Our Thoughts on the 7th Annual European Fund Finance Symposium

Introduction

The Fund Finance Association (FFA) hosted its 7th Annual European Fund Finance Symposium at the QEII Centre in London on 19 June 2023. It was a great success. The Symposium was supported by 78 sponsors and attended by over 800 delegates from across the global fund finance community. The day was insightful and all attendees had the opportunity to reconnect with colleagues and other industry professionals around engaging panel discussions. Members of the Maples Group’s Global Fund Finance team from Dublin, Jersey, London and Luxembourg were delighted to attend the symposium. This note summarises their thoughts and key takeaways from some of the panel discussions.

PANEL: Evolution of Fund Finance

• The Evolution of Fund Finance panel took a practical approach looking at recent changes and, in particular, the imbalance of supply and demand in the finance space.  Demand has slowed in the fund raising environment with many panellists seeing financing in existing areas where funds have slower exits and the need for capital lines past the investment period.  GPs are looking for different types of financing and an increase in NAV (Net Asset Value) facilities is indicative of some of the changes in the market.  Fund raising periods have elongated, with some investors slow to come back to the market and an increase in demand for SMAs.
• Pricing has become a big factor with limited partners focusing on the cost of facilities.  Banks have seen some funds simply lock in for shorter periods in the hope that prices will go down, particularly as since 2020 costs have only been increasing although there is some stability now.  Some smaller funds have questioned the need for bridges particularly where they have seen the cost impact on their funds.  Lenders are also finding that pricing is not an easy conversation to have with their clients in the present environment and more managers are asking about NAVs, adjusting their traditional structures to have follow-on investments, generally longer timelines to put financing in place and less appetite for committed risk.  GPs are considering reliability more given the recent lender issue. They want long-term relationships and to be able to rely on lenders for extensions and frequently look at lower starting amounts for loans with increases on extensions.
• On the supply side, as there are fewer lenders in the market there are opportunities for lenders that have balance sheet availability. There is still capacity in the market but banks are being more selective and focusing on GP track-record and potential cross-sell opportunities.  The process with lenders has become more interactive and looks more at the long-term relationship.  In the US there are more regional lenders, whereas Europe has more institutional lenders in syndicates. Either way, the first question is nearly always on pricing and generally borrowers are asking more questions.  Banks are being more up front on those initial calls and more teams are involved in the discussions, not just the fund finance team, to provide a more tailored approach.  The panel is seeing more non-traditional lenders, such as insurance companies, as lenders of record which gives investors other concerns over potential exposure.
• Looking to the future, the main existing lenders will be there and funds will also have access to non-bank capital.  There will be some product changes and more term loan type products.  Ratings will definitely transform the market. We’ll possibly see some fundamental changes here as other ratings agencies appear.  Other potential evolution will be seeing more open-ended funds looking for facilities, more hybrid structures and more tailor-made products.  Challenges for the banks will be more teams working on deals and having to split the fees.  Relationships will be key.

PANEL: Legal Update: Implications of Defaulting Lenders

• The moderator invited the panellists to discuss their experience and the questions that they received from their clients following the US banks’ failures. The responses very much depended on whether they came from borrowers, whose capital call accounts were opened in the books of failing or weakened institutions and that needed funding to carry on, or lenders.
• On the fund / borrower side, these events also triggered some regulatory questions. For instance, whether a fund was able to call capital into accounts opened in the books of those succeeding semi-public institutions. In Luxembourg, as most of the borrowers are alternative investment funds falling within the scope of the AIFMD, the contractual obligation set out in the finance documents to fund the commitments into the account that has been pledged in favour of the lender and which may be opened in the books of a failing institution could conflict with the depositary’s duties and obligations. The foregoing led some depositories to envisage reaching out to the regulator.
• On the lender side, there were typically two concerns. First, when participating alongside the same institutions in syndication arrangements the concern was such institutions’ inability to fund committed amounts, or second, where the failing institution was acting as security or collateral agent. In the later case, under Luxembourg law, the issue could be fixed easily, as the benefit of pledges could be assigned under private seal to a succeeding collateral or security agent, subject to the account bank of the pledged collateral accounts  being notified. One fundamental issue that panellists saw coming up in onshore jurisdictions is that the security taker cannot have greater rights on the secured assets than the security grantors, which could be an obstacle to the effectiveness of the security over the pledged accounts when the account holder has no access the funds kept in the account opened in the books of a failing institution.
• One solution which the panellists envisaged and often implemented was moving the collateral accounts to new institutions. This triggers the need to take new security over the new accounts (it being reminded that in Luxembourg the consent of the institution of which the accounts are opened is a condition to the creation of the pledge). However such path presents some practical obstacles, if only from a timing perspective, as opening new bank accounts, especially in these circumstances, can be challenging. The advantage under Luxembourg law is that the new pledges over the replacement accounts would fall within the scope of the Luxembourg law on financial collateral arrangements and no hardening period would apply to such new security – hence such new security would be as effective from day one.
• There was a consensus amongst panellists that the legislation adopted in the aftermath of the 2008 crisis were designed to protect depositors, public interest and retailers. For such reason, this may negatively affect banks and cause damage. Credit funds may offer a viable and safer option. They are not affected by the legislation that aims at protecting depositors. However, they would not fall within the scope of government backed resolutions, hence the solidity of their investors’ commitments is key.
• The trends that the panellists have identified in the market is for borrowers to not restrict themselves to one relationship with just one institution. As it may prove difficult to swiftly open a new account with a new institution, the trend is to establish several relationships with different banks (and lenders) across the fund groups, so as to be able to move quicker in case one of them fails. More flexibility is brought to the provisions in the documentation so as to ensure that the mechanism allowing the borrower to move its collateral account(s) to a new institution is streamlined.

