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Loeb Finance partner Peter Beardsley gives an insider perspective on the world of fund finance, with insights into the rise of hybrid and net asset value (NAV) facilities, the increasing role of high net worth and retail investors, and the legal challenges posed by legacy limited partnership agreements (LPAs). He explores how market shifts, lender innovation and fund structuring issues are driving change in the sector.
Tell us about your practice and the types of fund finance matters you generally handle.
My practice focuses on fund finance, asset-based lending and private bank lending to high net worth individuals. I represent a wide range of financial institutions and borrowers, typically in secured credit facilities, including subscription lines, NAV facilities, asset-based lending and specialty finance transactions. I also advise on private banking matters like art loans and securities-backed lending and regularly write and speak on topics relevant to financial institutions.
What are some of the key trends you’re seeing in the fund finance space right now?
We’re seeing a bit of a slowdown in new sublines, especially for newer funds, largely due to fundraising delays, although larger sponsors are still getting deals done and winning more market share.
One trend we’re seeing is a bit of an uptick in separately managed account [SMA] credit facilities, where middle-market banks are working with sponsors and lead investors on custom strategies. Some of these SMAs are being set up for investors that have historically come with more complexity on the legal side, but lenders are now stretching to find solutions as to how to provide SMAs to Texas, Arizona or Illinois governmental entities, for example, and are leaning on legal counsel to assist.
We’re also seeing an increase in umbrella credit facilities. Lenders are using these to offer more efficiency and potential cost savings, particularly for sponsors that want to minimize unused fees. Similarly, there’s been a rise in uncommitted facilities for the same reason where there are funds that aren’t able to deploy capital as quickly as they’d like. There has also been growing interest in hybrid credit facilities and NAV credit facilities, especially among sponsors with private credit strategies.
How has the legal landscape around fund finance evolved in recent years?
Subscription credit facilities have largely become an off-the-shelf product, particularly for more recent vintage funds. But there are still legacy facilities from the mid-2010s with less sophisticated LPAs, where the investment periods have expired and there are lenders continuing facilities for relationship reasons. The challenge is that it may be unclear and also untested as to whether a lender can step into the general partner’s shoes post-default to call capital since the LPAs at inception weren’t as explicit as newer-vintage LPAs with respect to typical lender protections.
There has been a noticeable demand from funds looking for more debt. Whether it’s for bolt-on investments or dividend recaps to funding distributions to investors, sponsors have broader financing needs. In turn, sponsors are leaning on their lending partners to find creative solutions or, in some cases, to push the boundaries of what credit committees might have been comfortable with in the past. Sometimes, this comes in the form of second lien facilities with higher advance rates to lend against suppressed availability or layering in a NAV facility where there is an existing subline.
There has also been an increase in high net worth investors (sometimes outside of feeders), particularly in the middle-market space. Historically, lenders might have shied away from funds with those investor compositions, but that’s starting to shift.
Lastly, we’re starting to see some lenders securitize their loans and create more novel credit facility structures to allow them to sell down exposure later to get more favorable capital treatment, which has created some initial headaches in structuring syndicated deals for lenders that aren’t as familiar with that product but still want to build relationships with those agent banks. It’s taken a bit of education and diligence for some of our clients to ensure the collateral package and facility mechanics still get everyone to the same place as they would in a more traditional subline.
What types of issues or questions are top of mind for clients when it comes to fund finance?
There’s always a question as to whether the fund is financeable—that’s the fundamental question—both from a legal structuring and an underwriting standpoint. Every so often we will still come across a structure where sponsor counsel would have benefited from speaking with their finance colleagues much earlier in the fund formation process to ensure that they were creating a structure that a lender would ultimately be able to lend to. It’s surprising that this still happens, particularly in the NAV and hybrid spaces, where maybe those structures weren’t contemplated at inception. It can sometimes feel like trying to fit a square peg into a round hole if the investments are held in a nontraditional way or there are cash management issues around distributions. In some cases, only a portion of the deal fits the more traditional model that a bank would consider lending to.
For NAV and hybrid deals for private credit funds, we’re very focused on what the underlying assets are. These facilities ultimately look more like warehouse facilities that are dressed up as NAV facilities, but functionally they behave very similarly to traditional “lender finance” deals. Sponsors recently have been trying to add in payment-in-kind interest and have more flexibility with respect to restructuring the underlying loans as the exits on their end become slower, and I think lenders need to remain vigilant to ensure that the underlying credit quality is there.
What’s next for fund finance, and what should market participants be thinking about from a legal perspective?
I hope lenders are getting comfortable with lending to funds with high net worth investors and retail investors, since a lot of the institutional investors are likely capped out in the short term as they are waiting for exits and distributions from legacy funds. We’ve seen some prominent institutional investors in recent months sell down their private equity (PE) exposure in the secondary market, and PE will always be looking for new sources of capital. That relief may be coming in the short term if retail investors and 401(k)s are permitted to invest in PE funds. There’s a lot of speculation that the current administration may push to make this happen, which could bring a ton of new capital into the space. That new capital could be helpful in facilitating exits for existing investors, but there’s always the risk of an asset bubble if the growth case and valuation for those assets aren’t there. The big question then is: Who will be left holding the bag? If lenders need to call capital on those retail platforms in a distressed scenario, it’s not hard to imagine a different regulatory regime in the future that is sympathetic to investors and their direct retirement funds. That kind of situation could introduce some political risk into the process, depending on how those investments are performing.
Even though it’s not often discussed, the reality is that fund finance has long been a very safe space, with minimal defaults over the years. But if the boundaries continue to be pushed—adding more leverage and creative financing structures—and we do hit a bubble with respect to asset prices, eventually something is going to give. If that happens, both the loan documents and the underlying fund documents could be tested in ways they haven’t been before.
As someone who’s been trained in both asset-based lending and restructuring/bankruptcy, that risk is always in the back of my mind, even if it’s not widely acknowledged in the industry. Most of my clients are large banks that are well positioned to assess their portfolios and continue to take smart risks. Our clients that are private credit funds that lend to the fund finance sector are very experienced and price in a certain amount of risk for the more novel structures. In that environment, there’s always the risk of a race to the bottom, and that’s something we all want to avoid.
