The Fund Finance Market Passes the COVID-19 Test
With more than eight months passed since the COVID-19 pandemic was declared, the U.S. economy and capital markets are experiencing an uneven yet steady recovery. Similar to the broader and highly dynamic private markets space, the fund finance market is likely to come out of the pandemic stronger, more resilient and more widely valued for offering liquidity in highly disruptive times.
An economy moving forward in recovery mode
After suffering its worst contraction since WWII, the U.S. economy is recovering from the coronavirus-induced lockdown that began in March. Early and aggressive fiscal and monetary policy combined with the reopening of the economy have seen output rise and unemployment fall from its peak of nearly 15% last April. Going forward, the economy’s outlook will likely be determined by progress in controlling the virus and beginning to introduce a vaccine globally. What’s more certain is the deep and long-lasting impact that the pandemic and associated downturn will have on society, government policy and business.
North American private equity market continues to rebound
The shock and uncertainty created by the pandemic had a significant negative impact on deal-making starting in Q2 as general partners (GPs) focused on stabilizing their portfolio companies. According to Preqin, aggregate deal value for the first three quarters reached $132.7 billion, which represented a 22% decline over the same quarters in 2019. Similarly, the number of deals for the first three quarters fell nearly 20%, compared to 2019.
By shutting down roadshows and in-person due diligence in early spring, the pandemic and global lockdown disrupted fundraising and encouraged investors to allocate capital to larger, widely known GPs with solid track records. According to Preqin, total private equity fundraising volumes are expected to reach about 60% of last year’s volume, with less than 75% of funds closing on capital commitments during Q1-Q3 2020, compared to the same period last year. Fundraising is expected to bounce back as historically low interest rates push investors seeking yield toward alternative investments. Additionally, experienced LPs, aware that the best vintages coincide with severe market downturns, continue to invest in top-performing funds.
Figure 1: North American Private Equity Fundraising
Fund financing adapts and gains resiliency in a new environment
In line with the broader private markets, the fund finance market has experienced rapid growth since the Global Financial Crisis (GFC). The growth of funds and diversification of strategies have driven the demand for liquidity in the form of subscription credit facilities and other related products — reflecting a sizable subscription facilities market. On a global basis, Preqin estimates a borrowing base of around $800 billion for the $2.4 trillion in global private funds’ unspent capital, which includes private equity, venture capital, credit and infrastructure. This figure assumes conservatively that roughly one-third of dry powder is committed by investors with high credit quality, which banks would be willing to underwrite. With dry powder for North American private equity funds reaching almost $1 trillion at the beginning of October 2020, we estimate that the addressable fund finance market, solely for private equity funds, is roughly $500 billion.
Figure 2: Dry Powder, North American-Based Funds ($B)
The pandemic-induced economic disruption represents an early test of the fund finance market’s resiliency and integrity, particularly given its relatively recent emergence. There is little question that the value of short-term cash management tools, such as subscription credit facilities, increases significantly during times of market dislocation and uncertainty as liquidity becomes scarce. In addition, the pandemic helped, at least temporarily, to reshape some existing market trends while accelerating the evolution of new ones.
Adapting to market conditions
The sudden and unexpected nature of the pandemic quickly caused a few shifts in the fund finance market. Early in the pandemic, some banks became more attuned to managing their balance sheet and credit risk. In some instances, term sheets that may have normally taken a week or so to complete were extended to months or even retracted altogether — although this reaction has since attenuated. Across lenders, loan tenor of committed subscription credit facilities has generally shortened from three to two years, and the interest rate spread on these facilities increased, in some loans by 50 basis points. Pricing disparity was already prevalent across the industry before COVID-19 due to the wide variety of GPs and their unique LP bases, amongst a host of other factors. The market upheaval caused by COVID-19 in some ways has highlighted this disparity.
Opportunities emerge for more nimble lenders
The rapid shift in the investing environment caused by the pandemic has helped to highlight the breadth of available fund financing options and the comparative advantages of different providers. For example, while traditional bulge bracket banks bring scale and perceived size benefits, they also may come with higher costs and administrative burdens in terms of loan documentation and complex borrowing base formulas. Larger-sized lenders, especially lenders focused on megafunds and deals, may also become constrained in their ability to successfully syndicate a large facility in a stressed market.
The current downturn puts a premium on smaller, more nimble banks, which were positioned to quickly respond to managers’ requests for solutions to support their changing needs. As mid-size banks tend to offer simpler products in terms of lighter loan documentation demands and less complex borrowing base formulas, many were able to step in more rapidly to support the evolving needs of their clients. Other loan providers, such as some non-bank lenders, have seen discussion of net asset value (NAV) lending by funds looking to extend the runways of portfolio companies. With NAV lending, maturing funds holding on to portfolio companies — often beyond their typical 10-year life structure — are able to access liquidity based on a fund’s NAV or underlying cash flows.
The value of relationships to GPs
Once the pandemic hit, the first reaction for many GPs was to look inward and make sure their own portfolios were stabilized. As part of this process, fund managers naturally migrated to preexisting relationships with strong, trustworthy partners — especially those providing multiple services and products. In a time of stress and uncertainty, tremendous comfort can come with dealing with a long-term partner who is not only the GP’s main house bank, but can also provide simple credit solutions for the Fund, the Management Company and the GP co-invest entity.
With the economy stabilizing, the deal pipeline beginning to flow and the fundraising market rebounding, we expect robust competition to reemerge in the fund finance space. Institutions that continue to innovate and respond quickly to the needs of their clients, including both business and personal banking needs, will be best positioned to adapt and succeed in a more competitive environment where strong relationships and service excellence matter.
Takeaways — Pandemic Lessons
After eight months since the COVID-19 pandemic began, now is a good time to take note of some key lessons that have surfaced in relation to the fund finance market.
- By all measures, the fund finance market passed the COVID-19 test. In response to the unprecedented market disruption, banks were able to thoughtfully and deliberately work with clients to address short-term liquidity demands — whether it was supporting portfolio company needs or quickly putting in place credit facilities for new funds aimed at taking advantage of market opportunities. While limited partner defaults were speculated, they did not materialize to the degree feared. Stories circulated of one-off events: occurrences of late payers or high net worth individuals whose interests were ultimately sold or transferred. In general though, LP defaults during the pandemic were not an issue for the industry.
- The industry’s diversity of solutions and continued evolution are critical assets. Just as owners of companies gain tremendous strength from being able to choose from thousands of GPs to better match their needs in terms of capital, capabilities and vision alignment, GPs also gain an advantage from the breadth of ever-evolving fund finance options provided by a diverse banking industry.
- The pandemic highlights the value of looking beyond price to select a fund finance partner. The critical importance of experience, transparency and communication are heightened during market downturns and help to define the value of a trusted and aligned, long-term partner.
- Constant change and adaption are critical to survival and success. To respond to sudden and severe shifts in the market, fund finance groups, like their private equity clients, must be nimble and agile — whether it’s finding creative ways to leverage technology to better connect with clients or offering new and customized services to address new challenges and opportunities.
Like the broader private markets space, the relatively new fund finance market has held up well during the unprecedented change and disruption unleashed by the coronavirus pandemic. Going forward, the resiliency, growth and productive capacity of borrowing facilities, such as subscription credit facilities, will continue to offer strong support to the country’s dynamic private markets industry and the broader economy.