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In the beginning, private credit funds made loans to companies to finance a leveraged buyout or something. Nowadays, they make loans to all sorts of structures. Including [checks notes] private credit funds.
According to a new report from Moody’s, fund finance has got big enough to call a distinct asset class, with a total market size north of the trillion-dollar mark. While MainFT has written at length about each of its components elsewhere, we thought it worth pulling together a quick catch-up.
The genius of the finance industry is its ability to solve real-life problems, albeit in return for a hefty fee. And this genius extends to solving the problem of what to do when you can’t get your money back from products sold to you by the finance industry. As the authors put it:
As private equity and credit funds face delayed exits and refinancings, fund finance has emerged as a critical backstop that bridges liquidity gaps, enables operational flexibility and supports managers’ balance sheet management.
Fund finance used to mean subscription credit facilities. And these are still the daddy of the category.
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Around three-quarters of funds use sub lines, according to Preqin. Because sure, a private equity fund might have a host of large institutional pension funds, sovereign wealth funds, insurers, whatevs as limited partners from whom they can make cash calls. But if the general partner needs money right now, rather than in maybe 10 business days when LP cash call might come through, a short-term revolving credit line is going to come in handy.
Moreover, we can see it might be more efficient to draw on revolvers to handle day-to-day expenses, and administratively simpler to batch together LP capital calls periodically rather than dozens of times a year. And that’s before we even get to how using sub lines can juice performance metrics, boosting GP fees. All this makes sub lines a must.
But the fund finance kids are growing up fast, and while none of these oddballs is new, they’re far more gawp-worthy.
Private credit funds, Moody’s writes, have been particularly active in net asset loan lending, especially “in scenarios that banks typically avoid, such as transactions with moderately higher loan-to-value (LTV) ratios or highly tailored terms”. Moreover,
[g]rowth in the number of private credit funds has been a particularly strong driver of fund finance expansion: these funds’ granular, often self-amortizing loan portfolios are more readily financeable than typical private equity assets. As private market fund investors are becoming more accepting of fund level leverage, the rise of private credit and fund finance are mutually reinforcing.
It’s nice to know that private credit fund investors are becoming more accepting of private credit fund leverage, facilitating the funds’ financing by private credit. 🤨
Meanwhile, insurers have taken the lead in rated note feeders. Here, the borrower is a fund investor, and the lender’s collateral is that investor’s interest in the fund. As such, most insurers are in effect “taking exposure to the underlying private credit fund through both debt and equity positions issued by the rated feeder”. All totally normal stuff.
And although an ongoing constipation in PE exits has boosted PE secondaries’ transactions to around $200bn last year, this, according to Moody’s, is still insufficient to meet investors’ desire for cash. Which is great news for whoever is structuring collateralised fund obligations:
CFOs securitize pools of illiquid private equity fund interests by issuing tranched debt, allowing limited partners to access liquidity from otherwise illiquid holdings. These instruments provide rating-sensitive investors with exposure to private equity through rated debt tranches and serve as novel fundraising tools for general partners and liquidity management tools for limited partners, helping them recycle capital and support new investments.
Meanwhile, some banks have begun bundling portfolios of fund finance loans into asset-backed securities to transfer risk and achieve regulatory capital relief. This process enables them to offload exposure from their balance sheets while tapping capital markets to deepen the investor base for these loans.
When Alphaville described how, with enough subordination, it’s pretty straightforward to create rated securities, we meant really that it’s pretty straightforward to create rated securities out of assets with contractual cash-flows. We failed to mention that illiquid stakes in PE fund interests that managers have failed to offload elsewhere work fine too.
Further reading:
— Ask an Expert: Submit your questions: Who’s afraid of private credit? (MainFT)
— FT Alphaville’s toy Collateralised Whatever Obligations (FTAV)
— How private equity became hooked on second-hand deals (MainFT)
— The black-box funds fuelling insurers’ private credit binge (MainFT)
— Green shoots in the private equity winter? (FTAV)
— How banks fuel the private credit boom (MainFT)
— Collateralised fund obligations: how private equity securitised itself (MainFT)