PANEL: NAV 2.0 – Concentrated Collateral and Equity

• It was a very interesting discussion about NAV facilities and how the market has been gradually evolving. There has been a significant growth in the last couple of years, with NAV facilities as a more widely accepted product and portfolio management tool.
• Preferred Equity is considered an equity instrument (or equity underwrite) with no covenants, receiving preferred return by placing additional leverage to structure the portfolio and getting the repayment from the excess.  This is more flexible and cheaper for the borrower.
• The panel gave a broad explanation of concentrated NAVs.  It is generally discussed that anything above ten assets is diversified and anything below is concentrated. We need to look at the assets of the portfolio which will determine the solution. If it is concentrated the pricing will be different.
• There are very large transactions that have happened in the recent years and the product is now widely accepted.  From 2018 there was a limited number of users, but fast forward to today there are some precedent transactions.  There has been innovation in the use of proceeds, (i.e distributions or follow-on capital).  There are some sponsors that are putting in place hybrid products and is a toolkit that is akin to internalising a piece of the bank balance sheet which allow to support acquisitions to bridge capital structure of assets.
• Due to the current market; with low M&A and IPOs, it is important to consider other ways to create liquidity against the portfolio and bring down the cost of capital.  Distribution back to LPs or in lieu of been able to obtain senior debt (considering leverage markets are struggling).  There is a massive market and different kind of solutions available.
• Funds are also looking at liberal provisions in the fund documents and go to the market with some flexibility in order to consider different options (even if at the time there is no specific structure in mind). There is a shift from more offensive to defensive and as the fund matures the need will be more pronounced, particularly given the macro outlook.
• Managers are reflecting quite carefully how they are using these products. Some of the biggest hurdles are to consider whether this is permitted under the limited partnership agreement, looking into the fund structures in order to consider the security package and how the cash flow is structure.  We are seeing more bespoke transactions with special consideration on the type of security, covenants and form of repayment.  One important feature to consider is independent valuations given the volatility in the market.
• The predictions are considering an increase of market participants with more bespoke products.  The next twelve months will see increase of concentrated NAVs. If there is market volatility, there will be a search for strategic bolt-on acquisitions and how to support portfolio company balance sheets. There are more reasons to use this NAV product and provide some needed liquidity (probably looking for NAV 3.0 in the upcoming conferences).

PANEL: NAV 1.00 – Diversified Collateral and Debt Undertaking

Panel members observed that asset backed loans (“ABLs”) to credit funds function like any other NAV credit facility. ABLs could typically see an LTV of up to 40 – 45 percent secured against the underlying portfolio of loans. Lenders in the ABL space were attracted to asset quality, diversity of assets and liquidity with a strong preference for a mature loan portfolio with established cash flows.

Needless to say, the quality of asset is key:

• loans need to be subject to due diligence before becoming part of the fund’s asset pool;
• a concentration limit is key – lenders do not want to be over exposed to a particular geographic region or an industry; and
• lenders need to be aware that ABLs may carry a higher regulatory requirement and come within the securitisation regime where there is tranching or pooling of assets.

Panel members discussed the difficulties of agreeing valuations with lenders:

• in theory, valuations should be straight forward but banks and funds may employ different methodologies prompting challenges from lenders;
• transparency on valuation methodology from day one of the facility with lenders can aid understanding and lender comfort on this matter;
• it was recommended to negotiate how many challenges a lender can make to a valuation in respect of a particular asset at the outset of facility negotiations; and
• conservative valuations can provide sufficient headroom to borrowers as they negotiate tricky economic conditions in 2024.

