Fund Finance: In Strategic Spotlight

Fund finance has evolved from an administrative convenience to a value add tool, says Gianluca Lorenzon, head of fund finance advisory at Validus Risk Management

Q: How has GP thinking around fund finance evolved over the years, and how are GPs using fund finance in the current market?

Over the years, fund finance has be­come established as a critical compo­nent of running private markets funds. It has gone from being purely adminis­trative in nature to becoming a strate­gic tool and a source of differentiation.

After all, private markets – and es­pecially private equity – is a rapidly maturing space. And like any asset class that’s growing, evolving and moving into the mainstream, managers here have to start maximizing the efficiency of their operations. That’s why many are now focusing more and more on fund finance, recruiting dedicated fund finance professionals and working with advisers to ensure that their funds are taking full advantage of the flexibility, liquidity and innovation that fund fi­nance facilities offer.

The macro backdrop over the past three years has reshaped the fund fi­nance market. Rising interest rates have changed how lenders behave and therefore altered the way GPs need to interact with their fund finance provid­ers. This comes at a time when softer M&A and IPO markets are slowing both exits and fundraisings, putting GPs under increasing pressure.

Q: Let’s start with GP commitment facilities. What’s the rationale behind
the use of these?

Generally speaking, a sizable pro­portion of partners’ wealth will be invested in their firm’s funds, to cre­ate alignment with investors. Indeed, GP lines have long been used to sup­port managers who are growing their AUM. Prior to the slowdown in exits and distributions, GPs could draw on proceeds from earlier funds to fund the typical 2 percent GP commitment to the next vehicle. But when, say, the last two funds have not generated much liquidity and have not paid out carry, it becomes very challenging for the part­ners to meet that commitment to the next fund.

On top of that, GPs are also facing the most testing fundraising market since the global financial crisis. LPs are now more selective, and managers have to be able to differentiate their prop­ositions. All other things being equal, one way to differentiate your fund is to increase the GP commitment.

Finally, the rising volume of contin­uation vehicles is also a factor, as they too require meaningful cash contribu­tions from GPs in order to transact.

Put all that together, and managers are stretched when it comes to meeting their GP commitments. A GP com­mitment facility, then, can bridge that gap at a time when liquidity is reduced. Successful GP commitment financing is therefore becoming a strategic tool to progress the next fund and build the franchise effectively.

Q: What about NAV financing, which seems to have really taken off over the past five years?

NAV financing has actually been around for a long time, but it is true that the product has seen increasing uptake since the pandemic, particularly in private equity.

It started out as a defensive tool. If a manager coming to the end of a fund’s investment period was in need of eq­uity to support a portfolio company but was either out of commitments or didn’t want to call capital, a NAV facili­ty made it possible to lever the value of the other assets in the fund to support this business. Deals used to be fairly small and under the radar, but then the market really took off during cov­id. Now, taking on a NAV facility has become widely accepted.

Use cases have subsequently ex­panded. NAV financing is now be­ing used to support fundraising – for instance, if a manager has reached a first close but has invested all the capital and wants to make another acquisition before making a second close. That in­jects momentum into the fundraise too, because it mitigates the blind pool risk and J-curve effect for investors coming in later on in the fundraising process.

There is also the distributed-to-paid-in (DPI) use case, which has attracted headlines but doesn’t actually happen that often. Here, managers can raise NAV facilities to expedite distributions to investors at points in the cycle where exits are challenging and hold periods have been extended.

Q: Turning to capital call lines, how are GPs thinking about these facilities?

Capital call lines have been around for decades, and this is now a market worth up to $1 trillion annually. Most GPs will use some form of capital call facility.

Capital calls were mainly introduced to reduce the administrative burden on LPs and GPs, but using these lines efficiently is now very important – es­pecially in the current market. These lines allow managers to smooth capi­tal calls, give LPs more notice and be more competitive when it comes to speed of execution.

That’s why GPs are now paying closer attention to their capital call requirements and providers. These fa­cilities used to be easy to secure, with banks eager to lend and to use these products to deepen their GP relation­ships. However, between mid-2022 and early 2024, liquidity became tight­er and the cost of capital crept higher. While liquidity has since returned to the market, with subsequent pricing improvements, we believe there is fragility here, and GPs should ensure they have a diverse group of lenders to guarantee stability in the product and to underpin their ongoing importance to those lenders.

Several banks are now less keen on the product too and have scaled back their business in this area because of the return-on-capital considerations. Most have become much more selective in terms of who they support. The mar­ket has become more complex, nuanced and fragmented, and the provision of capital call facilities is no longer a given.

Q: So, what does this mean for GPs and how firms manage their fund finance requirements?

Fund finance is becoming an important strategic tool for GPs, requiring them to be more thoughtful about how they manage these facilities. Generally, our advice is to create optionality, which means diversifying your funding sourc­es while balancing that with remaining relevant to each lender. It is simply too risky to have all your fund finance facil­ities tied up with one or two institutions that could step back from the market or scale back their fund finance provision. Managers need to choose their partners carefully to minimize counterparty risk.

At the same time, from the sup­ply side, fund finance is moving from a market-dominated by banks, to one where non-bank providers are more influential. That means the products, terms and cost of capital out there are now much more fluid.

There is also a significant amount of product innovation occurring, reflect­ing lenders’ need to differentiate them­selves and to answer the changing needs of borrowers. However, these changes (which are broadly beneficial to the GPs) mean that there are more options and increased complexity in analyzing and structuring these facilities.

For GPs that tap the fund finance market infrequently, it is particularly challenging to stay at the cutting edge and compete effectively. Plus, given the pressures on fees for all GPs, manpow­er can be a limiting factor when arrang­ing these facilities. That’s why there is growing demand from within the GP community for more in-house and ad­visory support, to ensure that they are securing the best the market has to of­fer in a cost-effective manner.