Fund Finance Partners looks at the current priorities of a market that has experienced rapid growth through the good times, writes Andy Thomson

The fund finance market has grown rapidly in recent years as alternative asset managers have found themselves able to access a useful source of liquidity at low cost. But how has COVID-19 changed the game?

You can find all Private Debt Investor’s coverage of coronavirus and its impact at here.

In a conversation with Private Debt Investor, Richard Wheelahan and Zachary Barnett of Chicago-based fund finance specialist, Fund Finance Partners, identified three key dynamics in the market today. They are as follows:

1. Fund sponsors are drawing down and/or extending their fund level credit lines

This would include subscription facilities, net asset value and hybrid lines of credit, as applicable. Proceeds of which are being used to either shore up portfolio investments or position for offensive capital deployment. We anticipate these requests will only increase in the coming weeks.

2. Credit fund balance sheets are being tested for the first time in a decade

Deterioration of borrower earnings leads to requests (or demands in the case of unfunded commitments) for supportive follow-on investments by the fund. At the same time, as earnings decline, valuation adjustments at the end of Q1 and Q2 will stress fund liquidity when NAV-linked covenants are breached.

3. Attention bandwidth among fund finance providers (both banks and speciality finance companies) is being stretched.

Though everyone is getting accustomed to new work routines, lenders are still plugged in, and deals are getting done.

In a client note, FFP said it had been in discussions with several debt fund managers over the past week with a view to developing finance-based or stop-gap liquidity solutions to either temporarily or indefinitely refinance credit facilities in danger of being pulled.

Also being looked into are partial refinancings in which performing loans are left in place, securing the existing credit facility, and fallen angels being used to collateralise new, rescue or curative financing. The note concluded that funds needed to act sooner rather than later. “Debt funds that act now, before the inevitable margin calls …will receive better terms than those that ‘wait and see’ or hope for a v-shaped recovery.”Read Original Article

Only a few weeks ago (although it now feels like another era), Fund Finance Partners (“FFP”) published an article on the numerous ways that direct lending funds and BDCs (collectively, “Debt Funds”) could finance their investment portfolios in order to increase liquidity, enhance returns and offer more competitive spreads to borrowers.  (Article)  Now, though, is the time for Debt Funds to confront challenges in their portfolios, and fund-level leverage defaults, aggressively. 

Since the outbreak of COVID-19, followed by the ensuing dramatic social and economic isolation meant to contain it, the entire economy is showing its first signs of widespread contraction in over a decade.  Practically all asset classes and sectors are impacted, but for purposes of this alert, we are focused on how this economic slowdown, which severely impacts corporate earnings and liquidity, is impacting the ability of Debt Funds that have, over the course of the past decade, increasingly met their financing needs, to continue to do so.  

Debt Funds, in the aggregate, have billions of dollars of unfunded commitments to portfolio companies, whether in the form of revolvers or delayed draw term loans.  Likewise, Debt Funds will be called upon by portfolio companies to provide incremental rescue financing as practically the entire economy struggles to hold onto precious liquidity.  Prior to the onset of this crisis, Debt Funds had been availing themselves of more, cheaper and even structured leverage for a while.  Most of these credit arrangements were made with financial and other covenants that the Debt Fund must maintain in order to access debt capital.  The fact of the matter is that the banking system, which largely left the small and medium-sized business leveraged lending market to the Debt Funds, after the downturn, is once again a critical source of liquidity to small and medium sized businesses, as well as middle market companies.  

For most Debt Funds’ credit facilities, one of the covenants that must be maintained in order to be able to access precious debt capital is some type of “NAV” or “asset coverage” covenant.  The valuation component of this covenant moves up or down, based on the value of the underlying portfolio of loans.  Many of these loans are valued by applying an enterprise value, based on an EBITDA multiple, to the company’s capital structure waterfall.  As earnings decline across the board, those enterprise values are expected to fall precipitously, and loans marked at par today, or on December 31, 2019, may not be on their next valuation determination date. 

Deterioration of asset values is expected to lead to NAV or asset coverage covenant violations, for many Debt Funds, resulting in credit facilities being unavailable (or worse, called), only further starving small and medium sized businesses and middle market companies’ liquidity.  Meanwhile, Debt Funds that are out of covenant compliance due to NAV deterioration are expected to be negotiating amendments or forbearances with their lenders, or seeking liquidity from other sources.  Margin calls and mandatory repayments are undoubtedly coming, and some Debt Fund managers are – painfully – considering selling valuable, performing assets in a market where all asset prices are falling. 

FFP has been in discussions with several Debt Fund managers over the past week, developing finance-based or stop-gap liquidity solutions to either temporarily or indefinitely refinance credit facilities that are in danger of being pulled from Debt Funds, or to arrange for partial refinancings, in which performing loans are left in place, securing the existing credit facility, and fallen angels are used to collateralize new, rescue or curative financing.  All refinancing possibilities should be considered and discussed with your advisers, prior to distressed sales of good assets.     

Whether your Debt Fund’s assets are quotable on a daily basis, and a covenant breach is imminent, or your Debt Fund’s loans are not quoted, but subject to quarterly revaluation on March 31, or June 30, now is the time to educate yourself regarding all options.  Debt Funds that act now, before the inevitable margin calls (in TRS-financed portfolios or CLO warehouses), mandatory paydowns (resulting from loan quality deterioration) will receive better terms than those that “wait and see” or hope for a V-shaped recovery.   FFP is available now, to help implement solutions.  

March 17, 2020

By: Alex Lynn

Drawdowns could enable managers to pre-empt liquidity issues arising from the pandemic but may compound the problem for certain LPs.

Some general partners are considering early repayments for subscription credit line drawdowns in anticipation of potential liquidity issues among LPs arising from coronavirus.

Modern limited partnership agreements typically specify a clean-down period, or a deadline by which individual loan drawdowns need to be repaid. The Institutional Limited Partners Association suggests this period be no longer than 180 days, though it can vary from fund to fund.

“Funds with outstanding loans that are closer to the end of such clean-down periods could call capital to repay these loans early because they want to pre-empt any liquidity issues that LPs may have in a couple of months,” Fi Dinh, a Singapore-based fund finance director at ING, told Private Equity International.

 “A number of GPs that we spoke to have indicated they may consider [this option].”

Institutions such as underfunded pensions could face a liquidity crunch in the coming weeks and months following a rout in the public markets and slowdown in private market exit activity. Q1 is expected to be a write-off for sales, with Brookfield Asset Management among those shelving deals following disruption to travel and market stability.

The spectre of diminished liquidity could make early loan repayments an unappealing prospect for some LPs.

 “Some of our sponsor clients have received calls from LPs instructing them to utilise subscription-backed credit lines as much and as long as possible,” Zac Barnett, managing partner at debt advisory Fund Finance Partners, said.

“This is because LPs are expecting to receive numerous capital calls from GPs looking to stabilise certain of their portfolio companies in the downturn or amass cash so they’ll be able to seize opportunities in the new world of attractively priced assets.”

FFP is negotiating two credit line extensions for that reason.

Borrowing could be easier said than done. ING is among those taking a closer look at underlying portfolios as LPs are more likely to prioritise capital calls to a better-performing fund when facing liquidity issues, Dinh noted.

“Overall our lending rate has slowed in Q1 because there are fewer funds and facilities being raised, but generally the market is still seeing this as a short-term issue and there is still plenty of optimism around the long-term nature of this asset class.”

At a broader level, the US Federal Reserve announced several measures on Sunday to encourage banks to lend, including slashing interest rates to nearly zero and lowering reserve requirements. The People’s Bank of China and The Bank of Japan have also taken similar action.

“It’s a little harder to get banks’ attention on new transactions right now as they’re understandably busy reviewing their existing portfolios and facing logistical and technological issues due to the disruption to traditional office working,” Barnett said. “The end result is a much longer period from term sheet to execution.”

The rise of uncommitted debt in recent years might be cause for concern as lenders are under no obligation to honour a drawdown. Such a move is, however, unlikely given the potential reputational impact to lenders that veto a utilisation request.

“We’re aware of some difficult conversations around uncommitted draw requests and expect them to increase in frequency,” Barnett noted. “Lenders will be reviewing their exposure to any one particular GP or – derivatively – LP during times of stress.” Read Original Article

March 11, 2020 – Since FFP’s inception in 2019, the vast majority of our fund sponsor clients’ mandates stem from our collective expertise in and around the fund finance markets.   Between the number of fund finance transactions our principals have executed and our long-standing, deep relationships with virtually every bank and alternative lender in the space, our clients recognize the unique value we offer.

In addition to those (expected) value propositions, discussions with fund sponsors have made us aware of other supplemental or (surprisingly) even primary reasons for mandating FFP:

1. Conflicts Clearinghouse: Large, multi-strategy sponsors with multiple investment vehicles are accustomed to evaluating whether to enter into affiliated transactions (i.e., joint transactions involving affiliate funds). For instance, a sponsor may manage a private credit fund that provides a participant loan to a private equity fund that it also manages. The private credit and private equity vehicles have distinct, sophisticated investor bases that have received extensive disclosures of the potential conflict. Perhaps the respective investors have also consented to the joint transaction with the other fund. Even in this example, most sponsors want to take every precaution to ensure that each fund transacts on market, arm’s-length terms and consistent with its fiduciary duties and the SEC’s regulations.  Fund sponsors may engage FFP as a third party advisor in the joint transaction. Given FFP’s (i) neutral, unaffiliated role in the transaction and its (ii) singular awareness of market terms for transactions such as these – including FFP’s ability to obtain legitimate, third-party bids validating the sponsor’s terms, the sponsor is assured of being able to authoritatively support its transaction in the event of potential inquiries into the transaction’s structure.
2. Mitigating Conflicts: In addition to the multi-strategy manager example, above, a mature private equity fund with an investment in a company needing follow-on investment capital in excess of such fund’s uncalled capital presents a different challenge.  The sponsor may manage a newer private equity fund, with ample uncalled capital, with an investment strategy identical to the legacy fund.  As in the previous case, the investors in each of the vehicles are sophisticated and have consented to the sponsor’s conflicts provisions in the respective fund governing documents. By engaging FFP in considering the range of capital solutions (whether allowing the newer fund to make a co-investment alongside of the legacy fund, in the same company, or procuring a tactical, NAV-based credit facility for the legacy fund’s financing of follow-on investments, so as to avoid a joint transaction among affiliate funds), the fund sponsor can attest to having truly evaluated all options. FFP’s (i) neutral, unaffiliated role in the transaction (ii) in depth experience in resolving complicated conflicts of interest among funds and investors, and (iii) unique ability to obtain the most attractive terms available to the market, the sponsor is assured of being able to respond to any and all questions regarding potential conflicts in the transaction’s structure.
3. Fiduciary Duties: As all sponsors know and understand, they owe a fiduciary duty to their limited partners to achieve the best terms, including but not limited to the best price point for any financing. This is particularly pertinent when it comes to subscription financing, given it is the investor’s unfunded commitments that are the collateral. This is often reinforced by more and more frequent requests by limited partners to review subscription facility terms to verify that the terms are indeed the best that could have been achieved. An additional basis for fund sponsors’ mandating FFP has been our experience, market knowledge and our unique, un-biased, competitive process.  The result has consistently been financing terms that are virtually unassailable to any limited partner inquiry. 
4. Ethical Considerations:  Not all conflicts of interest contemplated by fund sponsors are limited to investors or funds.  Sometimes, a fund sponsor will have to confront a possible, or perceived, conflict of interest between funds and the general partner or fund sponsor, itself.  One such potential conflict arises when a fund sponsor is procuring fund-level leverage (whether a subscription line or other type of financing) and leverage in respect of the general partner’s capital commitment to the fund.  While investors obviously support general partner alignment through “skin in the game”, and leveraging GP commitments has become the norm, rather than the exception, fund sponsors are rightfully cautious when a lender proposes to provide both financings.  It is reasonable for limited partners to inquire into the fairness of the general partner’s leverage terms, in light of the same lender’s financing of capital calls.  When FFP oversees a fund sponsor’s comprehensive leverage strategy, limited partners are assured of the fairness of the financing terms, for both the general partner and the fund, by demonstrating the thorough, competitive process and transparency of the range of financing proposals obtained.  

In addition to fund sponsor community’s recognition of FFP’s unparalleled market reach and knowledge, FFP’s usefulness in identifying, mitigating and resolving potential conflicts of interest and support for fiduciary duties to investors have been called upon by fund sponsors who have trusted FFP to advise on their leverage strategies.  Both general partners and limited partners can rest assured that their overall financing goals are being optimized cost-effectively and ethically.  

February 4, 2020

By: Alex Lynn

GPs can avoid potential liquidity issues by drawing down loans early and performing greater due diligence on their lenders

Uncommitted capital call facilities have taken the private markets by storm, but fund managers should be cognisant of the potential for lenders to withhold financing during a liquidity crunch.

The notional value of debt facilities provided on an uncommitted basis is estimated to have grown 12 to 15 times over the past decade, Zac Barnett, managing partner at debt advisory Fund Finance Partners, told Private Equity International. These facilities mean the lender has agreed to provide capital at set terms when asked but is under no obligation to do so.

Such loans are often cheaper than committed facilities as banks don’t need to set capital aside to meet liquidity requirements, according to a 2017 report from Mayer Brown.

“Private fund sponsors have eaten up uncommitted debt, which is where the bubble would pop, if anywhere,” Barnett said.

Subscription credit lines have grown in popularity as they enable capital to be called in one lump sum, often only on an annual basis, rather than relying on LPs to act quickly to finance each individual investment. Capital calls can take up to 12 business days to provide, making debt a useful tool in completing investments in a timely fashion.

The Fund Finance Association, an industry trade group, estimates that existing subscription line commitments have grown to approximately half a trillion dollars, reports sister title Private Funds CFO.

Terms of endearment

For committed lines, GPs pay an upfront commitment fee, a margin on drawn capital and a fee on undrawn capital, according to Matt Hansford, head of UK fund finance at Investec. Uncommitted lines only charge a margin on what is committed, meaning a GP only pays for what they need.

This debt can sit on top of a committed facility, much like an expansion valve. A GP could, for example, arrange an $80 million committed facility with an optional additional $20 million portion that can be accessed if required, provided the bank approves the request.

“People have gotten comfortable with uncommitted capital call facilities because the conditions under which a bank is lending will remain pretty constant, provided the fund hasn’t faced any major changes like a secondaries transaction or the loss of a key person,” Hansford said.

“There’s also the potential for reputational impact to the lender if they veto a utilisation request.”

That uncommitted lines can be withheld – however unlikely – could be problematic in a downturn if GPs are unprepared. Liquidity constraints due to macroeconomic conditions could limit the speed or ease with which LPs can meet a capital call, placing undue pressure on their relationship or potentially delaying an investment if the GP can’t access leverage.

 “You’ve had around 40 new entrants to the capital call space in Europe alone in recent years,” Hansford noted. “There was a big pullback from the capital call space in the last crisis, so there’s a risk that the field would narrow again in the next downturn.”

One solution is to ask banks to commit the loan in advance of when it’s needed so that the money can be called from investors in due course if necessary, he added. Borrowers also need to consider how large the lenders’ capital call business is and whether they continued to be active during the last downturn.

Some uncommitted lines in the US are provided on demand, meaning a lender has the right to call in debt at any time in exchange for a cheaper fee. An untimely demand from a lender could force a GP to call capital or exit certain assets to repay debt when they’re not ready, Barnett said.

