Unlocking value in fund finance loan portfolios
The panel focused on both securitisation (cash and synthetic), sub-participation and syndication of loans primarily in the context of subscription fund finance.
What is syndication in a fund finance context?
From a legal perspective this is typically the more straightforward method of transferring risk. Syndication typically involves the outright transfer of debt to an investor who will replace the arranger of the debt (or often a proportion of the debt). Careful consideration will need to be taken with respect to the parameters for syndication in the credit agreement (as with other forms of risk sharing) and transferring legal title to the debt will involve the new lender of record forming a new relationship with the GP.
Capital call facilities are traditionally syndicated to banks given the RCF nature of capital call facilities (non-bank lenders do not routinely offer revolving loans), however there are other innovative ways of transferring the un-utilised portions of a capital call facility which can be held by a range of non-bank investors.
What is sub-participation in fund finance?
In a sub-participation arrangement, the originating lender remains the lender of record and no transfer of the fund’s debt occurs, meaning (as for synthetic securitisation) the arranger of the debt maintains relationship with the GP and is able to manage the level of information passed to the incoming investor in the debt. The sub-participation is effected by a sub participation agreement or funded participation agreement reflecting the transfer of risk to the new investor in the debt and the “back to back” arrangement, mirroring the economic effect of the loan participations to be passed on.
What is securitisation in a fund finance context?
Simply put, fund finance loans are packaged up and risk is transferred (often synthetically) sometimes via an SPV to a number of investors. Investors are repaid from the cash flows collected from the underlying fund financing debt and redistributed through the capital structure of the securitisation. Often the risk transfer is managed synthetically which means that the loans are not transferred, but the investors agree to take on the risks synthetically as if the loans had been transferred.
What are the benefits to an arranger of fund finance in transferring risk?
- Risk transfer arrangements provide capital relief to the arranger of fund finance debt by freeing up balance sheet to write more business with their core customers. By facilitating a lender’s balance sheet to write an increased number of deals, this consequently generates higher returns and unlocks value.
Synthetic risk sharing
- Both sub-participation and synthetic securitisation structures have the benefit of circumventing most restrictions on transfer language in credit agreements, given the majority of such language does not extend to sub-participations or synthetic arrangements.
- This allows the originating lender to maintain the relationship with their GP customers (both contractually and commercially) and manage levels of information flowing to investors to a level GPs are comfortable with ensuring the risk sharing does not interfere with the GP and lender relationship.
- From the perspective of the investor in the debt, there is therefore an extra layer of insolvency risk taken by the investor, given there is exposure to both the insolvency risk of the underlying LPs to the fund and the lender of record. Given the largely very highly rated LP base, the limited number of historic defaults in the market and the financial strength of the majority of lenders to funds, these risks appear to be low in comparison to other credit products.
Why is Fund Finance an attractive market for investors investing in risk transfer of fund finance?
The panel highlighted some of the benefits of investing in fund finance:
- subscription facilities offer limited credit risk and an extremely low historic default rate;
- if rated, the LPs are often highly rated leading to an attractive risk reward ratio;
- the illiquidity premium provides a higher return (despite the high quality of the underlying credits) vs liquid publicly traded debt;
- capital call facilities are (from a documentation perspective) often short dated so investors looking for a cash alternative can utilise the fund finance debt market;
- from a portfolio risk perspective, the risks are uncorrelated with other asset classes; and
- for a non-bank institutional investor, it allows them to access the market without needing to build origination capabilities. For the arranger, a non-bank institutional investor is not competing to sell its own ancillary financial products to the GP.
What are the obstacles?
- Concentration – given the highest quality LPs are active across a large number of funds an investor investing across a range of capital call facilities can find that they are overly exposed to a particular fund. A suggested way forward is to include the tier of LPs below the highest quality within the borrowing base of a capital call facility, given the financial standing of LPs, this would reduce concentration concerns while maintaining the low risk profile of the product.
- Disclosure in synthetic risk sharing contexts – (e.g. synthetic securitisation and sub-participation). In most cases an investor is likely to be told the domicile, credit rating and type of LPs against which they are investing however it can be difficult for an investor to take credit decisions on investments when they do not to know the names of the underlying investors, which is often the case. This feature however provides comfort to GPs and LPs from a confidentiality perspective.
- Disclosure in syndication – a new lender of record will usually require the disclosure of information regarding LPs in the borrowing base, which could be problematic for the arranger to provide.
- Transferability in syndication – credit agreements sometimes dictate that an arranger obtain the consent of the GP to transfer their debt. This could be refused.
- Committed facilities – given the relatively low levels of commitment fees in subscription finance an institutional investor needs a high degree of confidence that a committed facility will remain drawn in order for them to be comfortable investing.
- GP concerns – disclosure is the biggest concern given naturally GPs do not want their competitors to obtain information about them or their investors. In particular, specialist managers have more acute concerns where they are competing for a smaller pool of investors and deals. However ultimately the benefit of risk sharing could lead to a consequential reduction in price for GPs as the market adapts their level of comfort regarding disclosure.
- Immature market – the market for risk sharing in this space is still fairly immature and capital call facilities make up a very small proportion of the overall loan volumes in the risk transfer space, however given extremely low levels of defaults and the high quality LP base it seems a well suited loan product to risk share and therefore scale up.
- Growth – in the fund finance space has led to many banks hitting their risk limits more quickly, the market for risk sharing has similarly increased providing willing institutional investors with increased volumes of attractive risk weighted returns.
- NAV – NAV facilities are much more difficult for arrangers to risk share. The investor base willing to invest in a NAV facility by way of risk sharing will be highly differentiated from the pool of investors investing in capital call facilities, both due to structuring and the differences in credit protection afforded by both types of fund finance. As the NAV market matures, we are likely to see new investors looking to invest in NAV deals by way of risk sharing but at present this is more challenging.
- Competition – the numbers of lenders of fund finance has been increasing year on year and consequentially we may see a greater number of fund finance deals being subject to a risk sharing mechanic as lenders (i) compete to obtain the highest returns for their own investors and (ii) use risk sharing as a way to compete on price in an ever more competitive market.
- Reg cap pressure – as lenders work through a disrupted economic market it seems likely that they will want to release some of the regulatory capital pressure via risk sharing.
With institutional investors keen to invest in fund finance, the strong risk weighted return, the effects of market disruption, reg cap pressure and increasing competition, it seems likely that risk sharing mechanics and risk sharing in the space is set to increase.