Author: Marc Wagman
The demand for fund finance solutions has risen steadily in recent years, as alternative sources of liquidity are vital to general partners (GPs) at key stages in the fund life cycle. Fund finance is widely used in buyout funds, real estate, the private equity secondary market, private credit and venture capital.
As an emerging and growing asset class, fund finance services are provided by both non-bank and bank lenders, but in the current environment of rising interest rates and higher capital adequacy ratio requirements from US bank regulators, non-bank lenders are poised to provide even greater levels of competition to the banks in this space.
Such market conditions have played an important role in the increasing use of non-payment insurance (NPI) by lenders as a means of mitigating credit risk, obtaining regulatory capital relief (where applicable or possible) and providing lenders with a way to secure greater lending headroom. The potential benefits of NPI in this context are now visibly more high profile than ever, given the often-sounded concern of an impending economic downturn as well as heightened geopolitical uncertainty.
One of the fastest growing segments in the fund finance space is subscription finance, specifically in the private equity arena. Typically involving a loan from either a bank or non-bank lender, subscription finance agreements are secured by a fund's investors' uncalled capital commitments. GPs regularly use subscription lines of credit (aka capital call facilities) to finance activities — such as new investments and acquisitions, fees, or expenses — that would otherwise be funded by capital calls from the limited partners (LPs).
According to UK-based PE industry data analysis firm Preqin Pro, nearly 50% of private equity GPs have used subscription finance credit facilities since 2010, versus only 13% prior to 2010.1 Relative to other asset classes within the private capital space (i.e., venture capital, private debt and real estate), Preqin Pro's data indicates that the growth of this sub-asset class is strongest in private equity.
Some other popular fund finance products include:
- Net asset value facilities (NAV or hybrid NAV) — lines of credit or loans secured by the underlying cash flows and distributions that flow up to the fund from its underlying portfolio investments
- Leverage lines — asset-based facilities that uses a borrowing base calculation to determine availability based on the value of the fund's underlying holdings, which serve as collateral
- Co-invests, margin lending (both recourse and non-recourse) and receivables monetizations, among others
The Role of Non-Payment Insurance in Fund Finance
Lenders can use NPI to cover payment defaults under a variety of fund finance facilities, such as subscription lines, net asset value-based lines (NAV), leverage lines and hybrid facilities (Subscription and NAV lines).
When underwriting fund finance transactions, insurers will prefer to support senior secured loans with well-rated LPs behind them. Some other underwriting guidelines insurers like to see include:
- Advance rates of 50% to 90%
- A collateralization ratio of at least 1.5X when taking into account externally and internally rated LPs
- LPs included under the borrowing base
- Joint and several LP obligations, not exceeding each LP's initial commitment
By using non-payment insurance, lenders can benefit from:
- Increased lending capacity to support larger ticket sizes
- Regulatory capital relief
- Concentration risk mitigation (Industry, borrower, etc.)
- Increased return on capital
- Cost (often less expensive than CDS or other mitigants) and in the case of CDS, NPI is expensed, not capitalized to the lender's balance sheet, so there's no need to mark to market
In short, by protecting lenders from default by a counterparty — whether borrower, guarantor or other — lenders are able to assume credit risk with greater confidence, grow their positions and manage their own capital more efficiently.
Benefits of Non-Payment Insurance to Lenders and General Partners as Insureds
Lenders will often cite internal capacity limits, borrower concentrations and regulatory capital constraints as reasons for not increasing line or facility sizes. By insuring a facility with NPI, these limitations can be addressed with increased availability under the credit agreement.
GPs can benefit from NPI with increased lines and facility sizes, thus reducing the need to source alternative financing and offering the fund more liquidity for acquisition and investment purposes.
Frequently Asked Questions About Non-Payment Insurance
1. How do I discuss non-payment insurance with my lender?
While many banks are aware of NPI and the benefits it can offer, there are often some common misconceptions about the utility of the product. Gallagher's Credit and Political Risk team will consult closely with you to address your lender's concerns and structure a coverage solution to enable your financing objectives.
2. Who pays for non-payment insurance?
The lender is typically responsible for covering premium costs as the lender would be the named insured under the policy. A GP can also cover the premium cost on behalf of the lender, which could be offset with returns recognized by the additional borrowing capacity. Paying for the premium cost could give the GP leverage when discussing line or facility increases.
3. How do insurers underwrite coverage for fund finance?
Insurers will want to see full details of the borrowing base, security package information, the lender's due diligence of the GP, the LPs and how they are rated by the lender, as well as other supporting information. With this information, and in close consultation with Gallagher, insurers will underwrite the deal to generate proposed coverage, pricing and structure.