The energy was high and the sessions were packed at DealCatalyst's Future of Fund Finance conference at the Landmark Hotel on Tuesday.

European fund finance is at an inflection point, as a market once dominated by sleepy institutional relationships has become one of investment banking's most exciting corners. Goldman Sachs, for one, sees financing funds as an essential driver of returns in its fixed income business.

The changing of guard is symbolised by the actual people involved, who are increasingly structured finance people, as securitisation and distribution take centre stage. Structures are in flux, with multiple routes to the same economic objectives, and innovation aplenty. It happened to fintech, now it's happening to fund lending.

What does fund finance mean?

The lowest risk and possibly the largest segment of the market consists of subscription lines (otherwise known as capital call facilities). These sit between funds and limited partners, and are secured on the limited partner commitments, making them extremely low risk (two defaults have been recorded, both related to fraud. The typical bank's portfolio has a historical PD of 0).

When fund managers (GPs) want to make an investment, they can draw on the sub line and collect the LP money later. Cynics/realists would say this administrative convenience is outweighed by a much more attractive property. Drawing a sub line rather than LP cash allows GPs to increase the LP's internal rate of return. LPs have to account for capital commitments, but not like a bank does; cash out the door really is what matters.

Subscription lines are short term and revolving (although, the more they are used for juicing returns, the longer term they may be). Commitments are often unfunded. One could consider them the working capital of a fund, analogous to a receivables facility for a corporate borrower.

If the subscription line is a working capital facility, a NAV line is more akin to ordinary corporate debt. It is term leverage provided against the portfolio in question. And the portfolio is very much in question, as it can cover almost any asset class.

There's a spectrum from private equity classique (a buyout fund with single digit numbers of assets) to a granular private credit fund, or a secondaries fund with a ton of diversified PE stakes. The loan-to-value of a NAV line varies depending on these underlyings. 5-15% is normal for a buyout fund, but 60-80% might be seen in private credit (where the structure is essentially a private CLO). Still, there's a lot of equity left in these transactions, and NAV lines are generally structured to be investment grade-equivalent.

Hybrids of these approaches are also possible, especially given the different financing requirements through the life of a fund.

Subscription lines are most important (and most likely to be drawn) early on, as a fund is deploying. Once fully invested, usage typically declines. Portfolio companies might need to finance acqusitions or capex, fund equity injections to placate lenders, or deploy incremental cash for other reasons, but these demands are much lighter than deploying in the first place.

Meanwhile, NAV lines make little sense early in a fund's lifecycle. If you don't know what's in the portfolio, how can you lend against it? Once a fund is deployed, or during the realisation period, NAV finance can juice returns, fund earlier distributions and help to manage slow-moving realisation. This is particularly important in what one panellist called the "realisation winter".

Smaller and more bespoke is GP or ManCo financing, slightly different structures that essentially lend to the fund manager as a business. Funds kick off a a stream of management cashflows, but GPs usually have stakes in their own funds. Funds can use either or both income streams to secure financing, which they could use to cover new fund commitments, or other ordinary course-of-business activities. Most companies have a bit of debt in the capital structure, so why should fund managers be any different?

What’s the future?

The 'future' element in the conference came because, despite the distinctions between products, all forms of fund finance are going through rapid change, transitioning from bank-dominated relationship market to institutional distributed market. The drivers are demand and regulation.

Demand comes from the rapid expansion of the broader private markets ecosystem. Private equity is larger than ever and more companies are sponsor-owned. Larger sponsors are now broad-based alternative asset managers with infrastructure, private credit, asset-based lending, and commercial real estate sat alongside traditional buyouts. These activities are mostly housed in co-mingled closed-end funds with a defined lifecycle.

When 'alternative asset management' mostly meant hedge funds, these vehicles were fully funded and mostly invested in public stocks, bonds, commodities and derivatives. All of that could be levered, using mark-to-market financing such as repo.

Now alternatives mostly means unlisted private assets of all kinds. Other structures are more suitable, and the old business of fund finance has grown along with the private markets sector.

Regulation mostly means regulation of banks, through the Basel capital accords and particularly the incoming rules known as the Basel Endgame.

Capital rules don’t really deal well with fund finance lending.

Mark-to-market fund leverage, prime brokerage, repo and similar are covered off with concepts of counterparty and market risk, but lending money to a fund isn’t broken out as a distinct category; the loans are basically tagged as unrated corporate lending.

For subscription lines in particular, this is a huge disadvantage. The entire subscription lines market has seen two defaults, both related directly to GP fraud. Most banks have suffered zero defaults across their sub line portfolio. But nonetheless, risk-weighting for a bank using the standardised approach is 100%.

For banks using the internal ratings-based approach, the situation is much better. The lack of defaults makes it hard to put something sensible in the 'probability of default' box (banks and regulators have a floor PD above zero) but the model spits out figures comparable to decent quality mortgages.

The whole point of the Basel IV reforms is to close the gap between standardised and IRB banks, on the grounds that it’s unfair banks get to mark their own homework. Yes it is… but the system doesn’t quite work for sub lines.

Rated revolution

A variety of solutions exist, and a big one is ratings. In most capital markets, ratings are a fact of life, but rarely the most glamorous end of the business. In fund finance, though, the advent of ratings is nothing less than a revolution. Assigning a rating, for a bank using the standardised approach, can slash the risk-weighting. Instead of exposure to a no-name unrated company, suddenly it’s risk-weighted like a loan to Microsoft.

