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How has demand for fund finance been impacted by the Covid crisis?
Jonathan Harvey (JH): Demand has been strong. There have been no material defaults and so credit appetite among banks remains stable. There was a slowdown in fundraising and investment in the early stages of the crisis, two things that usually drive activity in our industry. That is now picking up and Covid has not had any material impact in terms of the overall risk profile of this type of lending.
This crisis hasn’t impacted lending appetite to the extent that the financial crisis did. But how would you describe market capacity?
JH: The pandemic isn’t the same as the 2008 crisis. But we are still feeling the effects of 2008. One of the outcomes of that period is banks now have to retain a lot more rigour and diversity to their balance sheets. They cannot be overweight to one asset class, meaning there are limits to what the banking system can cope with in terms of demand in any one particular asset class. The subscription finance market has been competitive for years. As a provider of fund finance facilities, we have positioned ourselves at the more innovative structured credit end of the market, where we can add more value to our clients. The increase in demand is exactly the scenario we envisaged a few years ago when we decided to apply our innovative mindset to expand beyond Investec's balance sheet. We did this by positioning the product with institutional investors such as pension funds and insurance companies – the type of investors that invest into funds as limited partners. Not only does this give us first-mover advantage for the potential growth going forward, but it enables us to be a holistic provider of fund financing solutions across their entire lifecycle in a scalable way. Whether that's subscription lines or more structured NAV-backed facilities.
The pandemic isn’t the same as the 2008 crisis. But we are still feeling the effects of 2008. One of the outcomes of that period is banks now have to retain a lot more rigour and diversity to their balance sheets.
How has the institutional market responded?
Neno Raic (NR): Institutional markets responded positively to the fund financing opportunity due to attractive returns for the risk profile of the product. Institutional investors being LPs themselves, were able to understand the market dynamics. The main hurdle to getting institutional investors on board with the strategy was creating a capital-efficient structure that allowed institutional capital to invest in fund financing opportunities. We were the first bank that created a rated debt instrument tailored to the institutional investors’ needs, without making any changes to the solution that we provide to our borrowers and the market. We have ensured maximum capital efficiency and solved the regulatory constraints that institutions have, whilst providing flexibility to the underlying fund borrowers. Investec has raised more than £3 billion ($4 billion; €3.3 billion) of institutional capital alongside our balance sheet, meaning our ticket sizes can reach up to £600 million. We have gained scale at that commoditised end of the market while doing the smaller, creative deals we are best known for.
What are the benefits of an institutional approach for the borrower?
JH: More so than ever a single, trusted point of contact is very important for borrowers. That is something that is lost in multi-bank club deals. Private equity firms understand how investors behave, managing committed capital themselves, so there is a sense of familiarity there. Equally, there is an opportunity for general partners to forge new investor relationships.
NR: There have been instances where investors got to know a GP as a lender and went on to become a fund LP. The other advantage for GPs is that capital call products are often perceived as relationship openers, designed as a gateway to ancillary income such as FX or M&A advisory fees. Meanwhile, our institutional investors are happy with a standalone risk/return profile they are taking with this product. This allows us to seamlessly manage both the investor and clients’ needs from day one.
Demand has been strong. There have been no material defaults and so credit appetite among banks remains stable.
How are LP attitudes to fund finance evolving?
JH: A few years ago, when the market was more buoyant, there was a lot of negative press about subscription lines being used to manipulate perceived returns. But the industry has become more transparent. There is, however, a desire from investors, particularly in periods of uncertainty, to have regular drawdown periods. If you are a large pension fund, it is beneficial to know when you are likely to have capital called - so you can manage your liquidity. Investors are generally more supportive of NAV facilities as well these days. Whether they are protecting value in the portfolio or, as we have seen during this crisis, capitalising on buying opportunities that the fund might have previously missed due to the lack of available capital.
Over the past five to 10 years, we have seen exponential growth in the fund finance market. From 2017 onwards, on an annual basis over a trillion dollars has been raised for alternative closed-end funds.
What innovations are we seeing in terms of the way deals are being structured?
JH: Liquidity alongside trusted banking relationships are key during uncertain periods. We have seen a number of positive opportunities for expansion of businesses via bolt-on transactions or further new acquisitions have arisen meaning we have seen an uptick in enquiries around hybrid and NAV facilities. In particular, NAV facilities play a more prominent role, where the fund itself may have high value but low liquidity at this point in time.
NR: We are also seeing innovation at the more commoditised end of the market. One of the structures we have employed recently involves a combination of revolving credit facility (RCF) and on-demand facilities. The RCF gives that certainty of funds and the on-demand facility provides additional capacity if needed without ongoing cost-minimising any drag on fund returns.
JH: That is particularly relevant when you have uncertainty around investment horizons, which is the case at the moment. The other area of innovation I would point to – although I fully expect it to become mainstream in due course – is facilities and ESG criteria linking together. That pressure is coming from investors, which want to align themselves with GPs that are not only talking about doing the right things but actually adhering to internationally recognised standards.
How will the fund finance industry evolve?
NR: Over the past five to 10 years, we have seen exponential growth in the fund finance market. From 2017 onwards, on an annual basis over a trillion dollars has been raised for alternative closed-end funds. And even with Covid, 2020 may also hit that trillion-dollar number. Demand for capital call lines fall at around 20-30 percent of funds raised, so this market is set to grow. That growth in demand has predominantly been satisfied by banks. What started as a handful of banking institutions doing this type of business, has grown to 50 or 60. Going forward we don’t believe the banking market alone will have sufficient capacity. Instead, we would expect increasing amounts of non-bank capital to come into the market to meet demand.
Please note: this interview originally appeared in Private Equity International, February 2021 edition.
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