To print this article, all you need to do is be registered or log in to Mondaq.com.
William Cowper once wrote that “variety is the very spice of life”. This can ring true in many circumstances, but becomes particularly relevant for alternative asset managers, or AAMs, when evaluating sources of liquidity across a variety of fund financing solutions.
Since the dawn of finance, the differing requirements of debt providers have created a range of financing options in the private and public capital markets. For corporate borrowers, these markets are mature and well understood. However, for AAMs, debt markets are relatively embryonic and constantly evolving, with a range of capital providers. Here we explore the types of capital available to AAMs across the different fund financing products, and the growth of institutional capital in each.*
Let’s first turn to the most developed, widely understood and liquid fund financing product available to AAMs – the underwriting facility. This is a market segment historically only served by bank lenders. In the past, the main driver of this, and the headwind for insurance capital in particular, was prepayment risk which, due to the revolving nature of underwriting facilities, created complexities with adjustments correspondents under Solvency II. However, the appetite is changing and we are starting to see an increase in the availability of this product from non-bank lenders, for several reasons:
1 Innovation: Insurers, asset managers and banks are all finding ways to solve the Solvency II problem with longer-term transactions. This has been achieved either through the incorporation of prepayment penalties linked to SWAP rates to offset breakage costs resulting from prepayment, or through the incorporation of term facilities that interact with traditional revolving underwriting facilities, which reduces the undrawn portion of the main revolving tranche, thereby improving lenders’ returns (which are diluted by large undrawn commitments), while increasing the internal rate of return on AAMs by removing capital calls;
2 Revaluation of short-term liquid reserves:There has been a review of many insurers’ asset allocation and willingness to hold cash, given the low yields resulting from money market rates, with insurers shifting assets to short term underwriting facilities (12 months or less) that generate comparatively higher absolute returns.
3 Trade in relative value: Third-party rating agencies are now SPONSOR CADWALADER The Spice of Fund Finance Analysis August/September 2022 ” Fund Finance 45 able to rate underwriting facilities. According to the rating methodology and composition of the investor base, most underwriting facilities are rated between BBB and single A. With insurers and asset managers focusing primarily on relative value, the question is whether rising interest rates will continue to make facilities subscription a reasonable value proposition.
The short answer should be yes – the ICE BofA Single-A US Corporate Index, which takes a weighted average of investment-grade US bonds, currently returns 4.23% for instruments with more than a year to maturity. deadline. An investment grade underwriting facility will yield approximately 3.60% (SOFRA + margin + annualized initial charge), for shorter term floating rate risk that is less affected by macro credit headwinds. For insurers and asset managers who are less focused on relative value, higher benchmark/risk-free rates improve overall returns on an absolute basis, as they do not face corresponding increases in costs due to financing on the interbank market
For private funds, the return on underwriting facilities has always been unattractive. However, for the reasons above, those who hold investments in insurance companies are now looking to portfolio assets to utilize the capital position and invest in underwriting facilities.
Missing out on what was once the opposite end of the liquidity spectrum, general partner funding or management company loans have been sought after by AAMs since the inception of the fund funding market in the United States and Europe. These facilities were traditionally seen as a relationship tool for bank lenders who provided subscription financing to funds managed by the GP/manager, with only a handful of bank lenders capable of providing such structures, and subject to a maximum of five or six years.
Missing out on what was once the opposite end of the liquidity spectrum, general partner funding or management company loans have been sought after by AAMs since the inception of the fund funding market in the United States and Europe. These facilities were traditionally seen as a relationship tool for bank lenders who provided subscription financing to funds managed by the GP/manager, with only a handful of bank lenders capable of providing such structures, and subject to a maximum of five or six years.
GP and ManCo line ratings are investment grade, driven by contractual management fee cash flows, with many agencies viewing the payment of these fees as a quasi-bank/LP risk, with fee payments being often funded by drawdowns under underwriting facilities. On a CFADS (cash flow available to service debt) and/or EBITDA multiple leverage, the GP and ManCo lines are comparatively more robust than many investment grade corporate facilities.
This risk profile, combined with AAMs’ desire for longer duration capital, opens the door for many other institutional investors to participate in this market. The question will be whether insurance capital accesses these types of facilities through the US private placement market, where coupons are fixed (usually on US Treasury bills), or whether the capital will be provided by the loans with a spread over risk-free floating rates. /EURIBOR, and whether there is a possibility of benchmark arbitrage.
Finally, NAV facilities are where we have seen the most evolution and interest involving institutional capital over the past few years, especially emerging from the pandemic. For managers of real assets (infrastructure and real estate), credit funds and secondary funds, this is not a new phenomenon, and the bank loan market which has always served as a reliable source of liquidity should continue to do so. do in the foreseeable future. . For private equity managers, however, access to leverage within the fund structure is a relatively new concept and increasingly embraced by AAMs.
The set of guarantees/remedies and the terms of the covenants for NAV facilities will dictate both the performance and the type of lender that provides these types of facilities. Private equity NAV facilities can be provided either directly within the fund structure (with or without direct collateral on the underlying investments) or through an orphan SPV providing a prime rating in the structure of the fund.
Given the residual equity value underwriting risk profile for a portfolio of leveraged buyout investments, liquidity is almost exclusively provided by direct lending funds, asset managers and LPs that invest directly in the fund. However, a few selected bank lenders can also provide liquidity to these structures. Conversely, direct recourse facilities tend to have more appetite from the banking market than non-recourse facilities.
Given the newness of the product, the type of lenders and the highly structured nature of the financing, it remains a very fragmented market where transactions are truly priced according to risk rather than “market” based on a number of factors, including portfolio diversity, credit measures of the underlying assets and experience of AAM.
In summary, the theory of evolution is not new, and applying one of Darwin’s assumptions that those who are most adaptable to change are likely to succeed, might have some relevance for debt markets. of AAMs. However, with differing demands, requirements and risk appetites of different liquidity pools, lenders from all sources will likely have the opportunity to co-exist.
*All benchmark rates and yields are from Bloomberg and are accurate as of July 5, 2022.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.
