Closed-ended fund managers may require leverage for a number of reasons. Some fund strategies require fund-level leverage to generate required returns, while some private equity funds make follow-on investments after its LP capital commitment period has expired. Other funds wish to generate liquidity on assets whose value has appreciated, though the debt at the asset level may not be economically refinanced. Regardless of motivation, each of these funds needs an experienced lender who understands the complex world of alternative investments.
Enter the lender who specializes in asset-based fund finance. A number of banks, insurance companies and even some pension funds have embraced the complexity associated with alternative investments and lend against the NAV of illiquid closed-end funds.
The lenders offer significant benefits. Funds usually pledge a subset of their assets to the lender to borrow the requisite capital and optimise capital allocations. Typically, a bankruptcy-remote subsidiary is established by the borrowing fund, sheltering the pledged assets from external events, as well as maintaining compliance with fund-level leverage rules.
Borrowers should be mindful of eligibility criteria outlined by the lender. Performing assets will have differing advance rates; if an asset becomes impaired, it shall be subject to re-margin requirements (requiring the borrower to either pledge more collateral or pay down the loan). It is important for all constituents (the borrower’s capital advisor, the lender and the borrower) to clearly understand how both the assets and the credit facility are likely to perform under various economic scenarios.
These credit facilities are typically highly structured and bespoke. Both pecuniary terms (advance rate, interest rate, fees and other costs) as well as non-pecuniary terms (covenants, re-margin requirements, eligibility criteria, cure provisions and so on) are subject to vigorous negotiation. Borrowers are well-served to choose an experienced, reputable capital advisor to secure the best terms.
It is important to draw a distinction between NAV facilities and traditional subscription lines, which are secured by a pledge of commitments from limited partners to the fund. NAV lenders will spend most of their time determining the value and volatility of the underlying assets. Both the lender’s valuation methodology and the time period for data analysis are important in determining the final credit terms.
To achieve best execution, borrowers should focus on those lenders who can apply sector, geographic and asset class expertise to the underlying portfolios. Given the myriad lenders who are active – or claim to be active – in the market, this is no trivial task.
Next, it is important for the borrower to subject the lender’s credit proposal to stress tests. How does the portfolio perform under various economic scenarios? Under what circumstances will the credit facility need to be paid down to comply with financial covenants? Responsible borrowing requires a robust, diligent analysis of future contingencies.
Recent increases in private lending, private equity, commercial real estate and infrastructure AUM has driven a new need for asset-based lending. As a result, the ecosystem of asset-based lenders has grown significantly, as capital has returned to the alternative investment space, post-crisis. Dodd-Frank, Basel III and EU regulations have further complicated the landscape of capable capital providers. Borrowers need to carefully evaluate the pitfalls as well as the benefits of different asset-based lenders. n