How will the fund finance liquidity gap be met?

Key takeaways:

• Macroeconomic challenges are exacerbating supply-demand liquidity imbalance
• Current conditions will lead to the fund finance market evolving and changing its products
• Funds need to engage earlier to secure financing as timescales move out
• Managing relationships and ancillary business continues to grow in importance

Britons “have never had it so good” quipped Prime Minister Harold Macmillan during a famous speech in 1957, borrowing a phrase from the US Democratic Party’s 1952 presidential election slogan. Up until 18 months ago, the same might have been said for alternative investment funds.

Globally, assets under management had soared from $7.23 trillion in 2015 to $13.7 trillion in 2022, according to figures from Preqin, stoked by low interest rates that had sent investors searching for better returns on their cash. Suddenly, alternative investments had gone mainstream.

Then Russia’s invasion of Ukraine deepened an energy crisis that had already been brewing as economies rebuilt following the coronavirus pandemic, sending inflation spiralling and prompting central banks to hike interest rates. As well as such wider macroeconomic issues, the growing fund finance market was also dampened by banking sector strains seen earlier this year, which caused some lenders to reduce their capacity to lend.

All of this has aggravated a supply-demand imbalance that has seen the latter outstrip the former.

“The past six to eight months have arguably seen the biggest shock to the fund finance market since the global finance crisis,” explains Andy Roberts, Senior Director at RBS International. “The global financial crisis was a shock to the market, but the fund market was so much smaller back then and has been growing exponentially for the past 10 years. Changes to the interest rate environment in particular will take some time to adjust to, both in terms of LP allocations and appetite for borrowing”

RBS International Director Stefan Szczurowski adds: “Banks will also be analysing the impact that higher interest rates will have on their corporate lending books – will there be increased defaults or provisioning coming through that may curtail bank appetite towards further loan book growth in the short term? We don’t necessarily see higher interest rates as translating in the same way with respect to credit quality in the fund finance space, which historically has only seen rare instances of defaults, but more broadly we think the full ramifications of rising interest rates are yet to feed through to the wider market.”

No ‘one size fits all’ approach

Those macroeconomic factors are also having an effect on the wider market, with fund managers holding onto their investments until they can sell them at a higher price. Keeping funds open for longer before launching their next fund means that managers are also thinking about using their fund finance in different ways.

“Alternative investment funds have effectively been a shining light in terms of returns since 2008,” says Stefan. “While central banks rates were at zero or sub-zero, more traditional asset classes just weren’t generating the required yields, and so that attracted institutional investors such as pension funds and insurers into the alternatives asset class.

“Whether or not managers can get bridge financing for their facilities is not going to be the factor that puts the brakes on fundraising growth, because these facilities are a tool managers use to control how they hold or deploy capital. Instead, now that interest rates are set to go through 5%, it will be interesting to see how managers use those facilities going forward, as they weigh up the increased cost verses the operational efficiencies they provide.

“It won’t be the same for everyone – some smaller managers with only a handful of limited partners and a less frequent deployment profile may see facilities as being too expensive to justify the benefit. But, for the majority, these facilities are invaluable tools, especially for managers with a diverse pool of investors, which need to manage capital calls and regular investments into their portfolios.”

Andy thinks that the shift in alternative investments will also lead to the fund finance market changing its products. “Historically, subscription finance and bridging dominated managers’ requirements but now if they’re holding onto their assets for longer and they need liquidity to fund  follow-on investments or LP liquidity they are thinking about other options. Banks may also take the view that more leveraged products with higher yields are a more efficient use of their capacity,” he says.

Evolving relationship between funds and lenders

While a lack of finance isn’t holding the market back, funds are facing higher barriers to entry and longer lead times to secure financing. “The days of securing lending within six to eight weeks from a standing start are over,” says Andy.

“Go back 18 months and a fund that wanted a subscription line could knock on a few doors and find capacity relatively easily, but now some banks face an increased opportunity cost on their balance sheet – if they do one asset then they can’t do another, so they’re going to choose the most attractive asset with the best ancillary wallet available. Many banks now need to plan their deployment further in advance, so funds need to engage earlier in the process.

“In many ways there are parallels with to how discussions with LPs have evolved, with LPs reviewing allocations and a slowing of realisations impacting  their ability to recommit. Fundraising has definitely slowed as a result, which may yet impact aggregate demand for fund finance products”

Stefan adds: “In the past, a manager might have partnered with a single bank for its facilities across a stable of funds for simplicity, but now having several banks at their disposal is useful if banks’ appetites for lending change over the lifetime of a fund. It’s about making sure you have access to liquidity over the longer term, not just the short term.”

Andy highlights how financiers are also looking at more innovative options to bring more non-bank lending into the market; while more straightforward products – such as five-year, single-currency term loans – have traditionally appealed to institutional investors, efforts are now being made to consider how subscription lines – which tend to be short-term, multi-currency revolving facilities – could be made more attractive to non-bank capital.

The challenge for financiers is whether non-bank capital can be accessed in a way that compliments the existing relationship (and wider product set provided to GPs), and on a structural basis that remains relevant for managers. Ultimately, we can’t lose sight of the need the product is looking to meet. “Ratings agencies are also now getting involved and are examining subscription lines in particular,” he adds.

A proactive approach can help mitigate risks and bolster resilience

Amidst a supply-demand liquidity imbalance, maintaining access to multiple sources of finance is an essential step fund managers could take to bolster a fund’s resilience.

Strength, depth, and breadth of relationships are key, especially so in times when black swan macro events that impact lender appetite or availability over the lifetime of a fund. Fund managers looking to navigate the liquidity gap can take steps to strengthen relationships with lenders, including brands they pick for ancillary services – whether general banking, depository, foreign exchange, or otherwise. Open and frequent communication is key.

Over the following the weeks we will continue to deep dive into some of the current challenges facing alternative funds.

Look out for our next update on what will rising interest rates mean for subscription lines or read our previous article on how can funds find their way out of the liquidity conundrum?