Fund financing for private credit

November 10, 2023
By Steve Berry, Roger Fox

A defensive allocation to private credit for an investment grade portfolio

• Credit portfolio financing is asset-backed financing provided to private credit funds, with security over a diversified portfolio of loans to middle-market corporates. It is an opportunity to gain exposure to middle-market direct lending through a structure that provides an investment grade-equivalent credit profile. There is demand for this portfolio leverage from private credit managers to deliver the returns being sought by investors.
• Credit portfolio financing is traditionally a market dominated by large banks and has grown since the early 2010s to an estimated market size in Europe of €30-40 billion per annum (p.a.).¹
• Deal flow is predominantly driven by new fundraising as managers look to put in place leverage early in a fund’s life. However, the increasing sophistication of market participants is driving changes in structural features and new appetite for leverage. Recent macroeconomic volatility has also created new secondary opportunities as incumbent banks seek to manage their balance sheets.
• The market is primed for institutional investors to meet borrower needs for tenor, loan size, bespoke facility features and other structural elements where banks are less competitive. The market is also underpinned by compelling deployment growth and strong risk-return characteristics.

Credit portfolio financing provides institutional investors a defensive private credit allocation to middle-market lending structured as an investment grade exposure.

Demand for leverage from private credit funds

The global private credit market has grown significantly since the global financial crisis and is now estimated to be approximately $US1.2 trillion globally, having grown more than 10% p.a. through the 2010s.²

Over this time, private funds have taken significant market share in many sectors, especially in corporate lending where direct lenders have widely displaced banks in the US and in Europe. Around 70% of lending to middle-market companies in Europe is now from non-bank lenders, up from 14% in 2013 (Figure 1). This has been fuelled by banks’ retrenching their lending capacity due to increased regulatory pressures as well as by demand from institutional investors seeking additional yield and diversification. Institutional investors now dominate in an asset class that has matured over a full credit cycle and shown resilience to economic shocks, including the recent COVID-19 pandemic. New private debt fundraising globally was between $US120 billion and $US225 billion annually in 2021 and 2022, with direct lending strategies accounting for more than 50% of annual fundraising.³

Increasing relevance of fund financing and portfolio leverage

Fund finance is the financing provided to funds, secured over commitments from investors or underlying invested assets. Fund managers use these tools for different purposes, including:

• Liquidity and operational requirements, such as subscription credit facilities
• Portfolio or net asset value (NAV) financing, which is increasingly being implemented as investors seek a higher return profile than is otherwise achievable from an unlevered exposure to the underlying assets

this, credit portfolio financing – portfolio financing for private credit funds – has grown in tandem with the rapid growth in private credit. With ongoing investor familiarity and private credit market development, there is appetite for portfolio leverage as part of a private credit strategy. This is particularly evident within direct lending strategies, as the diversified portfolios of relatively homogenous exposures provide a suitably stable borrowing base for leverage.

The market to provide this financing has been traditionally served by a limited number of large banks, but institutional investors are now playing an active role. This has only increased in the current macro-market environment where multiple bank lenders have reduced their lending appetite in order to manage their balance sheets, with at least one major European market participant exiting the market entirely during 2023. Overall, the credit portfolio financing market is estimated to deploy around €20-40 billion p.a. in Europe and at least €100 billion globally, requiring new lenders to serve the needs of this market.

The need for alternative lenders

As the private credit market continues to grow and mature, there are two key factors driving the entry of institutional investors into providing credit portfolio financing:

• Evolving market requirements to meet the needs of private credit managers and investors, including new financing structural features
• Providing market capacity given a greater demand for portfolio leverage

Implementation of new financing structural features encourages participation of alternative lenders

Private credit managers are increasingly exploring different structures, terms or bespoke facilities that institutional investors are well suited to provide. For example, longer-tenor financing can often better match the underlying investment strategy of a direct lending fund. Institutional investors have greater flexibility in providing longer-tenor financing compared to banks that are constrained by regulatory capital requirements.

Greater appetite for levered exposure to private credit increases size of facilities

In the early 2010s, in the beginning stages of the private credit market, the typical proportion of investors seeking portfolio leverage as part of their investment strategy was less than 25%.⁴ As the market continues to mature, investors are becoming more familiar with the characteristics of the asset class. This has led to more investors making an allocation to private credit and other investors increasing their appetite for leverage as part of their strategy.

We estimate that 25–50% of investors allocating to a European direct lending strategy seek portfolio leverage

Significant growth in total private credit fundraising requires greater lending capacity

Credit portfolio facilities are generally put in place as new funds are launched. Private credit managers look to add leverage early in a fund’s life to maximise the benefit of leverage on the returns delivered to investors.

