1. Overview
It could have been worse – 2023, that is. Let's just take a brief inventory: the year started with the steepest global rate hiking cycle in history well underway. In January, short-term interest rates reached levels not seen since before the Global Financial Crisis. Recession alarm bells were ringing. Given the inverted yield curve, and tightening financial conditions, many viewed a recession as a near certainty. By early May, we had experienced three of the largest U.S. bank failures in history. All three failed institutions were deeply connected to the fund finance market. As the year played out, banks continued to navigate a kryptonite-laden environment of rising funding costs, sluggish loan demand, and intense credit scrutiny, only to see a sweeping proposed regulatory capital regime change handed down in July.
As 2023 progressed, inflation moderated, financial conditions showed signs of easing, and in the U.S., economic growth accelerated. In Europe, the economic picture was a slight contrast, with sluggish GDP growth forecast for the full year. In all of the aforementioned regions, the softening inflationary environment has meant there is no longer a debate as to whether peak interest rates have been reached, with financial markets starting to price in rate cuts. In fund finance, the origination platforms of the three failed lenders were ultimately absorbed by successor institutions and, while origination volume and deal count declined and margins widened, an orderly market prevailed.
Abrupt changes averted, the fund finance market is nonetheless being reshaped in fundamental ways. For private markets, 2023 marked the end of an era. The full impact of higher interest rates will take time to manifest. Public market returns, particularly in fixed income, look significantly more competitive. As the yield on liquid, hedgeable, leverageable, insured mortgage-backed securities, for example, moves toward converging with the typical closed-end fund preferred return, the liquidity give-up for incremental allocations to private markets becomes less compelling. At the very least, investment committee discussions in 2024 will be more animated, but allocations are also likely to be adjusted, and will pose a headwind to fundraising.
It is not just the changed relative value matrix – distributions have slowed meaningfully. On the practical side, reduced distributions mean that less money is available for new commitments, while limited partners that seek to reduce private market allocations may be led to secondary sales or liquidity-releasing financing solutions. More theoretically, private fund investments, in many cases, may be experiencing a lengthening in duration as rates rise, which may be contrary to expectations. Money is staying locked up longer right as reinvestment opportunities become more attractive.
Internal to funds, investment capital structure and fund capital structure are adjusting to the revised interest-rate regime. In some cases, acquisitions are being funded with higher equity contributions. Sponsors are working with fewer levers to pull on portfolio company capital structure optimisation. Fund finance facilities are sized to lower advance rates, and utilisation is more carefully monitored in light of higher all-in interest costs. All of these factors are likely to play into forward investment returns.
On the lending side, a number of players found 2023 to be a year of dislocation, relocation, and then reallocation. But for bank lenders generally, funding costs moved up faster than asset income, putting profitability under pressure, and leading a number of lenders to commit to a risk-weighted-asset diet. As balance sheet capacity became more scarcely rationed, multi-point revenue streams, deposits, and fee income became possible gating issues in the lending process. Transaction economics continued to be revised higher for renewals throughout 2023 in light of market conditions.
While these changes are bound to have a lasting effect on the fund finance market, we believe it represents a waypoint along the journey to the next chapter. Subscription finance stands out among secured fixed-income products as an asset class where collateral values are not directly impacted by higher interest rates. From a lender perspective, unlike corporate loans that rely on interest coverage ratios, consumer loans tied to borrower debt servicing capacity, or real estate financing tied to property values, subscription finance benefits from higher rates without an accompanying impact on the value of the collateral pool. This value proposition should have more appeal to the broader fixed-income community than what it has registered to date.
Fund finance lending has always been a hybrid sitting somewhere between investment banking and corporate lending. In 2024, we will all have to come to work with both toolkits as we continue to build a market that brings together a broader host of capital sources to solve evolving challenges for fund borrowers.
Originally published by ICLG.
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