Market Rebounds as Subscription Lines Remain Crucial for Deals, Despite Higher Borrowing Costs
The private equity landscape experienced a tremor last year with the collapse of prominent lenders like Silicon Valley Bank. This disruption threatened to derail the vital "fund-finance" market, a system of bridge loans that fuel deals and acquisitions. However, a year later, the market demonstrates remarkable resilience, thanks to the emergence of new players.
Prior to its collapse, Silicon Valley Bank reigned supreme in the fund-finance market, alongside major players like Signature Bank and First Republic Bank. Their sudden fall triggered a domino effect, spooking other lenders and causing a significant pullback in funding. The cost of borrowing skyrocketed, leaving private equity firms scrambling for resources.
In the year since, smaller and more nimble banks like EverBank, Huntington Bank, and Axos Bank have either entered the market or expanded their operations. This influx of fresh capital, along with increased involvement from foreign banks and institutional investors, has helped bridge the gap left by the previous giants.
Despite these positive strides, a chronic shortage of funds lingers. Borrowing costs remain higher, and overall capital availability falls short of pre-crisis levels. According to lenders and private equity executives alike, demand for bridge loans continues to outstrip supply.
The workhorse of the fund-finance market is the subscription line of credit. These bridge loans allow private equity funds to purchase companies on credit, with investor contributions following later. This eliminates the logistical headache of collecting funds from numerous investors before closing a deal.
Subscription lines have become an indispensable tool for nearly every private equity fund, as evidenced by a 2021 survey from the Institutional Limited Partners Association. Their importance is underscored by the fact that not even the Federal Reserve's recent interest rate hikes, which pushed costs from 2-3% to 7-8% or more, have deterred fund usage.
The consistent imbalance between demand and supply for subscription lines stems from the rapid growth of private equity itself. Lenders simply haven't kept pace with this expansion. Regulatory constraints further complicate the issue.
For banks, subscription lines carry a low risk profile, with virtually no history of defaults outside isolated fraud cases. However, this very safety translates to lower profitability compared to other types of lending. Regulations requiring banks to hold significant capital against these loans further diminish their appeal to larger institutions.
The banking crisis of 2022 exacerbated the already tight market. Subscription line costs surged, with spreads jumping a staggering 8.45% in the first quarter of the year. While spreads have narrowed slightly since, they remain far above pre-crisis levels. Albert Tan, co-head of the fund-finance group at Haynes and Boone law firm, describes the current situation as "premium pricing of the sort we haven't seen since the 2007-2009 crisis."
High borrowing costs, however, present an enticing opportunity for new players. EverBank, launched as a rebranding of TIAA Bank with backing from prominent private equity firms, exemplifies this trend. Jeff Johnston, co-head of EverBank's fund-finance division, cites the exodus of major banks as an opportunity his firm successfully capitalized on. "The availability of deals and pricing have both exceeded our initial expectations," Johnston adds.
The fund-finance market is undergoing a transformation. While new lenders fill the void, talent migration from failed institutions like Signature Bank strengthens existing players like Huntington and Axos. Additionally, large banks like JPMorgan are strategically entering the space with acquisitions, such as its purchase of First Republic.
The private equity ecosystem, shaken by the 2022 banking crisis, is demonstrably adapting. New lenders are emerging, existing players are expanding operations, and a talent reshuffle is taking place. While challenges persist – a shortage of capital and higher borrowing costs – the market shows signs of resilience. The future of fund finance seems to lie in a blended landscape with a mix of established players and nimble newcomers, ensuring the smooth functioning of private equity deals in the current environment.
