Correcting the imbalance

How has the macroeconomic and geopolitical environment impacted the lending market?

Jonathan Harvey: Increased interest rates have clearly impacted the overall cost of finance, which has made borrowers think more carefully about the debt that they are taking on. However, while we are still operating in a higher rate environment, there is at least now better visibility on the downward trajectory of interest rates, which is restoring a degree of confidence to the market.

Linked to the increased cost of financing, meanwhile, deal activity has slowed considerably; reducing demand and creating an excess supply of lending. Indeed, for the right deals the market can be quite competitive today, certainly when compared to a year ago.

In terms of the geopolitical backdrop, a majority government in the UK has improved perceived stability, albeit with some short-term challenges. Equally, the change of government with large-scale support in the US – regardless of your political views – should be positive for markets. However, while a sense of political stability has been restored to some major economies, others across the EU are facing difficulties. All of that feeds into the new operating environment that we are working in today.
 

Are there any particular trends or innovations that you anticipate in the way that fund finance is structured?

Harvey: There is likely to be an imbalance in supply and demand for subscription lines when fundraising eventually picks up and that is likely to drive change. Subscription lines have historically tended to involve committed revolving credit facilities, but there is now a move towards more structured credit participants coming into the market. These lenders are more likely to offer term loan structures, or part revolving credit, part term loans, because these can then be packaged into a securitisation or other structured credit vehicle. This makes the overall return attractive for institutional investors.

Furthermore, term loans are also attractive for borrowers; because it is essentially a pay-as-you-go model. Clients are not paying for facilities that they are not using, which, particularly in a slower deal environment, means significant cost benefits. We have been providing the term loan funding structure for a number of years, working with high-quality financial institutions to help them gain access to the subscription financing market.

Most recently, we have entered into a partnership with Ares Management to offer this. I think this shift will go some way towards rebalancing the supply and demand dynamics that the subscription finance market may face when fundraising returns to normal.
 

In addition to distribution of capital, what other use cases are you seeing for NAV loans?

Harvey: Prior to the increase in interest rates, NAV loans were a cost-effective way to return money to investors. With all-in costs coming in at or below the 8% hurdle rate, that gave GPs real flexibility from a borrowing perspective. Another use case that we see includes the use of NAV loans to support struggling portfolio companies, as an alternative to injecting additional equity and using NAV loans to support bolt-on acquisitions.

While a rise in interest rates has all but eliminated the distribution of capital models, because the overall cost of NAV loans now exceeds the hurdle rate, two other rationales have become more prominent. There are still portfolio companies that are underperforming, and NAV remains a relatively cost-effective way of supporting those businesses; curing covenants or providing additional firepower, so long as you believe the turnaround story.

Meanwhile, a lot of the NAV facilities that we are looking at today are purely for bolt-ons. These deals often involve very low loan-to-value (LTV) ratios – sub 10% – which keeps cost down while improving the platform’s potential exit multiple. From a lender’s perspective these are relatively low-risk loans, due to the low LTV, meaning this has become a much more popular motivation for using NAV loans than the distribution of proceeds.

How have you seen demand for continuation vehicles evolve through this period?

Harvey: Continuation vehicles have probably been the main beneficiaries of the slowdown in the M&A market. They have really come into their own as a viable exit option for GPs in the past 24 months. Managers are coming under a lot of pressure to create liquidity for LPs, but NAV facilities have fallen out of favour due to the overall cost and other exit options are few and far between. Continuation vehicles have stepped in to fill that void.

Buyers and sellers are happy agreeing on a price. LPs can choose whether to roll over into the new fund or not. In many respects it is a win-win and continuation vehicles continue to rise in popularity. That should be viewed as a positive; because when the market returns to normal conditions, continuation vehicles will join IPOs, trade sales and both minority and majority sales to private equity firms as viable exit solutions.
 

Are you seeing an increase in demand for ESG lending?

Harvey: ESG is obviously front of mind for GPs, LPs and finance providers. However, particularly in the fund finance space – where we were an early adopter of ESG-linked margin ratchets – demand for ESG and sustainability-linked loans has somewhat plateaued. To further accelerate demand, we need to see some sort of increased regulatory support in terms of capital treatment, otherwise the underlying credit does not change from the lender’s point of view.

Of course, there are benefits from an environmental and societal perspective, but it is hard to make a meaningful price adjustment when the risk you are taking as a lender and the capital treatment is the same. In order for the popularity of ESG-linked loans to increase, we need to see wider change in terms of how these loans are treated in the UK and European regulatory markets.
 

Do you expect to see a significant recovery in IPO and M&A activity in 2025? What would that mean for lending markets?

Harvey: I think there are signs that things are improving. Our own activity levels across the fund solutions team are up on this time last year. A lot of our facilities are linked to capital calls and capital calls, of course, are typically linked to making an investment. As I have already said, deal volumes have remained low for some time. However, we have now seen a slight uptick among our mid-market client base. There are green shoots appearing, which is good news.

Meanwhile, at the upper end of the size spectrum, some of the largest managers sent back meaningful distributions to investors during the first half of the year. This is a clear indicator that the market is coming back to life. Hopefully, we will continue to see the wheels turning ever faster as we head into this year.

Certainly, there is greater confidence in where interest rates are heading and the political environment in many regions is more stable, so the outlook is more positive than it has been during the past 12 months. It is unlikely that activity levels will return to pre- Covid levels any time soon, but we are heading in the right direction.