Panel discussion moved on from a specific focus on ABLs to what elements are driving the demand for NAV credit facilities in general:

• macro-economic factors such as the challenging fundraising environment;
• reluctance on the part of managers to sell assets until price is right but  subscription line investment has concluded and they need to tap additional liquidity to make follow on investments in their existing portfolio;
• managers do not expect to exit for another 18 months but time is right to redistribute to investors now; and
• greater lender familiarity with NAV credit facilities was facilitating greater supply.

Given this year’s defaulting lender crisis and the reduced supply of subscription line credit facilities from banks, a final point of discussion was the preference for managers to cultivate new relationships with multiple lenders for multiple products rather than rely solely on one lender for leverage arrangements (which we note was a recurring theme throughout several panel discussions of this year’s conference).

PANEL: Non-Bank Lenders – Current Status and What is Needed for More Growth

Non-bank lenders are very active in the market, and contrary to some beliefs, they are flexible and can offer multi-currency revolving facilities, not only term loan single currency facilities. The key is understanding how to take institutional capital, deploy it into market and alongside the banking funding, to allow the market to continue to grow. GPs and financial sponsors are actively seeking out non-bank lenders to participate in syndicates and clubs together with the traditional banks for both subscription lines and NAV facilities.

The reasons non-bank lenders are participating in the fund finance market is to address the supply issue in subscription line space and the lag in the NAV line space. There are gaps in the market that non-bank lenders can fill and banks/borrowers can identify pockets of opportunity to bring investors in through a co-investment or another fund structure. There has been significant growth in private credit over last 15 years and investors are looking for diversification; fund finance delivers two levels of diversification with sub and NAV lines; the fund finance market is stable, transactions are achieving higher ratings; it has attractive risk adjusted returns relative to other asset classes; it is a good asset class to sit alongside other assets; subscription line facilities are short term, the yields are good, and so it is a very interesting option for non-bank lenders.

Issues preventing non-bank lenders coming in to the fund finance market include lack of investor education and awareness of fund finance which can result in significant lead in time to get non-bank lenders comfortable with the asset class and ready to finance. There is a role here for the FFA to educate pension funds, insurance funds and family offices on the fund finance market. Other challenges include the certainty traditional banks offer borrowers in particular around ratings requirements vis a vis a non-bank lender. Overly complicated structures/collateral deter institutional investors but focusing on liquidity and having consistency in structures, documentation and collateral will make it more attractive.

Looking to the future there is a strong expectation that non-bank lenders will regularly be part of the discussions for fund finance deals with the changing regulations in the insurance market such as Solvency II in Europe and the UK opening up the market to other investments, which is expected to create a shift from investment in pension funds to the insurance space. There is also a possibility that banks and / or GPs will setting up their own non-bank lender funds/vehicles and perhaps more formulated/standardised documents will attract further non-bank lenders into the market.

PANEL: Structuring and Managing Risk in 2023

• The war in Ukraine, instability in the American banking system, rising interest rates, the long-term impact of the pandemic on global financial systems and various other macroeconomic factors have all contributed to the overall market turbulence in 2023. In response to such turbulence, and the expectation that these market conditions will continue into 2024, there is a growing emphasis across the market on structuring deals to mitigate risks and protect against future uncertainties.
• Given such turbulence and the increased cost of borrowing, the fund finance space has become and will continue to be increasingly relationship-focused, with the quality of client relationships influencing lenders’ decisions to deploy capital. Lenders aim to offer multiple fund finance products to their strongest client relationships, moving beyond the traditional subscription lines.
• Across the market, facility terms are tightening, pricing is increasing due to liquidity costs and there is reduced liquidity available from traditional banks due to capital constraints or proactive capital management. As a result, fundraising processes are taking longer, with funds extending existing facilities where possible or seeking smaller subscription facilities and potentially turning to non-bank lenders for capital. It is believed that institutional lenders will gain market share to fill any gaps left by traditional lenders. This is expected to drive the development of an active fund finance syndication market, where bank and non-bank lenders will collaborate to support sponsors’ larger facility needs.

PANEL: ESG Fund Finance Update

• Europe is a hub for ESG financing and continued growth is expected in the European fund financing market.
• The LMA (Loan Market Association)’s recent publication of model provisions for sustainability-linked loans marks a significant milestone in ESG financing. The provisions are intended to provide certainty in the market, while also maintaining sufficient flexibility in order for the provisions to be adapted across different contexts, asset classes and financial institutions.
• A key LMA provision is the sustainability amendment event which recognises that circumstances may change over the term of a loan and allows parties to amend KPIs if certain conditions are met. This will help ensure KPIs remain relevant over time.
• There are significant financial costs involved in realising sustainability goals and implementing ESG strategies and a key commercial question is who should bear such costs.

