By Steve Rickards and Gavin Rees
Fund-level financing, typically in the form of subscription lines of credit (aka equity bridges, secured by the uncalled capital commitments of investors in closed-end funds), has become increasingly prevalent across alternative funds of all asset classes, investment geographies and fund domiciles. The total global volume of sub line financing has been estimated by observers to be in the region of $200 billion. Encouraged by the excellent performance of sub lines, both in terms of the absence of facility payment defaults and negligible investor defaults, the product has evolved to encompass a wider variety of facility structures and to meet a wider variety of fund financing requirements.
The inherent flexibility of sub line facilities allows funds of different strategies to use facilities for widely different purposes. Though buy-out funds continue to use facilities primarily for bridging the period between purchasing an asset and calling capital one to three months later, infrastructure and real estate funds often see a distinct advantage in being able to use sub line facilities to issue letters of credit or guarantees to support the development phase of development projects, or to back fund level financing arrangements. Meanwhile, debt and secondary funds may find value in facilities that allow the fund to ramp-up its investment activity, before making a capital call several months into the fund’s life, helping to consolidate and temporarily defer the injection of capital. Other uses for sub lines include: (i) term finance for underlying fund investments where project financing may prove difficult to put in place; (ii) derivative lines (such as deferred premium options) where exposure may be too great for providers to underwrite on an unsecured basis and; (iii) financing investment activity between the first and final close of the fund, thereby avoiding the administrative headaches associated with making capital calls before the fund is fully-raised.
The primary limitation on the use of sub lines derives from the arrangement agreed at the outset of the fund between the fund manager and investors in the limited partnership agreement (LPA). The golden rule for new funds is to ensure that the LPA provides the necessary leeway to put in place the credit facility that the manager wants, all the while respecting the desire of the investors to have their equity put to work. Prospective sub line providers are more than glad to review the financing section of LPAs during the drafting phase to ensure the agreement is fit for purpose.
The last five years have seen a blurring of the distinctions between the European and North American fund finance markets. Traditionally, North American fund facilities were characterised by comprehensive security structures including a full assignment of investors’ uncalled commitments, and offered greater flexibility to the manager in terms of size, tenure, and usage than their European counterparts, which tended to be for shorter tenures (often 364 days) for more limited uses and for a smaller percentage of the overall fund size. However, a cross-pollination of providers – US and UK banks expanding their footprints to cover the others’ PE fund markets – has seen approaches harmonise, as European managers learned of the benefits of tighter structures offering greater flexibility, and incoming lenders adjusted their approach to comply with local custom.
A more enduring differentiator between the US and European sub line markets is the greater preponderance in the US of sub line facilities formed from clubs of banks. By contrast, Europe remains primarily a bi‑lateral market. This is partially born of necessity: the sheer size of the US PE market and its faster rebound following the financial crisis required multiple bank balance sheets to meet some of the largest sub line requirements, which can exceed $2 billion for some funds.
Furthermore, US PE houses have been more likely to adopt multiple fund sector strategies (buy-out, real estate, infra, debt, across different investment geographies), such that banks are likely to face overall fund manager exposure constraints, necessitating spreading exposure across a group of providers.
However, the bounce-back in 2014 of the European PE market and the growing size of European-focussed funds (as North American investors’ interest in the ‘old world’ is re-ignited) has increased the number of sub line facilities with 2+ lenders. Many managers have come to appreciate that pairing relationship banks to provide a facility does not necessarily entail an increase in time and cost, and that diversifying funding sources – just as with project level finance – can be a prudent strategy.
Considering the excellent performance of sub line lending, it is maybe surprising that the market has developed as gradually as it has. Perhaps due to the fact that sub line lenders have kept their exposure on balance sheet (rating sub line facilities to allow for securitisation remains elusive), advances in underwriting have been incremental. However, below we list five developments apparent in the market:
- Whither Investor Letters. Letters from limited partners, consenting to the existence of the sub line facility – long the bane of managers and limited partners – are increasingly recherché. This is due to the excellent performance of investors in funds and of sub line facilities, as well as the tendency for LPAs to contain more explicit language concerning credit facilities and the obligations of investors thereof. However, investor letters remain relevant where the risk is concentrated in a single or close group of limited partners, or where the fund manager is less established.
- Non-US and UK fund jurisdictions are no longer off-limits. The 2013 launch of the Luxembourg ‘special limited partnership’ structure (which more closely replicates the well-understood Anglo-Saxon LP/GP model), the progress made by resourceful Parisian law firms to establish robust FCPR sub line structures, and the inevitable growth of Mauritian and South African-domiciled funds to service the fast-growing developing world-focussed PE fund sector have all contributed to a broadening of fund jurisdictions compatible with fund financing structures.
- Facilities throughout the entire life cycle of the fund. As previously mentioned, sub line facilities often serve a purpose during the fund‑raising period of the fund. At the other end of the spectrum, the ability of funds to pledge recallable capital, and banks’ willingness to lend against it, allows for post-investment period sub line facilities to be arranged for managers seeking working capital or trade finance lines toward the end of the fund’s life.
- Eroding the distinction between Qualifying and Non-Qualifying Investors. Despite the excellent performance of institutional and non‑institutional investors in meeting capital calls to funds, traditionally the sub line market starkly discriminated against the latter, awarding zero credit in the sub line borrowing base to the uncalled commitments of family offices and high net worth individuals. Depending on the overall composition of the investor pool, experience of the manager, amount of invested capital, and facility size vs. fund size, a sub-set of banks (including Barclays) can now take into account the value of non‑institutional investor commitments, particularly later in the fund’s life when the performance of the investors has been tried and tested.
- Beyond uncalled capital. Where the purpose of the facility is working capital or trade finance (rather than long-term leverage), and a source of liquidity (uncalled capital, recallable capital or cash-flows from assets) is available, some banks – once again including Barclays – can look to provide fund facilities which aren’t secured by uncalled investor commitments.
In summary, the fund finance market continues to perform, grow and evolve, largely to the benefit of managers. The number of fund finance providers has expanded slightly, but remains the preserve of a relatively small number of experienced banks. Lenders are increasingly able to service a variety of potential fund finance needs, just so long as the pact between managers and investors, as reflected in the LPA, allows.
Steve Rickards has over 30 years of corporate banking experience in the UK and in other offshore finance centres. For the last four years, he has headed up the Guernsey Funds team providing debt solutions for private equity and working with locally based fund administrators.
You can read the other articles from Ipes' Private Equity update (edition 15) at the following links: