Perfect fit: The evolving craft of fund financing

The fund-level financing market – once a plain vanilla product used as an administrative bridge to help with working capital – has in recent years morphed into a more bespoke and, in some cases, highly sophisticated product. As GPs become savvier and get a deeper understanding of how to use these facilities, so has the number of requests for fund-level financing.

"We are seeing an increasing number of bespoke fund financing requests across complex structures," says Aimee Sharman, a senior associate specialising in fund financing at Hogan Lovells. "It is very interesting how bridge facilities can be used for the acquisition of investments by entities within a fund structure, but without the purchaser being a direct borrower."

"Getting the right financing for the relevant transaction can weed out inefficiencies," says Matthew Hansford of Investec's fund financing team. "It is about getting the right financing relevant to the transaction."

For example, if a sponsor is buying a business with a property that is not core to the acquisition strategy, but also non-negotiable to the purchase, financing everything with equity is not the right risk profile, as equity is meant to be returning 20%, whereas the property may well return only low single digits, explains Hansford. This type of bridge to divestment is essentially a bridge to a liquidity event rather than the plain vanilla bridge to capital call, though equally valid.

Delaying the debt
Another scenario may be with a buy-and-build strategy where a private equity house has identified acquisition targets for a platform asset, but is not able to subsume them into the portfolio company straight away. The GP may not necessarily want to draw down LP money on day one to bridge the debt potential, as it is the wrong capital for the risk, so it could use a fund-level bridge facility and then add debt later, which would be a bridge to refinance, says Hansford.

"It is about how to ensure that every penny and every pound is being put to the best use, to get the right and efficient return," says Hansford, who admits that the by-product can often be a boost for the IRR.

A bridge to distribution is becoming more common, says Sharman. A typical example is where there could be a purely administrative situation where regulatory approval is taking a long time to go through, but the deal is unlikely to fall through. "A short-term exit bridge in this way can have positive financial implications with the opportunity to boost returns," says Sharman.

These are essentially fund management techniques. A GP might be a top-quartile performer, but if they do not employ these techniques, and peers do, this may not be the case" – Mark Bulmer, Nordic Capital

Indeed, and as highlighted in both these common scenarios, some in the industry argue that LPs themselves are increasingly encouraging their managers to use this type of financing since they are benchmarked against other LPs based on IRRs. The more practitioners do it, the more it becomes a self-fulfilling prophecy, as they need to show comparable multiples to their peers.

"These are essentially fund management techniques," says Mark Bulmer, a partner at Nordic Capital. "A GP might be a top-quartile performer, but if they do not employ these techniques, and peers do, this may not be the case."

The benefit is easy to see if an LP can invest in a company at cost up to a year after the acquisition was made, when it is then marked at 1.2x.

"Some LPs encourage sponsors to use these techniques for benchmarking purposes, but others are equally frustrated, as underlying growth becomes difficult to gauge based on this alone and they ask for the cashflow calculation behind the return calculation," says Bulmer.

Pushing boundaries
With interest rates so low and fund financing facilities available at such a cheap rate, these subscription facilities can also be used as an arbitrage play. Sharman points out that standard bridge facilities can be available on very competitive terms: "Some banks have said they don't want to lose potential opportunities, so are prepared to be very competitive, as it is the volume they are interested in and getting ancillary business especially with strong sponsors. The default rate is close to zero."

Using these facilities in an arbitrage play is still relatively low risk, according to some, as the facility is backed by a pool of undrawn LP commitments, which is no different to if it were being used for a simple bridge to drawdown.

"The only risk to the structure is if the bank holding the facility calls in the loan, in a default scenario, and exercises its security rights. LPs would not be happy receiving the call from the bank in question," says Hansford.

This type of arbitrage play is arguably a grey area with some questioning who the beneficiaries are and whether interests are aligned. "[How it works is] you use your LPs' AAA rating to get a cheaper loan at say 1-2%, and get someone else to carry the risk," says Livingbridge CEO Wol Kolade. "It is a type of arbitrage between the cost of hurdle and cost of bridge, so you are using a cheap bridge to finance a purchase rather than drawing down on the LP pool of commitments. But shouldn't the LPs be doing that themselves? What started as something simple, people are now using to push boundaries," he says.

Although most adhere to bridges for only a short period of time and for purely administrative purposes, it must be noted that some bridges are offered for up to three years. In addition, as Sharman points out, bridge facilities are getting larger.

"In many cases, the fund financing facility is in the interest of both LPs and GPs, but the interesting part will be in the cases where it is clearly in the interest of one party, or a conflict of interest arises," says Dunedin partner Mark Ligertwood. Hansford also points out the need for transparency to avoid these conflicts as much as possible: "It is fine and LPs are fine with it when there is transparency – for a certain reason – but the problem comes when they are bridging without a supposed purpose."

Bespoke flavours
Last year, debt adviser Marlborough Partners noted that since the levels of debt liquidity remained high, sponsors were continuing to look for ways to put money to work and enhance returns for their investors and, as a result, there was a spike in the number of requests from sponsors for fund-level financing. It also noted that in addition to the traditional providers – Wells Fargo, Investec, RBS and Lloyds – the likes of 17Capital and Vision were offering increasingly bespoke, tailor-made products, taking a more flexible approach, such as offering few or no covenants, 100% payment-in-kind interest and long-dated maturity.

In these instances, rather than the undrawn LP commitments acting as security, a lender might use the net asset value of the equity portfolio to underpin the finance. Such arrangements would typically be more appropriate towards the end of a fund's life, owing to reduced residual LP equity available to be used as collateral.

"They [the LP base] may consent for a number of reasons, be it because there is no money left in the pot but an acquisition target is deemed essential, or perhaps there is no appetite from existing LPs," says Sharman.

In some cases, some of these more bespoke funds may offer a bridge facility before a fund is closed, from first close onwards, as well as a bridge to a co-investment. They can also be very flexible – at a cost – and, for example, at the other end of the spectrum can offer a facility for a distressed situation with loose or no covenants.

As the market matures, the likelihood is that there will be a rise in the number and types of facilities available, especially if LPs continue to acquiesce to their use. "As well as becoming more prevalent, there will also be more transparency, which is what LPs want. There will probably be a refinement of their use, more driven by a particular purpose, so there won't be any backlash from LPs stopping people from using them," says Hansford.

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• Hogan Lovells
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