Fund Finance: 2023 Reflections and Looking Ahead to 2024

A Global Offering

US Market Update and Predictions

A Turbulent 2023
Last year saw an acceleration of trends that emerged in 2022 with respect to the subscription-secured credit facility market, including increases in pricing and a tightening of the availability of credit from traditional market participants. Despite escalating costs, demand from borrowers remained high, and new lenders moved into the market to meet this demand. The market shock stemming from the failures of First Republic Bank, Silicon Valley Bank, and Signature Bank were significant, and the sales of loans to new lenders have resulted in new borrower-lender relationships.

Looking into the year ahead, we expect to see continued higher refinancing volume as venture and smaller funds change subscription line providers in response to last year’s banking crisis. Many such sponsors have existing lines of credit up for renewal or recently raised funds and note that they are looking to change providers because (a) existing lenders are not willing to renew the lines or to do so on competitive terms; (b) individual moves within the market mean that relationship bankers have moved to new providers; (c) an existing lender is no longer offering management company lines, general partner (GP) coinvestment facilities, or other products; and/or (d) new market entrants are making an aggressive push to take share.

Fundraising-Driven Trends
We expect demand for subscription lines to remain strong in 2024 and likely increase as fundraising gains momentum in reaction to flattening interest rates and market opportunities. Flattening and anticipated decreases to interest rates will enable fund sponsors to once again use facilities in a manner that is accretive to returns and not just for cash management and liquidity.

Another trend we expect to see in 2024 is a movement by both lenders and borrowers to rightsize subscription lines — borrowers will seek to minimize excess up front and unused fees, and lenders will focus on not over-allocating capital to facilities with low usage. Although early 2024 indicates a stabilization of pricing, we expect many sponsors to manage facility costs by putting in place smaller credit facilities, having a fully or partially uncommitted facility, and/or calling capital more frequently to keep drawn line balances lower.

In addition, as more sponsors turn to high-net-worth individuals and family offices to raise capital, we expect pressure on banks to take a more flexible underwriting approach that provides more borrowing base credit to types of limited partners (LPs) that larger banks historically have had a harder time underwriting (and often haven’t needed to underwrite to provide sponsors sufficient borrowing capacity).

A Bigger Toolkit
We expect to continue to see managers explore the full range of fund finance products and look to utilize a toolkit that extends beyond traditional subscription line financing. We predict a continued interest in and increased exploration by fund managers of net-asset-value (NAV) financing in the US market. In particular, we have assisted clients (across asset classes) on a variety of products that fall under the broad category of “NAV financing” but vary widely in purpose, terms, and collateral package (and associated structuring considerations) and we expect the increase in these varied products to continue into 2024 and beyond.

European Market Update and Predictions
Many of the trends observed in the US market were echoed in the European market in 2023. High interest rates have been compounded by pricing increases in the subscription line market as demand has outstripped supply (allowing lenders to adopt more cautious provisions and tighter facility controls). This led many managers to carefully consider the use of such products by their funds (notably against the backdrop of a more challenging fundraising environment); generally, the valuable treasury function of capital call lines meant that such financings were still being implemented but, as in the US market, with more careful consideration from participants as to size, tenor, and utilization profile.

The settling of pricing and cautious optimism about the 2024 fundraising environment provide a strong foundation for an exciting and busy year (one that is already well underway). As many traditional lenders continue to prioritize strategic relationships, we are seeing an opportunity for innovation and for more agile participants (including an increasing number of nonbank lenders) to make moves for market share.

We expect NAV financing to continue to be a key consideration for many private fund managers as they look to manage their liquidity, either as an option or an enhancement to other liquidity strategies such as continuation vehicles. Specifically, we anticipate that the continued trend of midmarket managers looking to explore and adopt such products will only continue; this is evidenced not least by the increased planning at the point of fundraising by managers for their implementation, including providing for the necessary flexibility under fund documentation and structures from the outset of fund formation. We expect the dialogue with investors as to the use case for NAV financing to continue as GPs adapt and increase their use of such products and are able to demonstrate clear benefits to investors; in many respects, we see echoes here of the conversations between market participants at the early stages of widespread adoption by private funds of subscription facilities many years ago.

Asian Market Update and Predictions
The US banking turmoil in early 2023 raised concerns for fund liquidity and accessibility among private equity funds around the world in the past year. Notably, however, the Asia–Pacific fund financing market has been less exposed to the direct impacts of the crisis given tighter regulatory supervision and more diversified banking relationships in the market.

A number of factors are driving growth in what remains a relatively nascent market when compared to the United States and Europe. Local pricing and the entry of new participants are key among these. On the supply side, new local market entrants have stepped into gaps created by the market shocks discussed above, offering Asia–Pacific borrowers more diverse financing options and access to a widening variety of fund financing products. Alongside this, US and European banks continue pushing to become more active in the wider region. And as the Asia–Pacific market remains dominated by bank credits, with alternative lenders making up only approximately 25% of the region’s markets, pricing remains cheaper than in other global markets. Against this backdrop, we have seen a recent uptick in US and European sponsors coming to Asia to borrow. This demand-side trend is coupled with local funds’ increasing interest in fund financing solutions. While a softer China sector will likely see less demand from China-focused funds for certain products, regional diversification could be a welcome trend for participants and the development of the regional market.

