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The Spice Of Fund Finance – Fund Management/ REITs

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William Cowper once wrote that “variety is the very spice
of life.” This could ring true in many circumstances, but is
becoming particularly fitting for alternative asset managers, or
AAM, when evaluating sources of liquidity across a variety of fund
finance solutions.

Since the dawn of finance, the differing requirements of debt
providers has created a range of financing options across the
private and public capital markets. For corporate borrowers, these
markets are mature and well understood. However, for AAMs, the debt
markets are relatively embryonic and ever evolving, with a range of
capital providers. Here we explore the types of capital available
to AAMs across the various fund finance products, and the growth of
institutional capital in each.*

Turning first to the most developed, widely understood and
liquid fund finance product available to AAMs – the
subscription facility. This has been a segment of the market
historically only serviced by bank lenders. In the past, the
primary driver for this, and the barrier for insurance capital in
particular, has been prepayment risk, which, due to the revolving
nature of subscription facilities has created complexities with
matching adjustments under Solvency II. Appetite is evolving,
however, and we are starting to see an increase in the availability
of this product from nonbank lenders, for a number of reasons:

1 Innovation: Insurers, asset managers and
banks are all finding ways to address the Solvency II issue with
longer dated trades. This has been achieved either by incorporating
prepayment penalties linked to SWAP rates to compensate for the
break costs resulting from early repayment, or by the incorporation
of term facilities that interact with traditional revolving
subscription facilities, which reduces the undrawn element of the
main revolving tranche, thus enhancing lenders’ returns (which
are diluted by large undrawn commitments), while boosting the
internal rate of return for AAMs by terming out capital calls;

2 Revaluation of short-term liquid reserves:
There has been a revision in many insurers’ asset allocation
and willingness to hold cash, given low yields resulting from money
market rates, with insurers shifting assets into short duration
subscription facilities (12 months or less) that garner
comparatively superior absolute returns.

3 Relative value trade: Thirdparty rating
agencies are now SPONSOR CADWALADER The spice of fund finance
Analysis August/September 2022 ” Fund Finance 45 able to rate
subscription facilities. Depending on rating methodology and the
composition of the investor base, most subscription facilities are
rated between BBB and single A. With the focus from insurers and
asset managers being, in the main, on relative value, the question
is whether rising interest rates will continue to make subscription
facilities a reasonable value proposition.

The short answer is expected to be yes – the ICE BofA
Single-A US Corporate Index, which takes a weighted average of US
investment grade bonds, is currently yielding 4.23 percent for
instruments with more than one year until maturity. An investment
grade subscription facility will yield in the region of 3.60
percent (SOFRA + margin + annualised up-front fee), for much
shorter dated floating rate risk that is less affected by
macro-economic credit headwinds. For insurers and asset managers
that are less focused on relative value, rising benchmark/risk-free
rates enhance the overall yield on an absolute basis, as they do
not face corresponding increases in costs from funding themselves
in the interbank market 

For private funds, the yield of subscription facilities has
historically been unattractive. However, for the reasons above,
those that hold investments in insurance companies are now looking
to the portfolio assets to utilize the capital position and invest
in subscription facilities.

Moving next to what was once the opposite end of the liquidity
spectrum, general partner financing or management company loans
have been sought by AAMs since the inception of the fund finance
market in the US and Europe. These facilities were traditionally
seen as a relationship tool for the bank lenders that provided
subscription financing to the funds managed by the GP/manager, with
only a handful of bank lenders able to provide such structures, and
subject to a maximum tenor of five or six years.

Moving next to what was once the opposite end of the liquidity
spectrum, general partner financing or management company loans
have been sought by AAMs since the inception of the fund finance
market in the US and Europe. These facilities were traditionally
seen as a relationship tool for the bank lenders that provided
subscription financing to the funds managed by the GP/manager, with
only a handful of bank lenders able to provide such structures, and
subject to a maximum tenor of five or six years.

Ratings for GP and ManCo lines are strong investment grade,
driven by the contractual cashflows of the management fees, with
many agencies considering the payment of such fees as quasi-bank/LP
risk, with fee payments often funded by drawdowns under
subscription facilities. On a CFADS (cashflow available for debt
service) and/or leverage to EBITDA multiple, GP and ManCo lines are
comparably more robust than many investment grade corporate
facilities.

This risk profile, combined with AAMs’ desire for longer
duration capital, opens the door for many more institutional
investors to participate in this market. The question will be
whether the insurance capital accesses these types of facilities
through the US private placement market, where coupons are fixed
(typically over US treasuries), or whether capital will be provided
by the loan market with a spread over floating risk-free
rates/EURIBOR, and whether there is an opportunity to arbitrage the
benchmarks.

Finally, NAV facilities are where we have seen the most
evolution and interest involving institutional capital over the
past few years, particularly moving out of the pandemic. For real
asset managers (infrastructure and real estate), credit funds and
secondary funds, this is not a new phenomenon, and the bank loan
market that has historically served as a reliable source of
liquidity is expected to continue to do so for the foreseeable
future. For private equity managers, however, access to
leverage within the fund structure is a relatively new concept and
one that is being increasingly adopted by AAMs. 

The collateral/recourse package and covenant terms for NAV
facilities will dictate both the yield and 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 over the underlying investments), or
through an orphaned SPV providing a preferred note into the fund
structure.

Given the risk profile of underwriting residual equity value for
a portfolio of leverage buyout investments, liquidity is almost
exclusively provided by direct lending funds, asset managers and
the LPs that invest directly in the fund. However, a select few
bank lenders can also provide liquidity to these structures.
Conversely, the direct recourse facilities tend to have more
appetite from the bank market than non-recourse.

Given the infancy of the product, the type of lenders and the
highly structured nature of the financings, this remains a very
fragmented market where transactions are truly priced to risk
rather than “market” based on a number of factors
including diversity of portfolio, credit metrics of the underlying
assets and experience of the AAM.

In summary, the theory of evolution is not new, and to apply one
of Darwin’s presumptions that those that are most adaptable to
change are likely to succeed, could have some relevance for the
debt markets for AAMs. However, with different demands,
requirements and risk appetites from the distinct pools of
liquidity, lenders from all sources are likely to have room to
co-exist.

*All benchmark rates and yields are sourced from Bloomberg
and accurate as of July 5 2022.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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