Breakneck growth in the US$400bn fund financing market could pose a systemic risk to the banking sector as alternative investors borrow to boost returns, bankers and investors said.
Banks’ exposure is soaring as lenders compete to offer loans to funds, including private equity firms, direct lenders and CLOs, which add new leverage to already leveraged investments.
“The market’s growth has been exponential,” said Lee Doyle, global head of bank industry at Ashurst in London.
Concerns that the loans are being used to artificially boost returns have been raised by some Limited Partners (LPs), which traditionally supply funds’ capital, said Jennifer Choi, managing director of industry affairs at The Institutional Limited Partners Association (ILPA) in Washington, D.C.
“Is it now being misued? The systemic risk is more real than many think,” a senior lawyer said.
The use of bridging loans or subscription facilities is booming, particularly in the private equity industry.
These loans cover the gap between calling for investors’ commitments and receiving funds. Loans based on the value of funds’ portfolios are also available, but less widely used.
Banks have piled into fund financing in recent years, attracted by strong returns and the apparently low risk of lending to LPs, traditionally high net worth individuals, pension and insurance funds and sovereign wealth funds.
Some banks are committing as much as US$500m each to individual fund loans, the senior lawyer said.
“The problem is some banks view it as easy money, but a lot of LPs now have a lot of very large funding line exposure,” a partner at a London-based law firm said.
Using bridging or subscription loans instead of LPs capital can artificially inflate funds’ returns by allowing managers to delay – or even avoid – calling on LPs commitments.
This boosts LPS’ returns as they appear to occur in a shorter time, or with less equity investment, despite absolute returns being the same.
“Now it’s a tool to effectively avoid calling LP equity,” a co-head of sponsor finance at a bank in London said.
The loans are usually secured on either LPs capital or assets in funds’ portfolios.
Some banks are seeking additional protection by asking for more collateral than the value of the loan, according to Matt Hansford, head of UK fund finance at Investec.
“You can’t assume it’s bullet-proof lending, there’s definitely risk,” Hansford said.
The ILPA proposed a set of guidelines over the use of subscription lines last year after enquiries from many LPs, and is now pushing for stronger dialogue on the issue.
Some managers are unhappy about the guidelines, which pushed the previously opaque market into the spotlight, Choi said.
“Our guidance definitely seems to have hit a nerve. The quality and level of disclosure around the use of these lines hasn’t been consistent,” she said.
Bridging or subscription loans were previously a niche, short-term product provided sparingly by banks including Royal Bank of Scotland and Lloyds to firms, such as BC Partners, which was one of the first to use them in 2000, the senior lawyer said.
Bridging or subscription loans are revolving credits with tenors of one to three years and are priced at around 160bp while portfolio loans are three to five-year term loans and are priced at more than 300bp, according to a bank that specializes in the deals.
This financial engineering is increasingly attractive as high valuations continue to put funds’ yields under pressure.
”The decline in yields is making more and more investors say ‘why not’?”, a partner at a European private equity firm said.
Growing appetite for the deals may prove to be problematic, Choi said, particularly as the market has largely evolved since the financial crisis and has yet to face a major downturn.
Lenders have suffered no capital losses to date, according to an internal prospectus on fund financing issued by the bank specialist, seen by Thomson Reuters LPC, but potential risks remain.
“Just because we didn’t see mass incidence of LP defaults in 2008 that doesn’t mean it could never happen,” Choi said.
After the publication of ILPA’s report, a standard methodology is being discussed for the private equity industry to calculate and report funds’ internal rates of return and introduce best practice on the use of fund financing.
Many LPs are now arguing that leverage at the fund level should not total more than 20% of the fund’s overall size, the European private equity partner said.
However the availability and relatively low cost of the credit lines still makes them tempting for managers, Choi said.
”The LPs do think that if the use of these lines continues unchecked at current course and speed then it could pose real risk, and we don’t get the impression that the pace of growth has cooled off,” she added.
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