UK: Travers Smith's Alternative Insights: Subscription Line Financing

A regular briefing for the alternative asset management industry.

Subscription line financing has been around for decades. It began as the solution to a problem: investors wanted a more regular drawdown cycle from their sponsors, and the sponsors needed to be able to access cash at short notice to do deals. The obvious answer was that a lender – usually a bank keen to cement its presence in the more lucrative leverage finance market – would provide a bridging loan. The lender would provide short term liquidity at relatively low rates of interest against the (excellent) security of the LPs' undrawn capital. On the next regular drawdown date, capital would be called from investors to repay the loan.

As the industry has grown in the intervening years, subscription line financing – in common with other fund financing tools – has become ubiquitous. The Alternative Investment Fund Managers Directive, drafted after the global financial crisis in 2007/8, even includes a carve out for sub lines from its fund leverage calculations.

As usage further increased during a period of very low interest rates, some investors became concerned that the financing tool was being over-used, and borrowings left outstanding for too long. This had the effect of increasing risk – and could magnify fund returns to make it easier for sponsors to jump the hurdle that triggers carried interest entitlements. This impact can be over-stated, as various studies, including analysis by Blackrock, has shown. Nevertheless, the investors' industry association, ILPA, issued some guidelines in 2017, updated in 2020, intended to set some parameters for sub line use and recommended enhanced disclosures.

But now there is another problem. While demand for subscription line financing has not abated, supply has slowed.

Pressure on banks' balance sheets has led many to scale back their exposure to subscription lines. For example, in 2022 Citi was reported to have scaled back its lending by over two-thirds in response to more demanding capital adequacy requirements. Rising interest rates and the failure of SVB, First Republic and Signature Bank – all of which were active in the fund finance space – have exacerbated the problem.

Although traditionally a low risk, low profit activity by banks – default rates were near zero – these new market dynamics have driven up the pricing.

Enter the rating agencies, who are now helping to re-energise the market.

If a sub line is rated it will help the bank to price it more competitively, in part because it will have a different impact on its capital requirements. Under the regulatory regimes of several jurisdictions, obtaining a rating enables a lender to access more favourable capital treatment, which reduces their cost of capital and overall cost of providing the product.

A rating could also encourage non-bank lenders to enter the market, particularly insurance companies and pension funds who can lend more easily when debt is highly rated.

Ratings could also stimulate innovative products, including securitisation structures that package sub lines together – although these might also require a change in the structure of the loans themselves.

The main rating agencies are all looking at this, and some have already published a specific rating methodology for subscription facilities. The currently published methodologies – by KBRA and Fitch – combine several weighted quantitative and qualitative factors. These require extensive analysis of the credit quality and diversification of the investor pool, whose creditworthiness determines the value of the security. The results of that analysis can then be notched up or down by a qualitative assessment covering the sponsor, the fund and the facility's terms.

Once again, the market is evolving to fill a hole that has, in part, been driven by regulation. Sponsors and their LPs will benefit if the outcome is more availability of low-cost bridging finance – although investors will watch closely to ensure that fund managers continue to employ sensible safeguards and provide full disclosure.

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