The rapid expansion of alternative investments over the past decade has led to the emergence of fund finance, the provision of credit to private funds and in particular private equity funds, as an important market for banks and non-bank lenders.
Fund finance is a type of credit extended to alternative asset managers to capitalise their fund, either to manage liquidity or to add investment capital.
The main fund financing structures include subscription lines and net asset value (NAV) lines. But there are also hybrid facilities, specific solutions for fund managers and secondary investors, as well as collateralised fund obligations, which all have their uses during different stages of a private fund’s life cycle.
Private fund structures
Fund finance takes unique forms because of how private funds work when they pool capital from multiple investors. A private fund is usually structured as a limited partnership or limited liability company.
A general partner (GP) manages the fund and makes investment decisions, while limited partners (LPs) are investors who contribute capital but do not participate in daily operations.
The GP raises capital from these accredited investors, pension funds, endowments or family offices, and the investors commit capital, which is drawn down as needed for investments over several years.
Instead of contributing the entire capital upfront, like in a mutual fund, LPs investing in a private fund commit a certain amount of capital (for example $10 million) as a binding obligation.
GPs request committed capital from investors over time when it is needed for investments, expenses or operations by using a capital call. The fund manager will issue a capital call notice identifying how much money is requested, the purpose, the due date and payment instructions.
One of the main characteristics of private funds is illiquidity for both LPs and GPs.
The investors may face liquidity challenges because their capital is committed for several years up until a defined exit strategy. And private funds, such as private equity funds which invest in a portfolio of companies, need liquidity during various stages of their life cycle. Early on as bridge financing until LPs have made their capital contributions, during the investment stage for leverage and additional investment capital, and later on for cash flow management, to support portfolio companies, provide distributions to investors or fund restructuring.
Common fund finance facilities
The main fund financing structures fall into two main categories: subscription lines, which lend against capital commitments from investors, and asset-based lines, which use the fund’s assets as collateral.
Subscription lines
Subscription lines, also known as capital call facilities or sub-lines, are lines of credit or loans secured against the unrealised capital commitments made by LPs to GPs.
It is the first form of financing that will be used by a new private fund and is often negotiated before the fund even closes.
Subscription lines offer liquidity in the early stages of a private fund’s life cycle by bridging the gap between receiving capital from investors and making investments.
As such they provide more flexibility to the fund manager to execute on investments quickly without the need to make frequent capital calls.
Because this subscription facility allows the fund to make investments without immediately calling investor capital, it can significantly enhance returns on capital.
However, lenders may restrain this ability to borrow for leverage by limiting the time drawn capital can be outstanding (for example 90 or 120 days). Sub-lines are usually revolving credit facilities, which means they can be repaid and then redrawn.
The subscription finance market is well established and was estimated to be $850 to $900 billion in size in 2024, compared to the entire fund finance sphere of about $1.2 trillion.
Although sub-lines are considered low risk, lenders need to assess the creditworthiness of the LPs as the fund is borrowing against the promised future capital contributions from its investors. These uncalled capital commitments and the accounts into which capital contributions are paid serve as security.
NAV-based lines
Sub-lines are popular in the early stages of a fund because there are no assets to lend against. The ability to borrow in a subscription facility will decline over time as investor capital commitments are called and the fund makes investments.
This can result in a need to refinance the subscription facility with asset-based financing.
Net asset value (NAV)-based credit facilities are loans extended to funds based on the net value of the fund’s portfolio, i.e. the value of the underlying investments minus the fund’s liabilities.
NAV-based lines are secured by cash flows and distributions from the fund’s underlying portfolio investments, and they are repaid from the proceeds of these investments, such as loans, debt instruments or stakes in portfolio companies.
Compared to the more homogenous sub-line loans, NAV loans are bespoke and individually negotiated so that terms, structure and covenants of the loan are adapted to the profile of the borrowing fund and its stakeholders.
NAV facility lenders typically select which assets in the portfolio of a borrower they are willing to lend against. Financial covenants are then set against this eligible pool of approved assets, with specific rules governing when and how assets can be added to, or removed from, the facility.
Leverage lines, which are used by GPs to increase the available investment capital (the so-called dry powder in private equity), are typically secured by the full holdings of the fund, rather than single assets, to lower the risk profile of the loan.
While subscription facility lenders are mainly banks and some insurance companies, there are specialist non-bank lenders frequently involved in NAV-based facilities.
A key consideration for NAV lenders is the accurate, regular valuation of the fund’s assets to determine the borrowing base and thus how much money can be lent against the assets.
The loan-to-value (LTV) ratio – how much can be borrowed against the security package – is typically much more conservative for NAV facilities (10% to 30%) than for subscription lines (60% to 90%).
In contrast to the revolving credit facilities used during a private equity fund’s investment period, NAV finance is often provided either during a fund’s value creation phase or after most of the LPs’ capital has been called.
The primary purpose of NAV lines is to provide liquidity for funds when this is not generated by the assets. NAV lending can for example facilitate additional investments, the restructuring of funds, extend the investment horizon, enable earlier capital return to LPs or support portfolio companies with expiring credit facilities.
NAV lines are most common in private equity, where security is provided by the fund’s equity stake in portfolio companies, and in the secondaries market.
Secondaries refer to the buying and selling of existing private fund interests. They provide liquidity to investors who want to exit a private fund or private equity investment before the fund reaches maturity.
There are also GP-led secondaries which allow the restructuring of funds, for example by moving portfolio companies into a continuation fund to extend the investment period.
Hybrid facilities
Hybrid facilities combine elements of both subscription and net asset value lines into a single facility. They are collateralised by uncalled capital commitments from LPs in addition to asset-based security.
They can be an efficient way of obtaining longer term financing, rather than having to negotiate a subscription facility at the closing of the fund followed by a separate asset-based line several months later.
Hybrid facilities are also often used by continuation vehicles to reduce the upfront called capital. However, the cost is typically higher due to the added complexity.
The benefits of fund finance
The rapid growth of fund finance is both the result of the expansion of the private equity market to $10.2 trillion by the end of 2024 and the benefits it provides to borrowers and lenders.
For borrowers it generates much needed liquidity, which can be used to fund additional acquisitions or to refinance more expensive debt and it limits the risk that assets must be sold at reduced prices.
Most importantly NAV loans do not compromise the upside potential of the underlying investments and as such can increase the returns of the fund.
For lenders the returns are similar to direct lending but with stronger downside protection. NAV lenders will only face losses if a portfolio experiences an extreme decline in value as the loans are well-collateralised by a diverse portfolio of investments.
NAV loans are senior-ranking, floating-rate instruments with long maturities and many of the assets in the underlying portfolio securing the debt are expected to be monetised before the NAV loan matures.
For banks, NAV financing diversifies the lending portfolio beyond traditional loans and it is subject to less stringent capital requirements compared to riskier forms of lending with similar yields.
