Alternatives in today’s finance market for funds
Funds are increasingly engaged in the finance market, on both the borrower and lender side, with products ranging from plain vanilla to more sophisticated alternatives. This article gives an overview of the finance market for funds, highlights some of the most common structures and considers where current trends may lead.
The fund perspective has long been equity-centric: traditional funds have issued equity, invested in equity and focused on equity earnings in assessing performance. However, as the fund sector matures, these models are changing. Investors accept fund and asset-level leverage as a regular part of investing; managers and general partners consider it essential to be able to compete.
In the last six years, the mainstream bank-sponsored funds finance market has expanded year-on-year. The subscription credit facility market - the traditional place for debt finance in the funds world - remains strong, and leveraged facilities for hedge funds, together with hybrid facilities have also become increasingly commonplace.
Traditional financing solutions
Subscription credit facilities have traditionally been used to enable funds' general partners to bridge capital calls and investments in private equity structures. Loans are made to the fund (which is most commonly structured as a partnership) and secured against the right of the general partner to call down commitments from limited partners. Proceeds are used to fund investments and can also be combined with letter of credit facilities to facilitate acquisitions. They are useful for:
- funds making investments in short timeframes, where drawdown periods mean that equity financing is not sufficiently flexible as an acquisition bridge to a future long - term asset finance arrangement (e.g. in the context of a real estate fund); and
- emerging markets managers who have to currency match between the amount being called and the amount required for investment, in often volatile exchange environments.
Funds wanting to borrow need to include certain provisions in their constitutional documents in advance. Many form limited partnership agreements, offering documents and subscription agreements already include the necessary terms permitting borrowing, providing appropriate powers to the general partner and/or investment manager, bankable drawdown terms, powers of attorney and third-party rights where appropriate. Side letters can still be controversial - terms need to be carefully considered as excused partners and partners with opt-out or transfer rights for their commitments will all impact the credit analysis.
In the credit and security agreements themselves, relatively standard documents have been developed, and negotiated provisions include events of default such as key man terms, negative covenants including those dealing with alternative investment structures and co-investments and terms around delivery of notices to limited partners regarding the assignment of call rights. However, there are a number of sophisticated lenders in the market who understand the challenges faced by general partners and investment managers in this context and commercial solutions are generally available.
Alternative and hybrid financing solutions
In addition to the traditional subscription credit agreement market, bank lenders also regularly extend facilities to hedge funds, including asset-backed facilities and derivatives-based arrangements. Funds are increasingly using hybrid facilities to provide whole life-cycle leverage - subscription-credit facilities can be drawn for purposes of making investments up front and converted into asset-backed loans for continued financing through the fund's life cycle.
Funds finance has enjoyed an excellent credit profile to date. Default rates are practically non-existent, except technical covenant-based defaults which have generally been easily remedied, and this has made it an attractive proposition for alternative credit providers. Financial commentators have highlighted a decrease in bank lending as a proportion of financial markets debt, while alternative credit provision is diversifying and expanding. In line with this general trend, leverage provision through the secondaries and fund of funds markets is growing fast, and in recent deals we have also seen funds using capital markets and securitisation-based structures to raise additional finance.
Administrators and other market participants are identifying opportunities in facilitating peer-to-peer lending arrangements which are attractive to funds as both borrower and lender. Lending platforms are becoming increasingly common, essentially electronic networks which connect potential finance providers with potential finance consumers for communication and trade purposes. These are often developed by banks or other large market participants, but funds are investing in them and managers are also using them to benefit from counterparty accessibility, open availability of pricing information and efficient trade generation.
The proliferation of financial technologies is breaking down traditional barriers to funding and generating opportunities in all corners of the market for alternative credit providers and alternative credit consumers. We expect that for the most agile fund managers, finding arbitrage between operations on both the lender and borrower side will be a lucrative source of income for the foreseeable future.