In 2022, at least €40 billion of capital was raised in European direct lending across 25 funds. (These figures exclude separately managed accounts, which we estimate could account for an additional 25-50% of fundraising.)

This market development includes the entrance of new managers with experienced teams as well as maturing managers scaling significantly in assets under management. These can present compelling opportunities to work on customised solutions for the borrower that often drive strong risk-adjusted returns for the lender.

Rise of mega funds requires larger individual portfolio facilities at greater frequency

The demand for portfolio facilities has increased in recent years as fundraising cycles have shortened and total fund sizes have increased, resulting in the need for larger leverage facilities on a more regular basis.

The number of global funds larger in size than €5 billion has also grown significantly, with multiple managers now capable of raising funds at this scale. The portfolio facilities required for these funds are too large for any one lender.

These two factors have created an opportunity for new lenders to enter the market and build relationships with top private credit managers.

Why does credit portfolio financing work for institutional investors?

A defensive allocation through the credit cycle

Credit portfolio financing provides a high-quality private credit risk profile, adding diversification to a fixed income portfolio and significant structural protections compared to direct lending credit exposure.

Senior secured

Each facility will be provided directly to a limited partnership or any underlying holding company and is senior secured over a portfolio of underlying loans.

Diversification

The financing will be secured across 20-100+ loans to middle-market companies. These are diversified by sector and geography based on pre-agreed limits in the financing documentation.

These assets also provide diversification from traditional public market fixed income exposures. The companies that receive lending from private credit funds do not access the corporate bond or broadly syndicated loan (BSL) markets, and each private credit fund will lend on a bilateral or small club basis. Each portfolio financing will therefore be set against assets that are not duplicated elsewhere in an investor’s public investments.

Quality of underlying loans

Underlying loans in direct lending funds are typically senior-secured covenanted exposures, to companies with moderate leverage, commonly between 3.0 and 7.5 times net debt to earnings before interest, taxes, depreciation and amortisation (net debt to EBITDA). Such loans typically offer structural protections materially stronger than seen in the high yield bond or BSL market, particularly financial covenants.

The LTV is tailored relative to the quality of the underlying loan characteristics. For example, a portfolio of mainly senior underlying loans will usually allow for a larger quantum of financing than a portfolio including mezzanine or second-lien underlying loans.

Cash flow and repayment

The underlying loans pay regular interest payments that provide cash flow to support interest or principal payments on the portfolio facility.

Repayment of the facility is driven by repayment of underlying loans that have a more predictable profile than private equity investments. The cash flows are applied to the facility according to an agreed waterfall or mandatory prepayment events.

Overcollateralisation

Typically, facilities offer a maximum LTV of 40-65% depending on the quality and diversity of underlying assets. This provides a strong level of overcollateralisation to protect lenders against underlying loan deterioration.

This represents a similar level of credit enhancement to the AAA-rated tranche for a CLO. However, the overcollateralisation of credit portfolio financing is recalibrated and maintained over time, balancing any underlying loan underperformance, compared to a CLO in which the attachment points remain static regardless of loan performance.

The two stress scenarios in Figure 3 show that a typical facility is able to withstand significant portfolio losses. These represent a material stress given there is no historical precedent for default rates to be sustained at the peak level for multiple years.

In practice, in both scenarios, various options under the facility documentation could be pursued to pay down the facility to reinstate the LTV ratio

Source: Macquarie Asset Management (2023).

Navigating the best route into the market

Institutional investors should consider the following factors in how they access the market.

1. Macquarie Asset Management (MAM) analysis based on underlying private credit fundraising and market knowledge on the implementation of financing
2. Based on a compound annual growth rate, McKinsey Global Private Markets Review (March 2023).
3. McKinsey Global Private Markets Review (March 2023).
4. Based on MAM market view as of October 2023.
5. Rating is estimated based on MAM Private Credit internal rating methodology, which broadly corresponds to Moody’s rating scale.
6. As at August 2023 using a reference basket of European A-rated corporate bonds with tenors between 5 and 7 years. Sourced from Bloomberg.
7. Based on MAM market intelligence, 2023.
8. Based on new issuances of AAA-rated CLOs in the three months to July 2023. Sourced from Pitchbook-LCD.
9. As at June 2021, Deloitte Alternative Lender Deal Tracker, Spring 2022.

Authors

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The views expressed represent the investment team’s assessment of the market environment as of October 2023, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Past performance does not guarantee future results.

Diversification may not protect against market risk.