Fund Finance Trends for 2023

Think back to the halcyon days at the end of 2021. The biggest issues on most minds were the fallout from Covid and continuing supply chain problems. Interest rates were expected to rise by a maximum of 1% during the year; military exercises on the Ukrainian border were little more than a blip on the radar.

Fast forward to the end of 2022 and it’s a very different world, with the fallout from the invasion of Ukraine leading to soaring energy costs causing inflation levels not seen for 40 years. Although these inflationary pressures are likely to drop sharply during 2023, this is unlikely to have an immediate impact on interest rates.

The general sentiment is that the US and UK are both heading into recession, with the UK suffering a longer term and deeper downturn, says Mat James, Head of Offshore Institutional Banking. “The political uncertainty we’ve seen in 2022 will continue, and the resulting lack of fiscal clarity translates into uncertainty for UK investors,” he says.

Realising assets

Market volatility and rising interest rates have led to a marked shift in borrower behaviour over the past year that is likely to continue into 2023, says Neil Walker, Head of Institutional Banking in London.

Funds are wondering where the tipping point is for interest rates, he says. “Where it becomes uneconomic for a fund to borrow will very much depend on where it is in its lifespan. This is particularly the case for sectors such as private debt or infrastructure, where the target yield tends to be lower than it is for private equity.”

Valuations are the big concern for many alternative funds coming close to the end of their lifecycle. As these valuations start to plateau, fund managers are looking to hold onto assets for longer in the hope that confidence returns in 2023 and valuations improve.

When LP funds are not realising their assets, they are not able to recycle capital into the next fund, says Walker. “The logjam at one end of the chain can cause a logjam at the other. With exits being delayed, the downstream impact is that fundraising is slower and more challenging as a result.”

New continuation funds

One of the ways the market has responded to this block is through the growing secondary market. Transaction volumes were already at an all-time high of US$85bn in 2019 before the pandemic brought fresh impetus to the market. One of the most interesting dynamics we are observing are continuation funds, often with concentrated asset bases (or even single assets), which is rapidly developing and can be very attractive to secondaries investors.

GPs are creating these funds and LPs are investing in them, says Ian Harcourt, Head of Institutional Banking in Luxembourg. “In some instances LPs aim to cherry pick the best single assets that GPs are putting into the continuation funds to build a portfolio of higher returning assets with a high internal rate of return. This can spread their risk as there is a diversity of GPs leading the single-asset plans, a diversity of asset types in the portfolio, and a diversity of asset managers.”

Another factor boosting the secondaries market is regulation. High capital adequacy requirements for banks and insurance companies mean these businesses are more actively managing and balancing their portfolios than in the past, fuelling significant secondary trading. The result is global transaction volumes in secondaries reached a new high of $130bn in 2021; recent estimates suggest the market could reach $500bn within the next five years. 

“Lenders are putting smaller facilities in place with more flexibility built in to match and react to the slightly different borrower profile than we would have seen historically”

Neil Walker, Head of Institutional Banking in London

Changing lending requirements

Borrowers keen to realise value are also looking at other creative solutions, such as bespoke sub lines, hybrids and NAV lines, while some of those with money held up in previous funds continue to use step-profile fundraising to get new vehicles off the ground. 

All of this is causing lenders to change behaviour, says Walker. “Lenders are putting smaller facilities in place with more flexibility built in to match and react to the slightly different borrower profile than we would have seen historically. This is in response to the need for adaptability at the front end and the back end, and is arguably a downstream impact from lack of confidence in valuations and challenged exit strategies.”

He expects to see slightly suppressed borrower appetite in 2023, especially for new funds. “All the market data points to a pronounced slowdown in fundraising. The backend requirement is different and arguably a higher credit risk, which lends itself more to NAV lending, raising preference equity, or finance from non-traditional lenders. The change in behaviour at the backend creates opportunities for lenders to be a bit more creative – to try and make an attractive, risk-based return that suits their specific profile.”

Sustained secondaries growth

The challenging market environment could make opportunities in the secondary market increasingly attractive. Research suggests that nearly 62% of secondary investors are targeting return rates of 20% or more in single-asset secondaries, a far greater proportion than the 40% and 16% of multi-asset GP-led and LP-led segments to have similar returns in their sights.

“The rise of secondary markets and continuation funds, and their importance as subcategories of the market, will continue to grow to support the liquidity that the alternative investment market requires to invest, divest and restructure as it becomes more sophisticated,” says Harcourt.

He points out that single-asset continuation funds can represent a good complement in a generic mix portfolio for LPs or an exciting new asset class for fresh capital. “Funds might see interest from LPs that have not previously invested with them, as well as LPs already in their fund who want to double down on specific assets. But there’s greater interest from a new breed of private capital that is looking to specialise in trading on the secondary market as a new way to increase liquidity.”

Open communication

In the current market it’s more important than ever for mid-market alternative investment funds to concentrate on relationships, says James. “Have an open dialogue with your banks around what you can do. If you have a concentration of banks, make sure this dialogue is with everybody and that there’s an equitable distribution. Each bank will have their own specialism, whether that’s depositary or foreign exchange or equity: there are a number of levers you can pull to ensure you remain close to your funding partners.”

Some smaller funds have a loyal investor base with whom they have built up a good relationship based on trust, James says, and they should put these connections to good effect. “Maintain a dialogue with investors and use it to reset expectations of what returns will look like in this environment. We’re not going to see bank pricing and returns on capital fall – if anything they will go the other way. You need to think about what a benchmark return will look like and share that with your investor base.”