20 Dec 2021
Fund finance and private equity: a review of 2021
Developments in private equity financing over the past year show how the market is maturing.
- Key trends this year have included flexible core funding: the more strategic use of funds borrowed for a longer period is changing finance terms
- Investors’ growing focus on ESG issues has flowed through to fund managers’ behaviour
- Net asset value (NAV) facilities – lending against the portfolio of assets within a fund rather than against institutional capital – are becoming increasingly mainstream
Private equity has had a very busy 12 months. Globally, there have been more deals completed than in any other year, and fund financing in support of these deals has grown too. Fund managers now routinely seek financing when they take a fund to market.
What’s more, borrowing is increasingly being sought for longer periods than it was pre-pandemic, with commitments being sought for up to three years and drawings remaining outstanding for 12 to 18 months – showing how strategic the issue of fund finance has become in private equity. But what other trends have we seen in the past year?
Flexible core funding
This more strategic use of funds borrowed for a longer period is leading to an evolution in the finance terms. Where funds used to be drawn at final close, when there is a highly diverse investor base, the trend is now for drawing much earlier, sometimes even at first close, when there are much more concentrated pools of investors and before there is any capital on the ground.
This helps borrowers’ return profiles and brings an administrative benefit, explains Spencer Goss, Senior Relationship Director at RBS International. “If funds were calling against those first closing investors, they would need to do some form of equalisation when they come to the second or third close in order to give everyone the same exposure to the initial asset. By borrowing under a facility they only need to make one call to all investors at the final close.”
Holding firm against fraud
Nothing tests any market like a brush with externalities. This happened to fund finance in spring 2021 when the CEO of JES Global Capital, a Florida private equity firm, was charged with creating fictitious investors in his application for a US$95 million loan against a US$500 million fund.
There was a great deal of market chatter about this case as fraud is still quite rare in the fund finance arena. But for Goss, the important point was the market reaction. “There was no knee-jerk reaction to this case; banks did not go to any kind of extreme in rewriting their credit models or their operational risk models,” he says.
This suggests that when lenders reviewed their policies and procedures in light of the JES case, they felt these were well formed and robust enough to manage fraud risk. “It’s always difficult to mitigate the risk of a rogue operator, but banks clearly feel reasonably well positioned to manage these risks,” Goss says.
Measuring up to ESG standards
Investors are increasingly focused on environmental, social and governance (ESG) issues and this focus has encouraged fund managers to be more explicit in emphasising their behaviours in this regard. Lenders have a role in encouraging and supporting this and today almost every new facility includes some kind of ESG conversation in the initial stages.
This trend has accelerated over the past 12 months, says Goss. “COP26 brought environmental concerns more obviously into the UK market. Precedents are being established and it’s acknowledged that there are benefits to society – and borrowers and lenders – in using these metrics.”
Lenders want to make sure the key performance indicators (KPIs) are challenging and give the fund managers incentives to deliver on them, says Goss. “We hold borrowers’ feet to the fire through margin ratchets. If they meet their KPIs, there is typically a margin discount; if they don’t, there might be an uplift.”
Growing NAV facilities
Net asset value (NAV) facilities have been on the horizon for the past couple of years but by the start of 2021 only a few deals had been done. However, this year, NAV finance – lending against the portfolio of assets within a fund rather than against institutional capital – finally hit the mainstream.
In 2020, a few managers who were fully invested saw potential stresses in their portfolio and used NAV facilities to provide liquidity support to bolster their defences.
“My perception is that only a small proportion of credible lenders currently provide NAV-based funding, but as more banks get familiar with the product and risks involved then these facilities are likely to grow further as borrower appetite certainly seems to be there”
Spencer Goss, Senior Relationship Director, RBS International
After those pressures eased, managers got wise to the idea of using NAV finance as a way of distributing proceeds to investors earlier, says Goss. “Instead of waiting to exit the investment, the managers will distribute some of the value from the fund to provide a return while holding on to the asset for longer.”
This trend is likely to continue, Goss thinks, as lenders get more used to the idea. “My perception is that only a small proportion of credible lenders currently provide NAV-based funding, but as more banks get familiar with the product and risks involved then these facilities are likely to grow further as borrower appetite certainly seems to be there.”
Managers going to market
American private equity managers have listed on the stock market for a while. Now, UK managers are following suit, with listings, potential listings and rumoured listings hitting the financial headlines.
This is unlikely to change the way the funds are run, says Goss, but marks a shift in the overall private equity business. “The greatest impact is in giving the firms ready access to equity markets if they want to grow their business rather than relying on the founder partners,” he says. “Instead of being relatively smaller owner-managed businesses, these firms are becoming more corporate, more institutionalised.”
The increased interest in listing along with the other trends for the year show a further evolution of the PE field, thinks Goss. “The market has been incredibly resilient over the last couple of years, especially when you consider the exceptional challenges thrown at businesses and society more widely. This shows the strength and maturity of the market and is all testament to the managers.
“As they continue to be successful with good investment decisions, positive active management and strong realisations, allowing them to raise more pools of capital, we in turn can be successful as we continue to support them.”
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