The panel noted that private and listed credit funds that invest in loans in the United States have a long history with leverage, driven primarily by investors who have preferred the higher returns that can be achieved on their equity investments when a credit fund’s loan portfolio is leveraged. This broadly accepted use of leverage has resulted in a deep bench of lenders providing financings for US credit funds.
By contrast, leverage lending to credit funds is far less common in the UK and European markets, where investors have historically shown more aversion to risk than their US counterparts and have accordingly discouraged the use of leverage. In these markets, leverage lending to credit funds is far less developed than the US market. That position, however, is evolving as UK and European managers seek to use leverage to increase credit fund returns and investors demonstrate a greater acceptance of leverage in fund finance structures.
The panel attributed this increasing use of leverage in the UK and Europe to the leadership of large private credit funds operated by managers with significant long-term presence in the market. Their track records over many years and at least one full credit cycle have helped foster a willingness among some investors to permit credit fund leverage and have provided a strong credit basis for banks to expand their lending to credit funds managed by these managers.
Lending to credit funds
The panel explored a number of types of credit facilities used to finance credit funds in the US, UK, and European markets.
Subscription facilities: Subscription facilities are commonly used across all of these markets. A subscription facility is a revolving credit facility made available to the credit fund itself, with the lenders underwriting the creditworthiness of the equity investors who have agreed to provide capital commitments to the credit fund and with the lenders taking security over (i) the capital commitments of such investors, (ii) the right to issue capital calls to such investors, and (iii) the bank account into which those capital commitments are required to be funded. Subscription facilities typically involve the lenders lending against a borrowing base calculated by reference to the uncalled capital commitments of equity investors in the fund whose credit has been underwritten by the lenders and may provide for different advance rates depending on how creditworthy the lenders view particular groups of such equity investors.
A subscription facility is typically used to bridge investor contributions in order to facilitate and expedite investments in loans while capital call are outstanding to the investors although some managers have used subscription facilities to obtain a degree of fund-level leverage by making investments without having to drawdown investor commitments.
However, as a credit fund ramps up its loan portfolio, typically the amount of unfunded capital commitments of the equity investors who create the borrowing base for the subscription facility are reduced and the manager of the credit fund may seek a credit facility the borrowing base of which is related to the loans owned by the credit fund, not the capital commitments of its equity investors.
The panel then explored some common financing facilities backed by the loan portfolios of credit funds. These facilities typically provide higher leverage over a longer period of time than subscription facilities.
Loan to SPV facilities: A common feature in the US market, a “loan to SPV” is a financing facility extended to a bankruptcy-remote special purpose vehicle ("SPV") wholly owned by the credit fund. The lenders underwrite the origination/acquisition and loan management procedures of the credit fund's platform and require that the loans meet certain eligibility criteria since the SPV’s loan portfolio is the primary collateral securing the financing which is non-recourse to the credit fund itself. A few lenders require that the SPV obtain their prior written consent to a loan before it can be included in the borrowing base for the related financing. Typically lenders will not extend any financing to the SPV borrower until it has a certain number and aggregate principal balance of loans included in the borrowing base. Managers frequently use the subscription facility provided to the parent credit fund to acquire these loans which are then contributed by the parent fund to its SPV subsidiary.
The amount of financing available under the SPV facility will be driven by a borrowing base calculation. Prior to the credit crisis, these borrowing bases frequently operated using mark-to-market methodologies, but since the credit crisis, most SPV facilities now employ a “credit mark” methodology, typically with the credit mark initially being determined by the lead lender, as administrative agent on behalf of the lenders (with the borrower being able to object to a particular credit mark and to require a third party valuation to be obtained in relation to the relevant asset) and with the credit mark being redetermined if certain specified events occur which are expected to have an effect on the creditworthiness of the loan, such as in the case of a material amendment, obligor financial distress or a default on the loan.
The borrowing base will be further modified by:
advance rates for specified types of loans (which currently range from 65 to 85 per cent for first lien loans and 35 to 50 per cent for second lien loans);
concentration limits which apply haircuts to loan values of loans that are in excess of related concentration limits;
discounted purchase price haircuts which apply haircuts to loan values which are acquired for a price lower than a specified purchase price; and
event haircuts which apply haircuts to loan values (and may haircut the value of a loan to zero in certain instances) if certain events occur such as default (loan values are typically haircut to the lesser of market value or a specified recovery rate) or an event that gives rise to a redetermination of the credit mark of the loan.
Although the manager usually has discretion regarding which loans are originated or acquired by the SPV subject to the loan eligibility criteria (unless lender consent is required for each loan prior to its being included in the borrowing base), these modifiers of the borrowing base ensure the lenders that the facility is secured by a loan portfolio that satisfies the lenders credit requirements.
There are a number of other structural features in an SPV facility that protect the lenders and ensure that their debt will be paid in the event of a significant deterioration in the loan portfolio including interest coverage and overcollateralization tests which, if not met, require that the lenders’ debt under the credit facility be paid before the SPV can reinvest funds or make distributions to its parent credit fund and trading restrictions to ensure that the loan portfolio is in line with credit requirements.
An SPV facility typically is a revolving credit facility with a two to four year reinvestment period followed by an amortization period when the platform is being wound down with moneys being applied to repay the facility and, after payments required by the credit facility are paid, distributed to the parent credit fund.