Demand remains strong in financing lines that have historically performed well in the region, such as subscription line and management/GP line financings. Market participants are also hopeful that the Asia–Pacific NAV financing market will continue to develop. It will be interesting to see how borrowers and financiers alike address asset management demands, valuations, and exit pressures as they turn to secondaries options and the fund finance toolkit over the year ahead.

We believe the Asia–Pacific fund financing market will remain resilient, continue to attract more market participants, and develop stably in 2024 and beyond.

Zooming in: Hot Topics and Growth Areas

Credit Funds
For credit funds in particular, the full suite of fund-financing tools is essential to smooth fund operations and achieving commercial objectives. We saw several key themes emerge in 2023 and expect them to continue through 2024.

Credit fund managers are leading innovative structuring in working-capital liquidity across their platforms, including through sponsor-provided solutions or sponsor-managed third party funds. This is particularly important for funds or separately managed accounts for which it is difficult to arrange traditional third-party financing (for example due to size or structure of the investor capital).

On the supply side, we have seen credit fund sponsors pushing further into the finance-provider market through, for example, preferred equity financings to funds or NAV secondary loans written on credit fund LP interests.

Finally, credit fund sponsors in particular continued to work on and complete structured solutions for insurance investors through rated notes feeders and collateralized fund obligations, notwithstanding concerns about the regulatory direction of travel based on National Association of Insurance Commissioners meetings throughout 2023. We see this as a creative part of the fundraising tool kit for credit fund sponsors to help differentiate themselves, which may become more important if fundraising activity in 2024 remains lower.

Secondaries
NAV and hybrid financing are increasingly being used as transaction financing on continuation fund structures. The secondaries market is undercapitalized, and debt financing can help fill the gap. Particular considerations for NAV financing in this context include the number and nature of the assets being transferred to a continuation fund (and ensuring the debt financing is not prohibitively expensive if the portfolio is very concentrated). Only certain providers can offer NAV loans on concentrated continuation funds, and they may require additional collateral from outside the continuation fund.

We expect to see hybrid financing continue to be an attractive financing solution in 2024, especially for concentrated deals. The investor base in these deals can be helpful; they typically comprise sophisticated specialist secondaries investors, some of whom take “lead investor” positions in the continuation fund (with significant skin in the game). While most large secondaries funds can utilize subscription facilities relatively cheaply due to their diversified investor base, NAV or hybrid financing at the continuation-fund level can assist smaller investors or those with limits on their ability to borrow directly.

Meanwhile, we expect to see a continued trend of established secondaries funds deploying levered and unlevered parallel structures, offering “sleeves” to investors with varying appetites for debt. However, we do note that this contrasts with a general trend in 2023 of leverage not being deployed as freely in LP trade transactions as has previously been the case, given the increased cost of borrowing.

We also see an increased scrutiny from managers of financing options to maintain or increase GP commitments to continuation funds.

Preferred Equity
Last year saw preferred equity as an important strategic option for private investment funds facing valuation uncertainties and a challenging exit environment. Our experts in this field were pleased to have contributed a chapter to the recently published edition of the fund finance market’s leading textbook, Global Legal Insights’ Fund Finance Laws and Regulations.

Because the year ahead is expected to see continued scrutiny of liquidity options, we encourage market participants to review the chapter “Assessing Preferred Equity as Part of the Financing Toolkit” here.

The article details the nature of preferred equity, highlighting its distinction from debt financing due to its equity characteristics, lack of a security package, and positioning in the capital stack with priority above common equity but below creditors. It examines the structure, key terms, and necessary confirmations for successful preferred equity financing, including the importance of tax, legal, portfolio company diligence, and accounting considerations.

The authors also discuss the strategic uses of preferred equity for sponsors, such as optimizing the capital structure, enhancing returns, and facilitating liquidity without the constraints of traditional debt. And they underscore preferred equity's growing appeal as a flexible, efficient financing tool that complements or serves as an alternative to NAV financing, reflecting its potential to address the diverse liquidity needs of funds and their sponsors effectively.

Fund Finance: A Vibrant Community and an Exciting Year Ahead
Goodwin has been a longstanding and active member of the fund finance community; 2023 saw our international team meet with clients at summits, symposia, and conferences across the United States, Europe, and Asia. Over the course of 2023, we hosted numerous market events and published an array of thought leadership on a variety of topics related to fund finance. (Do sign up for our market updates here!)

One particular highlight of our year was hosting the Fund Finance Association’s Diversity in Fund Finance Autumn event at our offices in London. The goal of the event was to create a forum to cultivate and promote diversity, equity, and inclusion in fund finance, and we were delighted to host so many attendees who shared that aim.

As the fund finance market continues to grow, so does the number of stakeholders involved; this is evidenced by the scale of the 2024 Global Fund Finance Symposium itself, where we look forward to seeing many of you: our existing and new clients, colleagues, and friends.

While reflecting on a busy 2023, we gratefully look forward to partnering with our clients and industry partners over the coming year in a fund finance market that remains vibrant and full of opportunity.

 

This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided on the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin or its lawyers. Prior results do not guarantee a similar outcome.