Committed to the cause

FFP was launched in late 2019 as a negotiator of more favourable credit terms for GPs. Barnett, an 18-year veteran of Mayer Brown’s banking and private investment fund practices, co-founded the business with Richard Wheelahan, a former general counsel at private credit manager Capitala and fellow Mayer Brown alumnus.

The firm, which operates from Chicago, Illinois and Charlotte, North Carolina, is sector-agnostic and has worked for private credit, real estate and multi-strategy fund sponsors globally. Although subscription lines are its core business, FFP has also arranged NAV lines, hybrid lines and advised on GP-interest deals involving private and bank debt, as well as sales of equity stakes.

Barnett and Wheelahan say moving from an uncommitted to committed facility impacts returns by as little as 0.1 percent. The pair also advocate greater due diligence on potential lenders to ensure they’re able to weather a recession without calling in loans.

“Everyone professes discipline,” Wheelahan said. “But they’ve got to maximize and justify returns in a valuation environment that’s gotten more exuberant every year, and nobody wants to see tears when the correction comes.”

Read Original Article

January 15, 2020 – The emergence of Business Development Companies (“BDCs”) over the last decade is not a surprise. BDCs are well-established as an essential provider of debt capital to small and medium-sized U.S. businesses. Since the peak of the financial crisis, the number of publicly-listed BDCs has more than doubled, and the number of private or non-traded BDCs has exponentially increased, as asset management firms increasingly add private credit and direct lending to their investment strategies, and investors (whether retail, institutional or non-U.S. institutional) seek exposure to the ever-maturing market for U.S. middle market credit. BDCs are an attractive destination for non-U.S. investors, particularly due to their tax advantages. They are an attractive product for asset managers because of the complement they offer other formats that attract capital to direct lending strategies. These advantages notwithstanding, BDCs present complex capital structure, balance sheet management, regulatory compliance and corporate governance challenges for asset managers that other formats (like commingled funds and SMAs) do not pose. Professional advisors and consultants well-versed in these intricacies can help fund sponsors and debt and equity capital sources unlock the numerous opportunities presented by BDCs.  

Leaving the “Banking System” … to Return 

One widely-known tailwind for this growth has been the transplantation of most of the smaller-end and much of the middle market’s leveraged finance holdings off depository institutions’ balance sheets and onto private funds, SMAs and – yes – BDCs’ (we’ll refer to them collectively as the “New Lenders”) balance sheets. It’s not that big banks have entirely left the chat, however, as they are vitally important to the New Lenders. The New Lenders rely on the big banks for some deal flow, treasury management and fund administration, but most importantly, for massive amounts of financing. The New Lenders to “main street” take on many forms. Still, most rely on at least one meaningful credit facility from a big bank, for liquidity and additional capital to make these investments, and as a key source of financing that reduces the overall cost of capital for the New Lenders, which enhances the gross- and net-level returns. 

Even though there are noteworthy differences among BDC structures and terms, management teams, strategies and performance, there are legal and regulatory boundaries, and in some cases barriers, that BDC managers – and their lenders, professional advisers and investors – should be prepared to neutralize. 

Leverage Limitations for BDCs are a Special Consideration 

As with all funds, governing documents may set limitations on leverage (among other areas). BDCs, however, are subject to additional limitations. First, all BDCs, whether exchange-listed, private or non-traded, are Regulated Investment Companies (each, a “RIC”) under the Investment Company Act of 1940 (the “40 Act”). The 40 Act restricts BDCs’ ability to utilize leverage; the regulatory consequence of violating the incurrence-tested restriction is the BDC’s inability to incur additional indebtedness. Until late 2018, BDCs were permitted to incur debt up to a 1:1 ratio to the fair market value of their respective portfolios. Following years’ worth of lobbying efforts led by the Small Business Investor Alliance, industry leaders and advisers, BDCs may now incur debt up to a 2:1 ratio to their portfolio’s FMV, so long as the BDC’s board or shareholders, as the case may be, permit such incremental leverage.

