Asset managers in the alternative market use loan facilities, structured differently depending on their use and fundraising stage. One of those methods is a subscription facility, or capital call facility, collateralized by investors’ unfunded commitments. It is used to temporarily finance investment opportunities in the pipeline that may arise at the early stage of fundraising. The market size of capital call facilities increased from $400 billion at the end of 2017, to $750 billion at the end of 2022. In 2012, 35% of capital was raised with access to credit lines. In 2023, according to Preqin, it is more than 90%.

Credit line’s typical maturity can be up to 12 months, some are repaid within 3 or 6 months. Due to time value of money, the credit line can boost IRR by up to 2%. BlackRock and Technical University of Munich conducted the analysis of 6000 buyout deals, invested up until 2013 and currently mostly realized. According to their conclusions, subscription lines have on average increased IRRs by 0.5%, decreased DPI by 0.02x and shortened duration by 43 days. However, that was the case when interest rates were low. The cost of subscription lines were 1-2 p.p. above LIBOR/SOFR before interest rate hikes. In addition to that, the Fed tightened capital adequacy requirements for banks, which also widened the spread on credit facilities. Now the cost of subscription line is around 7-8%, which decreases its IRR boosting effect and puts pressure on TVPI multiple. For example, if we consider $100 credit line at 8%, repaid within 6 months, assuming the final cash flow from the investment of $200 in 5 years, IRR will be only 77 b.p. higher, compared to the scenario without the use of credit facility. Moreover, TVPI would decrease by 0.08x, considering that investors bear the costs of financing. If the cost of credit line is 3%, IRR would be boosted more significantly by 140 b.p., compared to the scenario without the use of credit facility, holding everything else constant. TVPI would decrease only by 0.03x.

Regardless of its effect on returns, it rather has cash flow management benefits, e.g. allowing scheduling capital calls less frequently, which could be important for investors with long-term capital that cannot provide liquidity at a short notice. Fitch rating agency recently developed rating methodology for subscription line instruments that may lower the spread and reduce capital reserve requirements for banks. Ratings will depend on creditworthiness of LP base, fund terms, manager’s performance, fundraising pace, fund strategy, currency hedge, and manager’s resources. Usually, managers have a limit for the size of the subscription line credit at 25% of the fund’s aggregate commitments. Since the credit line is collateralized by the unfunded commitments of investors, the cost of such bridge financing is based on the credit quality of fund’s investors. Managers rarely default on such loans because it may hurt their business relationships further. The lender gets the right to call capital from investors to repay the credit if the manager defaults. In fact, there have been only two cases of default: by JES Global Capital and Abraaj Group, both due to fraud and mismanagement of funds.

Because one of the largest suppliers of subscription line credits were regional banks, the supply of such loans has recently decreased after the collapse of Silicon Valley Bank, First Republic Bank and Signature Bank. In fact, Signature Bank’s $16.6 billion portfolio of capital call loans was sold by FDIC to PNC Bank. Some banks have reduced such loans in line with general tightening in loans market. For example, Citibank reduced its subscription line portfolio for $65 billion to $20 billion.

At later stages of investment, managers can borrow against existing portfolio NAV, and the creditor is the first in line to receive any distributions from investments. While subscription line is a revolving credit, NAV based loan is a term loan. There is a cross-collateralization, because multiple assets’ NAV are used for one loan. There are specialized lenders, and some private credit managers have developed a sub-strategy for this asset class, raising NAV financing funds. Although currently a smaller market, Citco estimates that NAV financing loans market can reach $600 billion by 2030, from current estimate of $100 billion. One of the reasons for that is the expected growth of private equity market size from current $5.3 trillion to $8.5 trillion by 2030. The role of NAV financing would be in providing flexibility to pursue investment opportunities. Use cases of this tool ranges from refinancing portfolio companies to financing add-ons and scaling businesses to new markets. NAV financing especially helps to accelerate distributions to investors when the market environment for exits is not good and valuations decrease, as we observe currently. Therefore, NAV financing helps to extend the holding period of investments. According to Pitchbook, the median holding period of private equity-backed buyout investments has increased from to 2.7 years in 2015 to 3.3 years in 2023. As a result, 12-months distributions rate as of September 2023 fell to 11% of beginning-period NAV in 2023, from 38% in fourth quarter of 2021. NAV financing deals have surged in 2023, when discounts in the secondary market have increased to 13% on average. However, NAV facilities are more expensive than subscription lines, reaching 10-12% and higher.

For fund investors, it may become a factor for concerns, because besides using loans for add-ons and driving value creation on existing investments, managers can finance underperforming companies using the rest of the portfolio as a collateral. It can also take form of equity injection in a company to repay or refinance its outstanding debt at better terms, because borrowing at the portfolio level could be more expensive and difficult than at the fund level.

Therefore, current lending environment may have changed the way managers utilize debt capital to pursue different purposes, and that should get more attention at due diligence of funds in private markets.