PANEL: Ratings, Capital Relief Structures and Risk Transfer

• Increased demand in the past two years for the rating of subscription line facilities by credit rating agencies has had a two-fold effect. It has firstly allowed banks to better manage capital and has separately enabled a number of new non-bank lenders to enter the market.
• The publication by Fitch Ratings in Q1 2023 of a draft rating methodology document for subscription line credit instruments is a major step forward for the subscription line credit market. The panel considered that similar technology for NAV facilities may also not be far away given the obvious upside with rating these kinds of instruments.
• Main advantages of rating subscription line instruments include the potential for easing bank-lender supply constraints such as the restrictions which flow from concentration limits, regulatory capital requirements and balance sheet capacity. While subscription line products have not generally formed part of an ‘originate to distribute model’ for lenders, rating potential may mean that a wholesale debt capital market exit is possible for originating bank or non-bank lenders; could we see subscription line and NAV facility CLOs – watch this space!
• Regulatory capital relief in the form of significant risk transfer (or SRT) structures can be a key tool for banks in unlocking balance sheet potential to free up credit lines in the current market where leverage financing availability has tightened.
• SRT structures involve banks identifying portfolio assets on their balance sheet against which credit protection can be purchased from a protection seller or SRT provider which will deposit cash with the protection buyer. In essence, these arrangements are similar to a financial guarantee. This kind of off-balance sheet exercise provides banks with the capacity to continue lending without having to seek a range of consents to transfer lender interests.
• The panel noted, in particular, that no two SRTs are the same and that they are not packaged transactions. A key component of an SRT exercise is ensuring that the structure complies with applicable risk retention rules.

PANEL: Innovation and New Structures

• The fund finance market has continued to innovate and evolve over the past few years. It is no longer just revolving credit facilities, with borrower’s now being able to access a variety of products, including sublines, NAVs, umbrella facilities, hybrids, equity commitment letters and preferred equity. The panellists noted it is currently a lenders’ market.
• There is an increase in demand for NAV products, which are becoming more complex and used by a larger variety of funds.
• Some European banks are welcoming asset backed lending structures, which may bring them into scope of the EU Securitisation Regulation, which the associated requirements around risk retention, disclosure and reporting.
• Collateralised fund obligations (CFOs) are forms of securitisations which are structured as debt investments backed by a diversified portfolio of funds. These are particularly attractive for insurance companies investing into funds on a capital efficient basis for regulatory capital reasons.
• Rated feeders are also structured debt products, involving an SPV who issues rated notes to investors, which in turn invests into a single fund structure.
• The regulatory body for US insurers, the National Association of Insurance Commissioners, is currently assessing the regulatory accounting treatment afforded to debt instruments issued by CFOs and rated feeder structures, causing a wait and see approach for the continued use of these structures.
• Ratings will continue open up the market, especially for insurance and pension clients, who want to invest through debt structures. The panellists hope and expect to see more diversification in rating agencies assessing the market.

PANEL: Key Legal Points in NAV vs Subline

The moderator led panel members in a discussion that focused on trends they are seeing in relation to how fund finance borrowers are arranging for and obtaining NAV and subline debt financing in a market characterised by increased uncertainty and tightened liquidity. Key takeaways from the panel discussion were that:

• In an environment where there is increased risk associated with achieving the completion/execution of facilities, funds are more often looking to lock in facility options with more lead time in advance of their actual financing needs.
• While it remains true that subscription line facilities are usually sought early in the life of a fund and NAV facilities are more typically entered into in the mid and later life of a fund, there have been some subtle changes with respect to timing.  Planning and arranging for NAV facilities is occurring earlier in the life of funds.
• Fund managers are also searching more actively for new sources of liquidity.  In doing so, they are broadly reviewing the landscape of liquidity sources and looking to define with greater precision the liquidity providers best suited to understanding their needs and business, more frequently with the assistance of debt advisors.  For NAV facilities, fund managers are increasingly focused on lenders who have a demonstrated track record and understanding about such financings.
• Panel members observed that some fund sponsors are increasingly willing to pay higher fees in order to lock in facilities with longer terms, which fees they are in some instances mitigating by giving increased security in connection with the granting of such facilities.
• In the current environment, which is characterised by an increased cost of capital, borrowers are scrutinising more closely the question of whether they actually need a fully committed facility.
• As a precautionary measure, some funds are looking to oversubscribe for facilities in order to avoid having to face an uncertain availability of liquidity in the market in the future.
• When negotiating facilities, borrowers are seeking more flexibility with respect to the terms of facility extension requests, and they are planning for the implementation of facility extensions and re-financings earlier and earlier.
• Quality communications with limited partners/investors regarding debt financing remain a high priority for fund managers who consider it essential that their limited partners/investors understand the basis and purpose of such financings.  In doing so, the intention is to have fund documentation (limited partnership agreements, private placement memoranda and related fund documents) in place from the outset that is conducive to obtaining the necessary and appropriate debt financing that the fund in question may require.