What the 2018 BDC Leverage Increase Means for BDCs, Lenders and Investors

A breach of the 40 Act leverage limit generally prohibits the BDC from accessing any additional debt capital until such BDC is back in compliance. For publicly listed BDCs, the research and public equity investment community would also respond harshly to such financial and liquidity degradation. The most important practical consideration for public or private BDCs with credit facilities, outstanding bonds or convertible notes is to appreciate the extra-regulatory consequences of the BDC’s prevailing leverage limit.

Most, if not all, BDC credit facilities and debt securities are accompanied by maintenance covenants that would trigger an event of default if the BDC is out of regulatory compliance with the 40 Act’s leverage limit, or the BDC exceeds a 1:1 ratio of debt to assets. 

BDCs that are considering – or that have received approval to – avail themselves of incremental leverage, and their lenders and advisers, must anticipate the interplay of existing credit facility and debt security covenant packages with any change to the BDC’s leverage profile.

The Market Responds to Scale, First … Others Follow

Although some BDCs chose the expedited method of shareholder approval for increased leverage, some of the largest BDCs have completed impressive expansions of their credit facilities. Other BDCs that sought board, rather than shareholder approval – whether due to their smaller scale or relative portfolio performance – are only now able to access this additional leverage, due to the year-long waiting period between board approval and effectiveness. 

Beginning in early 2019, there was a backlog of requests from BDC managers for amendments to credit facilities and/or indentures, led by the largest BDCs with the most intricate capital structures. It just so happens that most of these BDCs are also part of larger platforms that are meaningful fee payers and counterparties to the banks lending to BDCs. Naturally, these institutions were at the front of the line. 

In mid-to-late 2019, many more managers approached their lenders and bond underwriters for similar changes, to accommodate additional leverage. The underwrite by these lenders has been BDC-specific and very focused on asset-level performance, investment strategies and modeling the BDC’s ideal leverage scenarios. Many of these BDCs are still seeking the requisite amendments. Some have not yet begun the process.

If You’re Still in the Queue, it’s Not Too Late

If you’re a BDC manager that seeks additional leverage but suspects that you may have to nudge your lender or underwriter, consider isolating certain investments in specific borrowers or offering approval rights to lenders that are providing additional debt capital than is currently available. If you have any industry specialization within your portfolio, consider isolating those loans in an SPV and seeking financing from a lender with expertise and a long view of that industry. If specialty finance is one of your strategies, a typical BDC-level revolver may exclude those investments from your borrowing base; however, there may be lenders that have a more accommodating view of the same collateral. 

In addition to optimizing asset composition and possibly expanding either the sources of debt capital or the types of credit facilities your BDC utilizes, BDC managers should be particular about the advisers they rely upon in connection with these amendments, refinancings or establishment of new credit facilities. There are many notable 40 Act lawyers with renowned BDC experience. Likewise, there are many thoughtful, driven fund finance lawyers with experience negotiating and documenting NAV facilities for credit funds and BDCs. It is not a foregone conclusion that those specializations universally reside within the same law firms. 

If you’re considering any sort of asset reorganization or specialization, or segmentation of your BDC’s sources of credit, consider the breadth of regulatory, specialty finance and market knowledge that you have at your side. 

What Fund Finance Partners Offers in the BDC Realm

• FFP is the only dedicated advocate for BDC sponsors with experience establishing numerous corporate revolvers, SPV financing, total return swaps and other leverage solutions for public and private, traded and non-traded BDCs.
• FFP is the only advisor whose leadership has substantial portfolio management, compliance and financial reporting experience specifically for BDCs to complement your CFO or capital markets desk, as well as regulatory experience to complement your 40 Act and fund finance counsel.
• FFP uniquely has the market experience and relationships to elevate your BDC’s profile in the crowded neighborhood of New Lenders seeking financing, capital and brand recognition.
• FFP appreciates the relationship between BDCs and other direct lending or investment vehicles on asset managers’ platforms, such as JVs, SMAs and other funds, and the opportunities and challenges that those assets present, and is equipped with creative product development, conflict recognition and mitigation and process-improvement solutions for BDC managers.