Over the past five years, we have consistently seen more than a trillion dollars raised for closed-end private markets funds on an annual basis. With demand for subscription lines at around 20 to 30 percent of capital raised, the fund finance industry has clearly experienced exponential growth.

At the same time, the net asset value finance market has risen from relative obscurity to become one of the most talked-about areas of the asset class in a matter of months, while GP financing solutions have become ever more sophisticated and nuanced.

The make-up of the lending community has also changed dramatically, with a proliferation of private debt players alongside the traditional banks, as well as growing appetite from institutional investors. The speed of this evolution and the liquidity options it presents is exciting, certainly.

But it also raises a number of questions that borrowers need to address. How are LPs viewing these changes? Leverage at a fund level has historically courted controversy, given the implications for internal rates of return. Investors were initially concerned that managers were simply looking to artificially inflate performance.

Those fears have now largely been allayed, as LPs have experienced the cashflow management benefits of subscription finance. But a rapid increase in the uptake of net asset value lines, particularly in the face of a possible impending recession, could once again be giving investors the jitters.

Meanwhile, CFOs must also navigate an increasingly complex lender ecosystem. What are the pros and cons of working with a bank, as opposed to a specialist lending fund or even an insurance company? And ESG-linked facilities are also increasingly garnering attention. Is this something that a chief financial officer should be pursuing? And, of course, the big question is how an industry that has grown up in a benign environment will fare when the economy sours.

“Leverage is a sensitive topic for LPs,” says Carolina Espinal, managing director at HarbourVest Partners. But while scepticism was rife in the early days of the subscription finance market, when limited partners feared that the facilities were being used to manipulate optics and boost IRRs, there is now a broad consensus that the advantages in terms of treasury management outweigh any initial

A recent Investec survey showed that the frequency with which GPs are calling down capital from LPs has continued to fall, from an average of 2.3 times per annum in 2020 to a 10-year low of 1.9 times last year, alleviating pressure on back-office functions. It is also now considered best practice to report IRRs both with and without the facility, so investors have clarity on the impact of the line.

Nonetheless, LPs will sometimes seek to curtail LTVs and, more commonly, duration. “I have seen side letters where LPs are saying that although the LPA allows the GP to borrow for 24 months at 30 percent, they want the facility to be cleared down every 12 months,” says Ian Wiese, head of secondaries at Investec.

Needs strong justification

Typically, however, LPs will not object to the use of a subscription facility if the justification is strong and well communicated. “If you are a blue-chip GP that has demonstrated performance time and again, LPs will have no problem,” Wiese explains. “Pushback only really arises when you have an underperforming GP suddenly using excessive lines in order to change the picture and to cover up performance.

“In terms of attitudes, you can draw a parallel with continuation vehicles. Those used to be called ‘zombie funds.’ Now they are called ‘trophy asset funds,’” Wiese adds. “Sub lines used to be seen as arbitrage – a tool for enhancing returns – now they are seen as an essential treasury management tool. If there is proper justification and the GP actively communicates that rationale to its LPs, then they will be happy to buy into it.”

LP attitudes to NAV finance are also evolving. Again, a clearly communicated rationale is key. “If there is a legitimate use of proceeds then LPs are reasonably relaxed,” says Thomas Doyle, head of NAV financing at Pemberton, who also points to the parallels with the continuation fund market, as well as dividend recaps on individual companies.

“NAV financing is just another tool. If your performance is good and your communication is good, then LPs are likely to be supportive.”

“LPs are more likely to approve a transaction when they can clearly see that it is accretive,” agrees Dave Philipp, partner at Crestline Investors. “If they deem the risk to outweigh the potential return, however, they will rightfully challenge those deals.”

Moreover, Zac Barnett, co-founder at Fund Finance Partners, believes LPs are more supportive of NAV lines than they are of subscription facilities. “With sub lines, the LPs’ own balance sheet and credit rating are effectively the collateral, whereas with NAV lines the collateral is the assets themselves,” he says. “I think they look at NAV financing more favourably because they don’t feel that they are carrying the load.”

Managers are increasingly looking to build the optionality to take out NAV financing into their limited partnership agreements and are, anecdotally, meeting little resistance. Furthermore, not only are investors comfortable with sponsors utilising NAV loans, they are also actively looking to participate in the loans themselves.

