Investment Insights

Looking under the hood: 

The essentials of fund-level leverage

By Neil Rudd/NXT Capital

Investors considering a new fund investigate its risk and return characteristics, the manager’s track record, deal sourcing and underwriting process, and reporting and controls. For levered funds, investors also evaluate the nature, use and terms of the fund-level financing. Or do they?

When it comes to levered funds, these factors take a back seat to the maximum leverage outlined in the placement memo. Considering this “sticker” leverage is one important measure of risk, but not the whole story. Fund leverage deserves a closer “look under the hood.”

There are various forms of fund-level leverage and no single right way to use them. Each approach offers benefits, but also has potential risks that investors should understand. A few key questions can reveal the manager’s leverage strategy and ability to protect investors’ interests.

The Basics

There are two primary forms of fund-level leverage: Asset-backed credit facilities and subscription facilities. Each is secured by different collateral and is often used for different purposes. Today, a levered fund is likely to include long-term subscription and asset-backed facilities.

Asset-Backed Credit Facilities

Asset-backed credit facilities are secured by a fund’s loans. Borrowing availability increases over time, in lockstep with the size of the loan portfolio.

There are two common types of asset-backed credit facilities with some important differences:

1. Approval Rights

2. Non-Approval Rights

Click image to enlarge chart.

Subscription Facilities

Subscription facilities are secured by the fund’s equity capital commitments and are generally used during the ramping period of the portfolio. Subscription facilities are typically less expensive than asset-backed credit facilities. Once the loan pool has been built, the loans are often rolled into an asset-backed facility.

Click image to enlarge chart.

Understanding A Fund’s Leverage Strategy

Fund-level leverage facilities can seem complex, but by asking a few of the right questions, investors can quickly come to grips with the most important elements.

• What fund level leverage is going be used?
• What is the Agent’s history? If more than one lender is required, what is the syndication strategy?
• What systems and controls are in place to fulfill compliance, reporting and other requirements?
• A six-year fund life in not uncommon, but most banks will not provide a credit facility for more than five years. What is the strategy to avoid hitting a maturity wall?

Look Under the Hood

Each form of fund-level leverage offers benefits and potential risks. Asking questions about a manager’s leverage strategy and ability to execute it effectively should become a standard part of investor due diligence. “Looking under the hood” to understand fund-level leverage is a prudent step in making fully informed decisions about levered funds and their potential returns.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of NXT Capital or TEXPERS, and are subject to revision over time. 

About the Author: