Future proofing fund finance

While there has been much written, and widespread analysis of the immediate and short-term implications of these topics, we believe that mapping these longer-term trends over the next five years offers a more comprehensive picture of how enduring shifts will reshape the sector. 

Ratings: Access to new lenders and investors

External ratings look set to become a factor in fund finance, opening the space to more bank capital and new participants. “A number of agencies are now either covering or preparing to cover the sector, and the market is showing more interest in ratings,” says Andy Roberts, senior director, at RBS International.

That interest is partly driven by evolving banking regulation, including the introduction of Basel 3.1, which changes the way banks calculate capital requirements. “With the regulatory changes, we expect to see more funds and their financiers actively seeking to have their facilities rated, initially with a focus on subscription lines, then extending to other forms of fund financing,” says Charles Bischoff, partner and head of finance at Travers Smith.

 “Additional advantages include, potentially, more favourable pricing and access to a wider, deeper pool of lenders, including institutional investors who may then become LPs in future fundraisings,” adds Charles. Ratings could also help reduce the liquidity gap in the market by attracting non-bank lenders such as insurance companies and pensions funds.

Ratings do have downsides which may limit their uptake. “The criteria applied by the rating agencies when rating these facilities means funds may need to find a compromise between a better rating and a facility which puts more constraints on how the fund is operated,” says Charles. “Operational flexibility may have to be limited if lender participations are predicated on a particular rating requirement.”

“Introducing a third-party ratings agency will complicate financing timelines; while disclosures will need to be managed carefully,” adds Andy. “Most fund managers are understandably sensitive over investor lists and details of assets being shared.” 

Cost is the greatest sticking point. “This would be borne by the funds and be ongoing, given the need for ratings to be refreshed during the life of the facility,” says Charles. Cost calculations would therefore need to be balanced against the ability of the fund to secure financing at acceptable terms. 

“Longer-term, it’s hard to make firm predictions as every institution and fund has its own requirements,” says Andy. “Currently only a small minority of lenders are actively seeking ratings and therefore we are unlikely to see a wholesale shift to a fully rated market in the near term, with ratings more likely to be used opportunistically depending on the desired mix of lenders. The market is evolving though, and this remains an area to watch.”

Consolidation: Changing the fund financing dynamic 

The recent pattern of consolidation among alternative funds seems set to continue over the coming years, with acquisitions and strategic partnerships creating larger fund managers with wider product offerings, thus changing the dynamics of fund financing. 

Whether the appetite for consolidation continues depends on the growth rate within the market. “An acceleration of growth and/or continued slow distributions from older funds may force some managers into the arms of larger players with deeper pockets,” suggests Andy. 

And succession planning will also be a factor. “A large number of founders have been in seat for two decades or more,” points out Stewart Hotston, sponsor coverage director at NatWest. “Succession planning is not simply about who replaces them, but what that means for the business strategy going forward.” LPs concerned over the departure of a founder may be reassured by consolidation into a larger fund manager.

Intensive consolidation resulting in mega funds might open up opportunities for small players to find specialised niches – or it could push them out of the market. “When the largest managers offer a menu covering a wide range of asset classes and markets, investors are able to increase diversification within fewer counterparties. Smaller players may have to work harder to attract investors,” says Andy. And predicts Stewart, bigger firms may buy their way into spaces that smaller firms struggle to raise finance in. 

For investors, consolidation can support investment in adjacent geographies; standardise reporting; and drive down costs through economies of scale. But it can also create disconnects, disrupting investor relations. “Look at any acquisitive sector and you’ll see businesses struggling following mergers and acquisition activity, because teams, systems and locations can often be challenging to assimilate, even for an industry with deep experience of driving integration within portfolio companies,” points out Andy.

Consolidation can only go so far, says Stewart. “There are finite firms that can be acquired or are attractive to potential acquirors.” Going forward, successful consolidation models will likely be those bolting on additional, complimentary strategies, creating partnerships between larger and niche players that play to the strengths of each. 

ESG: Greater focus on nature and adaptation

Climate regulation and transparency over environmental action will continue to carry weight with both investors and lenders. In addition, there should be a growing emphasis on nature-based and climate adaptation investments, and the need to balance the energy transition against energy security. Decarbonisation initiatives will be of particular relevance for private equity firms. 

Funds seeking financing will therefore need to demonstrate a decarbonisation and energy transition plan. “Despite a number of firms extricating themselves from public net-zero commitments, there is still an expectation from LPs that fund managers have a clear strategy,” says Rahel Haque, climate and ESG capital markets director at NatWest.

Many LPs already implement the Taskforce on Climate-related Financial Disclosures (TCFD) recommendations, with greenhouse gas emissions a key focus. But the Taskforce on Nature-related Financial Disclosures (TNFD) will require environmental monitoring and reporting beyond climate and including water management, methane emissions, and biodiversity. “Disclosures will become more fulsome,” says Haque. “There will be more nuanced ‘ESG’ allocations made by LPs based on specific themes around nature or decarbonisation.”

Funds must also be able to rebut suggestions of greenwashing. “They need to be transparent to avoid the perception that they are ‘hiding’ something,” suggests Rahel. “Funds already get scrutinised more than corporate sustainable lending due to the complexity of applying ESG to fund financing.” With the growing number of reporting obligations, funds may choose to establish dedicated reporting teams to centralise this activity and make it easier to obtain external assurance. 

ESG activities could also be used by funds to indicate good financial performance to lenders. “More managers are seeking to demonstrate financial value from their ESG strategies, such as increasing revenues or cost savings,” says Rahel, noting that cost saving implications are easier to quantify than potential revenue gains.

Technology: Balancing opportunity and risk 

Digital technology and artificial intelligence (AI) could offer a raft of benefits within fund finance, including real-time performance monitoring and predicative analytics. But implementation will also bring challenges around data privacy and security. The key for borrowers is trusting financial institutions with their data, so customer consent and transparency in how their data is used is critical. The future of the market will be shaped by how it balances advantage and risk. 

 “AI is already being implemented within the industry; however, the pace of change has been slower than other industries. As lenders in particular become more capable of standardising and scaling data sets and the quality of data becomes more reliable, adoption should increase and real efficiencies should start to be seen,” predicts Parin Avari, director at RBS International.

This includes risk assessment and due diligence, with varied data sources and AI combining to enable finance providers to accurately review the creditworthiness of fund managers at pace. It could also allow PE investment teams to assess potential investments rapidly whilst minimising human error. 

Real-time performance monitoring and predictive analytics is another benefit. “Historically the market has had to rely on annual financial statements or quarterly reports for monitoring purposes – a data set that’s technically out of date by the time it’s analysed,” says Parin. “By contrast, if market participants and lenders were able to captilise on richer alternative data sets such as real-time payments data, and easily combine this with all the other sources of external information available, this would provide a more informed view of the financial health of portfolio companies or investors.”

“Similarly predicative analytics will be another benefit, analysing borrower behaviour and market performance over a period of time will allow lenders to predict credit impacts through various economic cycles, such as interest rate changes and the corresponding result on asset valuations in specific sectors or utilisation of debt,” Parin adds.

There are, however, market-specific challenges that will slow tech adoption. “Fund financing providers face the challenges of balancing data security concerns, including obtaining consent from customers, with the benefits of adopting cloud technology, for example,” says Parin. “While cloud offers scalability, flexibility, and cost efficiencies, on-premises solutions provide greater control over security, compliance and data management.”

Data quality and integrity are also important concerns. “AI algorithms rely heavily on high quality, relevant data for training and validation. Historically, traditional financial institutions often have duplicate or conflicting data across different platforms, which can make integration challenging, and result in less accurate predictions and biased models,” says Michael Dowds, head of digitisation, strategy, innovation, and design at RBS International.

Regulatory compliance is another potential hurdle. “Regulators in the financial industry have raised concerns over how AI algorithms are using client data and how transparent companies are being with clients,” says Michael. “Strong governance controls need to be implemented and monitored for firms to stay compliant and maintain trust.”

“Due to the regulated and confidential nature of the market, the real opportunity is for banks and clients to work together to fully leverage the data available in a transparent and effective way for both fund manager and financier,” Parin concludes.

While it’s impossible to predict the exact shape of the alternative funds sector in five years’ time, it’s clear that a range of factors will significantly impact the funds finance landscape. Tracking developments in these key areas will enable fund managers to keep ahead of the game.

If you’d like to talk about any of the themes discussed in this article and how they might impact your organisation in the future, please contact your relationship team.

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