The lack of defaults, and the credit exposure facing limited partners, means a high rating can usually be achieved, often double-A equivalent. The LP composition matters a lot, however; funds backed heavily by friends and family or high net worth individuals will find their sub lines more expensive than those backed by blue chip sovereign wealth.

A rating can bring unwelcome transparency, but it can be done in private. A bank can use it for internal capital purposes but share it only in a private data room.

One could take things a step further. Leaving regulation aside, if sub lines are typically double-A rated, this is well above the ratings of most banks. From first principles, this doesn’t make much sense; why should the less credit-worthy institution be lending the money?

Despite this disparity, the business is attractive to banks because it’s a superb relationship play. Sponsors are some of the best clients for any investment bank. They are active in capital markets, require a lot of advice and a lot of balance sheet. What better way to cement the client than by lending to the fund itself?

Get some structure

Another solution to managing capital is the fast-growing Significant Risk Transfer market (SRT) for subscription lines, which can relieve bank capital requirements against sub line portfolios. The idea here is to tranche the portfolio, and buy protection on the junior tranche from outside the banking system, usually a hedge fund.

Sub lines represent a particularly attractive asset class for the SRT market, because of the large mismatch between capital requirements and economic risk. A bank can free up lots of capital at low cost, in other words. If there’s an issue with the market, it’s that sub line SRTs often don’t hit the minimum spread targets for the funds involved in SRT. It’s a fairly specialist market requiring deep expertise; nobody is playing in it hoping to earn 400bps.

The newest product is distributed cash securitisation for sub lines, which can achieve risk transfer as well as raise market-based funding. Goldman Sachs made headlines with its Capital Street Master Issuer vehicle last year, distributing the equity to Blackstone.

This solves for capital requirements and market-based distribution, but it runs up against other problems.

Subscription lines are revolving exposures, often undrawn and not paying. When they do pay, they don’t pay a lot, and some of the largest global LPs crop up repeatedly across a given portfolio. Term securitisations work best when loans have precisely the opposite characteristics; fully drawn loans paying a lot of interest to a diversified borrower group.

The structuring challenge is basically to bridge this gap, but you can’t solve it completely. Goldman’s deal uses a master trust structure, common in credit card ABS, to handle the payment fluctuations. The intuition here is that, across a large enough portfolio, you can get rid of some of the volatility inherent in a revolving structures and finance for term, on the basis that enough loans will be drawn and paying at any time to support the structure.

With credit cards, large portions of the drawn balance are not paying anything at any given moment; 0% deals, teaser rates, diligent debtors who pay down every month all eat into the margin. But those who are paying are paying a lot, which is not the case for sub lines.

It’s also less obvious that sub line drawings are uncorrelated. Credit cards are very granular, with random variation susceptible to statistical modelling. Sub line drawings have at least some relationship to the M&A market, credit cycle, economic conditions, valuations. Buyout shops tend to want to buy assets at about the same time.

So the challenges are formidable, particularly as the asset class is new. If it becomes more accepted and spreads tighten, these issues become more manageable. The rationale for sub line securitisation is stronger if spreads start looking more like prime credit cards than CLOs, and the advance rate is superb (95% to double-A for the Goldman deal).

One can also solve some of these problems in private. The Ares-Investec transaction, as covered here, is a private version of a sub line securitisation. Investec has adapted its book to ease some of the challenges of sub line distribution, creating staggered term loan products that mimic the drawdowns which might be seen under a revolver.

Rather less excitingly, securitisation (in private) serves as another useful capital management tool particularly for NAV lending. Capital treatment for a line to a fund could be improved by structuring into a senior securitisation position, or even tranching into senior and junior.

But regulation giveth and taketh away. Making this loan into a securitisation, even a private one, drags it into various reporting and disclosure requirements, which are poorly specified for fund finance. The regulatory templates don’t make much sense.

So exposures that are economically the same can be securitisation, or not. If you’re packaging mortgages, you don’t really have an option to go RMBS or not at the issuer’s choice. Fund finance is more flexible, and incentives can push in opposite directions.

Becoming a market

Packaging fund finance risk into securitisations and selling it to institutions is quite the market evolution, but the final form of market has to be making something tradeable. That’s already the case for the public Goldman deal, and there are some moves afoot elsewhere. Evercore, for example, is looking to establish a desk to cross trades in collateralised fund obligations.

Trades elsewhere are likely to follow the template of corporate private credit; risk can be moved, but there’s a heavy lift of NDAs and permissions, and any trades are likely to be private, and brokered, rather than traded as principal.

But it’s still a topic that’s emerging, and the more institutions become involved, the more there’s a possibility of two-sided markets coming together.

Telling the story

While fund finance is running headlong into its future, there’s a bit of a bunker mentality creeping in. Headlines like “Private Equity Pulls Back from Exotic and Controversial Liquidity Loans” or “How Private Equity Tangled Banks in a Web of Debt” aren’t popular in the industry! But they’re a by-product of the very evolution that’s occurring. Once financial products become institutionalised, they attract more scrutiny, from journalists and regulators and the casually interested, who may be less invested in the industries they’re writing about.

The coverage ought to be welcomed, and if the industry wants to do something about it, transparency has to be the way. Funds have justifiable concerns about disclosing too much on their portfolios, but showing the world the future of fund finance is safe means showing the world a little more about fund finance transactions and fund leverage.

If you missed us on Tuesday, we will catch you next January, for DealCatalyst's second Fund Finance | Europe conference in London.