Fund Finance and It's Siblings: Key Questions on Market Trends, Challenges and Opportunities

By: Kam Hessling, Senior Director, LMA

At the Loan Market Association’s 17th Annual Loan Markets Conference in September 2024, the panel discussion on “Fund Finance and its Siblings” generated no shortage of questions, though not enough time was available to address them all. As the fund finance market continues to grow and gain attention, it's only natural for questions to arise about this evolving and private sector.

Given the increasing interest and some misconceptions surrounding the market, we’re sharing answers to several important questions raised by the audience. Click here for our blog post on the themes discussed in the panel.?

How important are credit ratings for subscription facilities and NAV financing structures?

The importance of credit ratings depends on the context and the involved lenders or investors. Credit ratings can be driven by favourable regulatory capital treatment or for distribution purposes. Whilst obtained on some deals, ratings are not necessarily insisted upon or required – alternative risk assessment methods and the specific characteristics of a deal can negate the need for ratings. In a highly private market, confidentiality around asset valuations can hinder the ability to obtain credit ratings, as this information must be shared with rating agencies. For parties seeking ratings, the challenge lies in balancing the need for confidentiality with the necessity of transparency for risk assessments.

Furthermore, the drive for credit ratings is influenced by the desire to distribute risk and expand lending volumes. Ratings can play a key role in supporting insurance-backed investments, which help reduce correlation risk and promote diversification. However, these are complex issues and addressing them requires a more in-depth analysis than a brief explanation can provide.

Do you see hybrid facility lines progressing as an offering?? Are there limitations to such a product??

Hybrid facilities are increasingly useful because they can be tailored to fit the credit needs, assets, and stage of a particular fund. These facilities can provide financing throughout a fund's lifecycle, from securing uncalled capital early on to supporting continuation vehicles later. However, they can be complex to negotiate—essentially combining two agreements into one—and carry greater execution risks. Ultimately, their usefulness depends on whether a fund’s needs align with the advantages of both financing options.

How can NAV transactions on the fund to push debt to the fund from the portfolio companies be understood as leverage neutral??

The sustainability of "look-through" leverage—essentially leverage on leverage—is a key consideration for borrowers and lenders in NAV facilities. NAV financing is a useful tool for fund managers to optimise the leverage at the portfolio level over time, without the need to rebalance leverage at each individual company level.

The use of NAV proceeds will impact leverage. When proceeds are used for purposes like refinancing, inserting equity, or financing bolt-on acquisitions, it can be leverage-neutral or even reduce overall leverage (while growing the underlying NAV pool). Conversely, using NAV proceeds for distributions increases total leverage across the fund, which has garnered negative media attention in some cases. Nevertheless, the market is seeing a rise in deleveraging and leverage-neutral transactions, which ultimately enhance overall value.

A key driver for NAV facilities has been the impact of rising interest rates on floating and unhedged portfolio company debt facilities. This has placed strain on interest coverage and net leverage covenants. By using a NAV facility to refinance portfolio company leverage (such as a cash-pay second lien tranche) with a PIK (Payment-in-Kind) facility at the fund level, the transaction remains leverage-neutral for the portfolio company but provides broader benefits. The portfolio company reduces its leverage, gains more covenant headroom, and releases cash (shifting from cash-pay to PIK), which can then be reinvested to grow its NAV.

NAV facilities are also provided to a ‘seasoned’ private equity (PE) portfolio after the investment period. At this stage, the PE sponsor has held the assets for several years, which would have generally grown in value and, in theory, the assets have de-levered from original levels. So, the overall leverage on a ‘look through’ basis is often lower than the leverage at the beginning.

Are lender credit capacity constraints on sponsors and sectors holding back growth, and if so, how is this being addressed?

The market remains liquid, with lenders and sponsors actively collaborating to facilitate ongoing growth within the sector. Strategies such as credit ratings, syndications, partnerships, and innovative structures are being employed to overcome potential constraints. The increasing influence of non-bank lenders also helps mitigate these challenges. Moreover, the anticipated rise in the use of credit risk insurance and securitisation is expected to alleviate these constraints further.

While lender capacity constraints may raise concerns for some banks—given their diverse range of financial services—recent findings from the PRA Thematic Review of private equity-related financing activities underscore the importance of managing these exposures effectively. For non-bank lenders, adherence to counterparty concentration limits outlined in fund Limited Partnership Agreements is essential to maintain stability and mitigate risk.

Are there any asset class preferences for lenders in the fund finance space? Is there a particular asset class that is underserved?

Lenders may have preferences for certain asset classes based on factors such as risk profile, liquidity, historical performance and regulatory considerations. Private equity, real estate and infrastructure are popular due to their relatively stable cash flows and tangible collateral. However, there is generally a lender for everything – more specialised lenders may gravitate towards higher-risk asset classes, including venture capital, natural resources, and distressed assets, depending on their individual risk appetites.

Considering that lenders provide financing to funds, who are direct lenders, do the associated risks of default on the funds’ portfolio assets and on the direct borrower create systemic risk?? If so, how is this managed?

In theory, if the same limited partner (LP) base were to invest in debt funds, NAV funds, and equity funds—all targeting the same assets—this could create systemic risk exposure. The reality, however, is that different sets of LPs invest in each of the different asset classes, and each of these asset classes tends to engage in a diverse range of transactions. This diversity is crucial for mitigating systemic risk.

Also crucial is the management of conflicts of interest. Conflicts of interest may arise when the same LP, utilising a single internal pool of capital, invests at various levels of the capital structure for the same collateral. For example, an LP could be involved in both an equity fund and simultaneously co-investing in the NAV facility or senior debt. Managing these complexities is vital to ensure the stability of the financial ecosystem.

What next?

The LMA will continue to work with the market to tackle misconceptions. The LMA has now contacted its fund finance distribution list with the immediate plans for this quarter, as well as a look forward to potential H1 activity next year. If you are interested in working with us to shape the future of fund finance, get in touch with Kam Hessling and Scott McMunn.

We are also proud to say that we are working with Deal Catalyst as a partner in the inaugural European Conference on the Future of Fund Finance – Europe on 28 January 2025 and hope that you are able to join us.?