BDC facilities: A dominant player in the lower and middle U.S. credit market is a business development company (“BDC”) (which is a type of U.S. regulated closed-end fund that is not subject to regulatory limitations or capital requirements applicable to banks and other traditional lenders). The market in the U.S. has developed a panoply of financings available to this type of credit fund (e.g., loans to an SPV of the BDC, convertible bonds, baby bonds, securitizations, total return swaps, etc.). One of the most common is a traditional assets based revolving credit facility (“ABL”) directly to the BDC with direct recourse to the fund. Although the ABL is very similar in concept to the SPV facility, in practice the ABL facility generally offers the BDC significantly more flexibility at slightly increased pricing. As a result, many asset managers use the benefits of both facilities.
Similar to an SPV facility, an ABL facility would generally have a four to five year term with the facility revolving for a portion of the term and then essentially converting into a term loan for a portion of the term (in the case of an ABL facility, generally in the final year of the term). In addition, similar to a SPV facility, the BDC facility is borrowing base driven with availability under the facility based on the value of the fund’s assets. However, the types of assets included in the borrowing base of an ABL facility and how these assets are valued are vastly different from an SPV facility. In an ABL facility, the borrowing base may include first lien loans, second lien loans, subordinated loans, unsecured loans, first out and last loans, preferred equity and common equity (whereas, SPV facilities generally only include senior loans). The value of quoted assets included in the borrowing base of an ABL facility are valued weekly based on the bid prices of an approved dealer and/or approved pricing service or, to the extent applicable, the closing price for an asset listed on an exchange. With respect to unquoted assets, under an ABL facility the underlying BDC borrower is required to value the assets each week and one or more independent third party appraisers (retained by the Borrower or the agent under the BDC facility) value all (or for bigger more established BDCs, a portion) of the assets included in the borrowing base of such facility (with the ultimate value generally being the lowest valuation). An SPV facility, in contrast, permits the lenders to determine the value of the asset included in the borrowing base at the time that such assets are initially included in the borrowing base; and also gives the lenders the ability to revalue such assets upon the occurrence of certain events. For regulatory purposes, many bank lenders to BDCs mandate under the terms of an ABL facility that they have a right to cause a third party appraiser to determine the value of all of the assets included in the borrowing base.
The value of assets included in the borrowing base of an ABL facility is subject to haircuts based on various concentration limits, which (for example) can limit the amount of the borrowing base that can be based upon particular industries, categories of issuers, and classes of assets. These caps encourage a diversity of assets within the borrowing base of an ABL facility and accordingly manage risk exposures.
ABL facilities are a highly flexible leverage facility for BDCs. The initial credit decision for a lender to a BDC, and the design of each ABL facility, focuses heavily on the investment strategy of the BDC. This flexibility results, in part, from the need for the ABL facility to provide for the ongoing, working capital management of the BDC in order to facilitate investment flow at the level of the investment vehicle.
Gearing facilities: The most common form of asset-based leverage for credit funds in the UK and European markets is the gearing facility, which is a financing facility typically made available to a SPV wholly owned by the credit fund backed by the loan portfolio owned by the SPV.
A gearing facility is similar to an SPV facility in many respects:
it is non-recourse to the credit fund itself;
the loans must meet certain eligibility criteria; and
it is a borrowing base facility where the value of the underlying loan is modified by advance rates, concentration limits, discounted purchase price haircuts, and event driven haircuts.
Unlike US asset-backed leverage facilities that provide the lenders with a security interest over the loans in the related loan portfolio and certain other assets, the collateral for a gearing facility typically is limited to security over the shares in the SPV borrower and a collections account which will hold all proceeds and realisations from the underlying assets. Due to the complexities of taking effective and perfected security over receivables in multijurisdictional Europe, lenders typically do not seek security over the underlying assets which make up the borrowing base.
In addition, the values ascribed to borrowing base loans are typically prepared by the manager on a quarterly basis without verification by an independent third-party. These values are subject to a sense-check by the lender, and the gearing facility will frequently provide for a dispute mechanism where the lender considers – based on its experience of the loan market – that the manager's calculations require adjustment or are incorrect.
Gearing facilities tend to involve a considerable amount of negotiation around the eligibility criteria for the loans in the borrowing base and the borrowing base modifiers – i.e. the advance rates, concentration limits, discounted purchase price haircuts and event driven haircuts, and which apply to the loans – and the market is very relationship-driven at this stage.
While gearing facilities provide strong asset-based leverage for a loan portfolio, lenders also frequently require a degree of diversity in the borrowing base – typically measured by a minimum number of loans having a minimum aggregate principal balance – before they can be drawn. This requirement may be problematic for a credit fund or its SPV expecting to originate or otherwise acquire a limited number of large loans since such diversity requirements may not be met until well into the investment cycle.
The market is responding to this issue with the development of hybrid facilities – these start off as subscription facilities with a borrowing base calculated by reference to investors uncalled capital commitments, but they convert to asset-based facilities once the relevant diversity criteria have been satisfied. While the panel observed that hybrid facilities are rare at present, their emergence and development in the UK and European markets suggests an evolving product offering aimed at near full-life leverage for credit funds.
Dual track growth
The panel was of the view that, while the US market for lending to credit funds is deeper and broader than the UK and European markets, the use of debt and leverage is increasing across all markets. In particular, lending facility structures are becoming increasingly complex and sophisticated in the US. But the trend was also noticeable in the UK and Europe, where the market has expanded to include gearing and hybrid facilities as a supplement to the more traditional subscription line facility.
The growth of the market for credit fund leverage in Europe is expected to be slower in the medium term, taking into account the relative youth of the credit fund market which naturally limits the market presence and power of European credit funds. The considerable growth in the UK and European credit fund market, however, has seen a significant expansion in the size and activities of key market players, and the panel expects this increased base to build confidence in the industry and to further expand the scope for leverage.