Fund Financing Through a Credit Lens - Understanding the Basics of Alternative Investment Funds (AIFs)

This blog is the first in a three-part series on AIFs. The series is designed to: 1) help readers understand the basics of AIFs, 2) highlight the critical credit risk factors for AIFs and fund-level financing, and 3) present a solution to assess the creditworthiness of AIFs and fund-level financing.

AIFs provide an option to invest in different asset classes − such as hedge funds (HFs) and private equity (PE) − primarily for Limited Partners (LPs) that are typically large pension funds, endowments, and family offices. Alternative investments overall doubled their global market share between 2003 and 2018,^[1] and AIFs have been growing too. For example, in Europe (EU), the AIF universe expanded to reach € 5.8tn in net asset value (NAV) at the end of 2018, an 11% increase over 2017.^[2] This growth came mainly from the launch of new AIFs in 2018, rather than from valuation effects.^[3] Institutional investors dominate in the EU, but the retail investor share is also significant at 16% of total NAV, with most participating in funds of funds and real estate funds. The U.S. remains a key driver of the hedge fund industry across the globe, accounting for 72% of the approximate $3.6tn in global assets as of May 2018, compared to $1.9tn in global assets as of Dec 2013.^[4]

Whilst the NAV has been increasing, leverage has as well with some funds accessing loans from banks and other institutions. Since the memory of the 2008-2009 financial crisis is still fresh, the steady and quiet expansion of fund financing has triggered some industry experts to sound warning bells, particularly over subscription credit financing that has become very popular. This financing option enables AIF managers to fund expenditures at short notice, with the loans eventually being repaid by drawdowns from the investors.

What are AIFs?

In general, AIFs refer to any vehicle established for the purpose of raising capital from a number of different investors with an aim to invest these funds in assets to generate favourable returns. Looking at EU, the specific definition of an AIF under Directive  Article 4.1 is as follows: a collective investment undertaking, including investment compartments thereof, which raises capital from a number of investors with a view to investing it in accordance with a defined investment policy for the benefit of those investors and which does not require authorization pursuant to the Undertakings for the Collective Investment in Transferable Securities (UCITS) Directive.

Both open-ended and closed-ended vehicles, and listed and un-listed vehicles, can be AIFs for the purposes of the Directive. The definition captures a broad range of vehicles that would be regarded as “funds”, including all non-UCITS investment funds, wherever established.

Whilst an attempt has been made to harmonize the AIF definition across the EU, the definition may still vary from country to country. In addition, there may be nuances between EU and non-EU AIFs.  Given this, we typically refer to AIFs as HFs, PE funds, or funds of funds. In addition, if an entity is not formally organized as either, it can still qualify as an AIF, if an entity has characteristics similar to a HF or PE fund and executes a strategy or strategies that include elements of both PE investments and HF trading

How does fund financing work? 

Today, the typical fund-level financing options are subscription credit facilities, NAV facilities, and General Partner (GP)-sponsored solutions.

• Subscription Credit Facilities: This has traditionally been used for short-term bridge financing, which typically involves senior secured revolving facilities secured by the unfunded capital commitment of fund investors. The size of the facilities are becoming larger, however, and the tenor has become longer over the years.  
• NAV Facilities: Instead of "looking up" to capital commitment, NAV facilities "look down" to fund assets. The facility is secured by equity in the portfolio holdings and is commonly used for acquisition finance and re-levering concentrated pools of investment. Since the COVID-19 pandemic, NAV facilities are also used to provide liquidity for working capital and to fund downstream obligations for portfolio investments.
• GP-sponsored Solutions: GPs are also exploring alternative solutions for sourcing capital at the fund level. This is often through preferred equity issuance to new investors who provide capital in exchange for priority distribution from some, or all, of a portfolio’s investments. It may also be through fund restructuring, which transfers a portfolio to a successor fund capitalized by new Investors and existing investors who rollover into the new fund.

Fund financing has been booming in recent years.  More players have entered the market, attracted by typically high yields and relatively "pristine" credit performance. With the COVID-19 pandemic and its impact on the economy, however, some lenders have become more cautious. For subscription credit facilities, for example, some lenders have turned to "mega funds", as well as existing funds on books that they know well. Mega funds have appeal since they have more capital to repay a loan and tend to be run by more experienced managers than newer, smaller funds.

In addition, sponsors are increasingly turning to NAV facilities as a source of liquidity for invested funds with limited uncalled capital. This may help offset any lag in subscription facility origination. One of the key uncertainties raised from the valuation of assets under COVID, however, is that the potential devaluation of the assets can cause an increase in the Loan-To-Value (LTV) ratio, subsequently increasing the applicable margin. Further, the asset liquidity or cash flow liquidity of the AIF could be negatively influenced.

What are the critical factors when assessing AIF exposures? 

When assessing AIF exposures and credit risks, the initial credit strength of a fund is a critical factor, especially as we enter any economic crisis. Having a way to estimate the strength of a fund – such as fund-specific financials, funding stability, market-based sentiment, key personnel experience and commitment, and jurisdictional restriction – will help give an indication of the AIF’s ability to withstand distress, such as COVID-19 related business pressures.

Identifying these AIF credit risks may be challenging, since most AIFs are unrated. S&P Global Market Intelligence’s AIF Credit Assessment Scorecard uses a combination of historical and forecast data, together with expert-judgment, to provide an understanding of potential AIF credit risks.