The Liquidity Conundrum – Navigating Fund Finance for 2024

On 31 January 2024, DLA Piper hosted its first Fund Finance Seminar at its London office. Over 100 guests attended across General Partners (GPs), Limited Partners (LPs) and lenders.

The Seminar reviewed the Fund Finance trends throughout 2023 and looked ahead to the key drivers in 2024 for each core Fund Finance product (Subscription Facilities, GP Facilities, NAV Facilities and LP/Executive Facilities) in 2024.

The panellists comprised major market participants, including Ares, BC Partners, Crooklets, J.P. Morgan, Hedgewood Capital, Macquarie, MUFG Investor Services, Pemberton and UBS, as well as the relevant partners from DLA Piper.

We are pleased to share the main takeaways from the seminar.

General Fund Finance 2023 trends and 2024 key drivers

2023 saw Fund Finance overcome a myriad of obstacles including: (i) the macro-economic/geopolitical turmoil, (ii) the silent (and not so silent) exits of some lenders due to capacity and/or balance sheet constraints, (iii) the collapse of certain major Fund Finance lenders, (iv) a slower fundraising environment and (v) a challenging exit environment (collectively, the Liquidity Squeeze). Despite these challenges the market reported no material defaults across any Fund Finance product. This reinforces what a strong and resilient asset class Fund Finance is.

Comparable to during the COVID pandemic, the Liquidity Squeeze saw the Fund Finance community rally together to generate liquidity for the market, with: (i) new lenders (particularly in the alternative capital space) coming to the fore, (ii) long time lenders showing resilience and adaptability and (iii) an acceleration of increasingly sophisticated transactions such as Net Asset Value (NAV) facilities, Collateralised Fund Obligations, rated notes/loans (particularly subscription facilities) and/or the securitisation of subscription line books.

From a macro perspective, the market expects certain aspects of the Liquidity Squeeze in 2023 to continue for the first half of 2024. This will prolong the extended hold periods for GPs and continue the weaker than normal distributions to LPs. Whilst this may impact the subscription facilities’ market in the first half of 2024, the industry sees this as a reason for the continued rapid growth in NAV, GP and LP financing. The predicted easing of the exit environment and anticipated smoother fund-raising environment after Q2 2024 could lead to a significant rise in subscription facility demand in the second half of the year. Consequently, GPs would be well advised to start discussing their financing needs to ensure lenders’ capacity as early as possible.

Liquidity Squeeze in 2024

(i) Balance Sheet constraints

Market anticipation is that lender balance sheet capacity constraints will continue in 2024. In particular with Basel IV coming, which could see continued lender exits from the market. This may open opportunities for new participants to fill the gap and gain market share. Meanwhile long-time lenders will continue looking for creative solutions (such as the securitisation of subscription line books) to free up lending capacity and retain market share.

Lenders have become more cautious, increasingly focusing on clients who are the most strategic and accretive to their respective business model in the near/mid-term. This perceived flight to quality may put pressure on some mid-size funds and new funds in their hunt for liquidity. The anticipation is that this will continue in the first half of 2024.

Whilst the size of the GP lender market is growing, there is still a capacity issue. The market may see a divergence between banks and private capital offerings and terms. The flight to quality may mean smaller, niche funds and new funds find it challenging to find attractive terms.

(ii) Collapse of major Fund Finance Lenders

After the collapse of several major lenders, borrowers are focused on ensuring diversification across their lender pool. Equally (to pair with lenders who will be there in the long term) borrowers are more willing and accepting that ancillary lender products (such as FX, Admin services etc) need to form part of the package. This will continue in 2024.

(iii) Slower Fundraising

The market expects fundraising to remain slower in comparison to previous years. Therefore, borrowers (both current and prospective clients of lenders) will continue to request smaller ticket sizes with the ability to upsize as fundraising improves.

Consequently, the trend in the growing number of club deals (i.e., two or more lenders) for traditional size bi-lateral facilities, (i.e., USD100 million+) will continue in 2024. This is due to either: (i) lenders being cautious due to balance sheet constraints and/or (ii) borrowers looking for diversification.

(iv) Challenging Exit Environment

GPs will continue to look to financing due to slower exits, delayed carry crystallisation and pressure from LPs to continue to have greater “skin in the game” as they launch new funds. The anticipation is that size and volume of GP financings will continue its growth trend.

Due diligence for GP facilities is very similar to NAV facilities. Lenders will focus on what the anticipated management fee streams are to understand how these fees can be terminated, how long they may run and on what basis they may run off.

GP specific considerations include the size of sponsor, the number of funds they manage, their returns, previous fundraising and their future plans. GPs must consider its ability to service the loan, in terms of interest and any repayment, given the challenging exit environment and delayed carry crystallisations.

LPs will continue to look to their pool of fund assets to free up liquidity whilst they wait for distributions to start flowing again. LP facilities will see broadly similar challenges to GP facilities.

The challenging exit environment is also a critical driver in the rise in NAV Financing. See ”The continued rise of NAV Facilities and its Challenges” section below.

The impact of the rise in Private Wealth LPs

Funds will continue to see an increase in the number of Private Wealth LPs (whether they invest directly or via aggregator vehicles). This may pose challenges in terms of borrowing base availability when compared to the traditional investor pools. It will require some creative thinking as lenders get to grips with the type of due diligence required to advance against Private Wealth LPs.

The continued rise of NAV Facilities and its Challenges

In addition to the ongoing Liquidity Squeeze, in 2024 a debt maturity wall will hit at the portfolio company level. Consequently, GPs and LPs will continue to consider alternative liquidity options such as NAV facilities and Collateralised Fund Obligations to alleviate funding pressure at the portfolio company level. Particularly to finance further acquisitions and/or take defensive measures if stress continues to prevail in the market.

Market predictions are that NAV financing will continue its accelerated growth and grow to between USD500-700 billion by 2030. For context, Fitch Ratings estimated that the more mature subscription facilities’ market stood at around USD750 billion at the end of 2022.

NAV valuations will remain a focus for NAV facilities. However, lenders are focused on working with a GP and structuring the facility such that NAV valuations are not a gating item. The Financial Conduct Authority is expected to review private fund valuations, and this may impact the above point.

Market understanding as to the benefits of NAV facilities will continue to further develop. As LPs and GPs become more comfortable with how these facilities can maximise returns by offensive or defensive plays by GPs, any negative press should abate (as was the case for subscription facilities 6 years ago).

Accordingly, the industry anticipates that market standard terms in (i) facility agreements; and (ii) Limited Partnership Agreements (in relation to debt incurrence and security packages) will begin to develop (as they did with subscription facilities).

Thank you to all our panellists for their time making this a successful event and all the attendees for supporting our first Fund Finance Seminar. We look forward to hosting our next seminar.