company lines are based upon the sponsor’s contractual management fees received from managed funds, joint ventures and separate accounts.
Rather than raising dilutive equity capital, credit fund sponsors continue to use management company lines for strategic and tactical reasons. If a credit fund manager is considering any of the below initiatives, the manager’s management company financing solution can and should accommodate each one of those objectives:
- buying out a departing partner or partners;
- adding complimentary products or formats (such as a BDC manager adding a mid-market CLO);
- acquisition of a competitor or a competitor’s AUM;
- financing incentive compensation or earned but unpaid carried interest, thereby giving partners some liquidity;
- financing or back-stopping a commitment to a new or existing fund’s partnership or insider share ownership interest;
- facilitating succession planning, providing for incentive ownership shares or economics for recent middle or senior management team members.
Credit fund sponsors continue to avail themselves of management company lines in order to facilitate
long-overdue liquidity events for founders and other senior team members. These facilities can be critical in holding successful credit fund management teams together, after years of hard work and sometimes disparate economic benefits. They can also finance compensation schemes that retain personnel integral to the platform’s success.
General partner loans
Across the asset management spectrum, using leverage to finance GP stakes is as popular – and lucrative – as ever. Private credit is no different.
GP financing facilities are secured by a pledge of the GP’s right to receive distributions from the affiliated limited partnership. They are sometimes accompanied by management company guarantees, or personal guarantees by the members of the GP.
Expect private credit fund managers to examine their financing strategies for the ‘platform’ side of the house. Credit fund sponsors should make sure that their fund commitments are financed (and the financing’s credit support strictly tailored) as optimally as their dynamic management companies are financed.
First recognise your opportunities, then act
Although the news cycle in 2020 was either trumpeting the successes of the most formidable firms or sounding the alarm for the broader market, opportunities for private credit managers to make money are revealing themselves.
Whether establishing a useful leverage solution for your early-stage fund or unconventional loan portfolio, matching unique collateral to an investor with a certain risk-and-return appetite, or planning for your management team’s next cycle and opportunity, there are new and constantly evolving liquidity solutions available. Managers that identify those solutions and capably utilise them will be the leaders of private credit’s third decade.
Richard Wheelahan is co-founder of Fund Finance Partners, a Chicago-based provider of debt capital solutions to fund sponsors and investors