The non-Darwinian evolution of fund financing vehicles


In 1972, palaeontologists Niles Eldredge and Stephen Gould published a paper arguing that evolution proceeds in relatively rapid leaps, prompted by significant changes in an environment, followed by periods of stability. Known as punctuated equilibrium, this theory cited evidence from the fossil record to challenge the assumption of a gradual evolutionary process. Charles Darwin noted this pattern in On the Origin of Species. Assigning it to gaps in the fossil record, he believed that once these were filled, a more gradual evolutionary process would emerge. Over time, however, as the fossil record became more complete, it became clear that gradual change alone did not fit the geological evidence. Sudden, significant adaptations due to ecological changes are now accepted to be a critical part of the process of evolution.

The fund financing space, and net asset value (NAV) finance in particular, has recently experienced one of these sudden changes, prompted by a shift in the landscape fuelled initially by Covid-19. Almost overnight there was a need for managers to find additional sources of growth capital and/or liquidity. This demand, paired with the unprecedented pace of fundraising during the year, meant that 2021 saw a record level of fund financing activity. And this upward trajectory is expected to continue over the next decade and beyond.

Becoming essential

Capital call loans (also known as subscription finance), put in place at the start of a fund’s life and secured against the undrawn commitments of limited partners (LPs), continue to see strong demand across the private equity industry. They are fast becoming an essential tool to provide working capital to private funds, now estimated to be used by more than 95% of managers. These facilities enable managers to access capital quickly, provide LPs with visibility on drawdown cashflows, and avoid equalisations when making acquisitions during fundraising.

When LP capital has been invested, private equity managers need to look at different financing tools to provide flexibility during the period that they will hold assets and create value across their portfolios.  As Stephen Quinn, Co-Head of Credit at 17Capital, noted in a recent article: “Given the average private equity buyout fund now has an average life of over 15 years and the overall industry is sitting on an unprecedented $5 trillion in unrealised NAV, having financial flexibility is not just desirable but necessary.”

These factors, along with greater levels of industry awareness and adoption, have led to the rapid growth in the use of NAV financing, which involves borrowing against the fund’s equity interest in its portfolio companies. It is typically used once deployment periods are over and the fund doesn’t have capital to draw down from its LPs. Use cases include investing for portfolio growth, generating investor liquidity without selling performing assets, and supporting continuation vehicles and end of fund strategies. Financing is usually delivered by way of senior loans or preferred equity depending on factors such as advance rates (loan to value), underlying diversification and the flexibility requirements of the borrower.

Rapid rise in demand

Demand for subscription finance is estimated to be more than $650 billion a year, while NAV financing is currently around $100 billion annually and growing rapidly.

Combining capital call loans during the inception of a fund with NAV facilities later in the fund’s lifecycle offers managers and lenders the ability to create a fully bespoke financing solution that covers the entire lifecycle of a fund.  

Subscription financing can influence the internal rate of return (IRR) of a fund as capital is not called from investors immediately and can be returned in advance of proceeds from exits flowing back to the fund. Since IRR is calculated between the time that the fund draws capital from investors and when this capital is returned, delaying calls and accelerating returns can see IRRs increased.

An analysis conducted by Montana Capital Partners showed that credit lines improved IRR by 4% net on average, although the report highlights that strong performing funds will see improved IRR relative to poor performing funds. Aware of this, and appreciating the benefits fund financing provides, many LPs are now asking managers to report levered and unlevered fund-level returns.

New entrants on the scene

The demand has meant that deals for subscription finance are much larger than they have been previously, and banks, the traditional lenders in this space, are facing challenges managing such deal sizes. Internal risk limits and regulatory considerations mean banks are reaching their lending limits for fund financing, and institutions and asset managers are stepping in to meet demand.

Institutional investors are attracted to subscription finance for various reasons, not least the stable risk-adjusted returns that are uncorrelated to credit markets. The short-term duration and low credit risk of fund finance lending has meant that yield-starved institutions are increasingly keen to participate in these investments. Asset managers are also recognising the benefits and, since they share much of the DNA of borrowers, can customise financing solutions to meet specific challenges. They’re therefore becoming established lenders in the space alongside traditional bank providers.

A new asset class

The NAV financing market is growing at a double-digit rate and market participants forecast this to continue. “NAV lending will become an asset class on its own and will be the new direct lending in the next few years,” said Augustin Duhamel, Managing Partner and Co-Founder of 17Capital, in IQ-EQ’s recent webinar on the latest developments in the fund finance market. “We estimate that the market opportunity for NAV financing is around $100 billion a year, and it will keep on growing.”

17Capital was a trailblazer in the NAV financing space, extending its first loan in 2008. Since then, the firm has raised more than $9 billion across six funds and mandates, and in the 18 months to January invested more than $3 billion in NAV financing transactions. In recent projections, it forecast the market opportunity of NAV lending to be more than $360 billion in 2025 and more than $700 billion by 2030.

Private credit funds have taken note of this growth and been increasingly active in lending on fund finance transactions. As these funds generally have greater risk appetite and flexibility – and require a higher return – than banks, NAV lending is a natural hunting ground for specialist providers with dedicated pools of investment capital.

A sudden adaptation

Prompted by significant pandemic-induced changes, the fund financing market had a record year in 2021 and continues to go from strength to strength. Finance providers are increasingly willing to innovate and provide creative, bespoke structures to service the requirements of sponsors as comfort with fund financing grows. With aggregate demand currently at $750 billion a year and growing fast, fund financing is set to become a multi-trillion-dollar market in the coming years. Asset managers are fast recognising this opportunity, and their DNA means they are well equipped to meet the needs of borrowers. This combination means that fund financing is well on the way to becoming a standalone asset class.

A condensed version of this article was originally published by PEI.