“There is significantly more transparency and information available in the public domain around these products, which is helping LPs to better understand how they are used and what information to ask their GPs for,” says Wesley Misson, head of fund finance US at Cadwalader, Wickersham & Taft. “LPs are also looking to participate in these products directly. We began seeing a lot of this post-covid as GPs discussed various liquidity options with their investors. We are definitely now seeing this trend continue, which is perhaps no surprise, given the return profile and interest alignment on these trades.”

As inflation runs rife and the world teeters on the brink of recession, the fund finance industry finds itself facing an economic environment that it has never faced before. So how will both supply and demand fare in a downturn? Subscription finance’s fortunes will largely be dictated by the fundraising markets. Appetite for alternatives held up strongly through the pandemic, but the denominator effect could yet make itself felt. “Anything that lengthens fundraising cycles or reduces fund sizes will impact demand for subscription finance,” says Khizer Ahmed of Hedgewood Capital Partners, who adds that he expects lenders to pull in their advance rates to a degree.

It is also possible, of course, that the banking sector will come under pressure, creating a vacuum for non-bank lenders in the subscription finance space, akin to what happened with leverage finance during the financial crisis. The returns on offer will limit appetite from funds at this end of the risk spectrum, but there are non-traditional players demonstrating some interest. What is less clear, however, is how the nascent NAV financing market will behave. On the one hand, a downturn could create opportunity.

Years of stress ahead

“We are facing a number of years of economic stress, and I think this market’s performance during covid has demonstrated that NAV financing will prove incredibly useful in those circumstances,” says Doyle. “A lot of lenders pulled back during the pandemic, but, with its portfolio approach, the NAV market continued to support those businesses, so I think it will continue to be useful in these difficult times.”

“A challenging economic environment creates the need for liquidity solutions, which is why covid helped this market to grow,” adds Debevoise & Plimpton corporate partner Pierre Maugüé.

Nonetheless, risk tolerances will be impacted, and Investec’s Wiese says he is already seeing borrowers asking for lower LTVs. “There is a sense of caution starting to creep in as investors take a more conservative view on assets.”

And, of course, nobody knows quite how high interest rates will rise. The consensus appears to be, however, that modest LTVs, coupled with the potential for value creation that NAV lending offers, should maintain demand and insulate it from any severe shocks.

“When a sponsor decides to put a NAV facility in place, they will look at the cost and benefit,” explains Thomas Smith, partner at Debevoise & Plimpton. “If the cost goes up, it may or may not outweigh the benefit. That could put a bit of a brake on NAV financing for certain purposes. But in most cases I suspect the benefits will still outweigh the costs.”

“Benchmark rates are going up, and it is likely that spreads will widen as well – both will inevitably have an impact on the overall cost load associated with a given facility,” says Ahmed, who adds that transactions may also take longer to consummate as lenders spend more time evaluating risk. “What we would hope, however, is that the increase in benchmark rates or spread widening is met or outweighed by the expected returns that a manager can generate through the investment activity that the NAV loan facilitates.”

Joshua Cherry-Seto, CFO at Blue Wolf Capital, also does not believe that increased interest rates will reduce the appeal of fund finance for borrowers. “Markets move as a whole, and fund borrowing will still represent cheap credit compared to the commercial markets. In fact, if anything,” he says, “NAV lines are getting cheaper on a relative basis as the industry matures.”

Meanwhile, Barnett of Fund Finance Partners says borrowers need not be overly concerned either. “Rising interest rates may very well have a negative impact on certain portfolios, but not in a manner that would put a traditional NAV loan in jeopardy.

“The LTVs on typical NAV loans are anywhere from 5 to 25 percent, so I don’t think a measured, steady creep in interest rates is too much of a concern. Other forms of leverage, with higher LTVs and less diversity, will likely fail first.”

It is expected that there will be a shift from fixed-rate structures to floating-rate structures, in order to ensure that both borrower and lender are participating in the risk, says Philipp. But on the whole, the NAV financing industry appears relatively sanguine about the new economic environment.

“If you look at the decline in private equity values between 2007 and 2009 and the current LTV levels in the buyout space, it would seem that LTVs are conservative enough to withstand a major economic downturn,” says Samantha Hutchinson, head of fund finance UK at Cadwalader, Wickersham & Taft.

“We have seen two decades of low interest rates and QE, and now we are seeing the reverse as inflation hits 40-year highs,” says Hutchinson. “Naturally, that is a concern for private equity and there will be a lot of focus on valuations over the next 12 months as the impact of inflation and increasing interest rates flow through. That said, private equity has record levels of dry powder to deploy.”

The above is a version of a feature first published in affiliate title Private Funds CFO