Fund finance in times of rising rates

Low interest rates over the past 15 years meant closed-end private market funds were happy to use subscription lines for their initial financing as a low cost option. But will recent interest rate hikes lead to funds rethinking their financing strategy?

All-in borrowing costs have been mounting over the past 12 months, and are coming close to many funds’ hurdle rates. “There’s less benefit in having sub lines in place from a returns perspective, as this does not give as much of an IRR [internal rate of return] enhancement as it did a year ago,” says James Hamelin, Director, RBS International.

Dip in the cycle

A recent survey of institutional investors by investment data company Preqin found 62% of respondents think that the macroeconomic cycle is starting to decline, with 32% sensing the bottom of the cycle is approaching.[1]

Transactions across all sectors are at lower levels than they were a couple of years ago. This is leading funds to hold on to assets for longer, requesting extensions, prolonging fund lives, and bringing continuation funds into existence.

With assets taking longer to divest, distributions have slowed which makes new commitments more challenging. Many investors are pausing or slowing down their activity, partly because of cash matching issues, but also because they see more options to generate returns than they could even a year ago across their portfolio.

Investors are more comfortable to sit on cash that will now be earning a higher risk-free rate of return than it has since the global financial crisis, says James. “This will drive up return expectations when deploying into alternatives.”

There is a competitive environment for constrained liquidity, says Andy Roberts, Senior Director, RBS International. “There has been a lot more focus from investors on prior fund performance and what has been delivered against the target IRR, but DPI (Distribution to Paid-In Capital) ratios are coming into much closer focus.”

Increase in NAV facilities

For most asset classes, fund finance typically starts via a subscription line. Security comes from the investing commitment, which falls away as it drawn. Funding can then morph into a net asset value, or NAV, line once there is a portfolio of stable assets to borrow against.

In the current environment, however, fund managers are starting to show greater interest in NAV facilities. Initially this was to finance assets that are being held on funds’ books for longer than was anticipated at the start of the fund.

However, James has seen early indications of a potential shift in thinking. “There have been a number of early-stage inquiries about getting a NAV facility in place. We are seeing requests earlier in the fund lifecycle and in some instances, even while fundraising is still ongoing. Due to the tough fundraising environment, we are seeing some funds put NAV lines in place to provide additional capital while they are investing as subscription lines may be constrained due to the time taken to have investors closed.

“These facilities are also being considered to accelerate distributions to LPs, and to potentially supplement asset level leverage in a more constrained leverage market”, adds Andy.

Subscription lines still relevant, but strategy across sectors may differ

But subscription lines still have a place for the majority of funds. Many managers want the efficiency of having these facilities in place, and feel the operational advantages outweigh the costs. “Managers are not saying they do not want to use subscription lines anymore as they still see the benefits. But they are no longer automatically going with a large facility as they did when it was cheaper,” says James.  

The tighter credit environment has focused attention on ensuring that facilities are sized appropriately and thinking harder about how to use these facilities, says Andy. “Managers who previously might have drawn for 12 months are considering whether this remains the right strategy. The question for them is: does the credit line morph into being more of an operational product for some managers rather than an IRR play?”

The type of fund and returns expectations plays a part too. A private equity fund expected to deliver an IRR of 20% is less worried about the cost of borrowing than a debt fund with a lower target.

“A debt fund with floating rate instruments will see income benefits when interest rates are rising, although there will come a point where certain assets will trip over into credit stress. Whereas a private equity fund will usually have levered assets in its portfolio: more credit pressure on underlying assets from increasing interest rates will impact the equity value, or may mean more money needs to be put into those assets to stabilise the business. We will likely start to see a divergence in performance between strategies that have deployed prudent and aggressive levels of leverage” says Andy.

New role for derivatives

Behind the scenes, managers are also becoming more creative in how they finance their funds, and are taking notice of interest rate hedging products such as caps and swaps.

It has always been hard to hedge subline facilities because the drawn profile is very volatile given they are typically structured as a RCF (Revolving Credit Facility), says James. “What may work though is the introduction of term loans in subscription lines alongside a RCF. A term loan brings a known profile, and that could bring hedging opportunities.”

Where next for fund finance?

Fund managers approaching the end of their subscription lines need to focus on two things, says James. “Early engagement and visibility are vital, given the constraints across banking capacity. We need to know: What is it they are looking for? And how can we support them?”

This means managers need to have a good think about exactly what the facilities will be required for, says Andy. “Just because the funding has been used the same way for the past 10 years does not necessarily mean the past approach will be the right approach in the future. Think about what size facility you will need, and how you are going to operate it.”

Managers should also be thinking less about individual funds, and more about the overall fund manager relationship with the bank. “Managers need to consider right sizing and being flexible across various strategies. But most important is to view this as a relationship rather than a transaction,” Andy says.

[1] Prequin Investor Outlook: Alternative Assets H1 2023, page 7