This article is sponsored by 17Capital and appears in sister title Private Equity International’s LP Perspectives 2021 issue.
What is portfolio finance and how does it work?
Portfolio finance is a form of asset-based financing. An owner of a portfolio of private investments – either a GP with a portfolio of companies or an LP with a portfolio of fund commitments – raises capital based on the expected future cashflows to be generated by that portfolio, from realisations or from dividends. 17Capital is a provider of this type of financing, in the forms of preferred equity and net asset value-based credit.
What situations is portfolio finance typically used in?
Portfolio financing is used for a wide range of purposes, including raising capital for further investment in portfolio companies or in the management company itself; distribution of capital back to investors and accelerating liquidity. When we started the business, in 2008, the majority of the transactions we led involved solving problems associated with access to cash – helping with liquidity.
By around 2012, more of the financing we provided was used to fund growth, such as bolt-on acquisitions or to help GPs themselves expand into new products or geographies. The current environment is likely to create further challenges for underlying portfolio companies and we are likely to help shareholders address this by providing capital to support those companies. We are just as likely to be helping those portfolio companies to grow.
How is covid-19 impacting demand for portfolio finance and the typical use cases?
For example, if a manager owns 10 companies and their fund is fully drawn down but one of those companies has the opportunity to do a transformative acquisition, the manager will need outside capital to finance that value-enhancing move. We can provide the necessary capital to the fund, which will in turn provide it to the company. If that company is already highly levered, raising money at the level of the shareholder will often be the only viable option.
We are seeing increasing demand for portfolio finance to support both offensive and defensive strategies. There are GPs that may be looking to raise capital to pay down debt, or to put more cash into the businesses they own to ensure they are able to continue to meet their commitments. Yet there are also GPs who are actively pursuing growth opportunities. These are managers that believe now is a good time to invest, to develop new business lines or enter new geographies. We have been providing capital to funds in both situations since the covid-19 outbreak began.
What are the alternatives for GPs in these scenarios and why is portfolio finance preferable?
The alternative is a secondary market sale or to sell or raise capital at the company level, which is typically more expensive. Because we provide financing across an entire portfolio, we are taking less risk than an investor in a single entity and so our cost of capital is different. It is also worth noting that we can execute deals quickly – in a matter of just a few months. Investment at a company level typically takes longer.
How does your proposition differ to the fund finance solutions provided by banks?
We operate in a different space. Most banks offer LP subscription lines, which we do not – we provide strategic finance solutions later in the fund life. We are a dedicated provider offering portfolio finance in the form of preferred equity or NAV finance and we only work with investors in private equity.
In most transactions we can offer more flexibility, have a different risk appetite, and often can offer larger amounts and high LTVs.
What types of GPs are using portfolio finance and is that changing?
High-quality managers that can afford the cost of capital. That means they will tend to be strong performers, often top-tier larger GPs. We work most frequently with firms in the US and Europe. It also tends to be those managers that use leverage prudently. They will probably use our form of finance at the portfolio level, rather than maximising the debt raised against each individual portfolio company.
How are LP perceptions changing around the way in which GPs are using this form of financing?
The best way to answer that is to look at the evolution of the GP-led secondaries market, as the evolution is broadly the same. Today, GP-led secondaries are a totally accepted facet of the industry but that wasn’t always the case. LPs have come to appreciate that it is healthy to be able to close a fund while also providing the opportunity for those investors that want continued exposure to be able to roll over those assets. Initially there was scepticism, followed by curiosity, and now we see genuine enthusiasm. Portfolio financing is following the same path.
We have carried out 1,600 dealflow meetings over the past 12 months. We do a great deal of education, meeting with fund managers in Europe and the US. We have deployed several billion into this space and completed 60 transactions of which we have successfully exited 27. I would say, therefore, that we have now reached a point where portfolio finance is met with enthusiasm. It is seen as a useful tool.
What sorts of questions should LPs be asking of their GPs if they are looking to make a move in this direction?
What is the money going to be used for? Where is it going to go? If the money raised from us is not going to generate more than we cost, then obviously, the deal should not happen. Internal rate of return is one way to look at our cost, but I would argue that money multiples are even more relevant. If a manager is targeting two to three times their money and we cost less than that, then everything above is additive for investors.
Does portfolio finance negatively impact the level of alignment between GP and LP?
Not at all. If anything, it puts the GP in a more committed position. The GP is not exiting. The manager must work hard to continue to create value in the portfolio. There is no misalignment and no conflict of interest – quite the opposite.
What innovation are you seeing in the use of portfolio finance?
The private equity industry has become more capital intensive in recent years. We are seeing an increasing trend of managers raising capital at the management company level to invest in and grow their own firms. We are also seeing GPs committing larger amounts to their own funds. Instead of committing 1 or 2 percent, they may be committing 5, 10 or even 20 percent. Portfolio finance can also provide solutions for these scenarios.
How do you expect the fund finance market to develop going forward?
We have been doing this for 13 years, but I still think we are just at the beginning. I am not saying every GP will use us, but in many cases, we are going to become extremely relevant.
Funds raised between 2010 and 2016 have over $600 billion in their portfolios. A number of these funds will need additional capital to support them. That is creating a huge addressable market. And that is why investors have trusted us with their money – because they see the scale of the potential opportunity.
Supporting LPs in their hour of need
17Capital’s Pierre-Antoine de Selancy on the portfolio finance use case for LPs:
Portfolio finance can be provided to LPs in much the same way that it is provided to GPs – but instead of a portfolio of companies, the money is raised against a portfolio of commitments to funds.
Some investors employed this form of finance back in 2009 and 2010 when stock markets went into decline. Absolute allocations to private equity were reduced and that created the need for cash. We have not yet seen that level of pressure on LPs this time around, but we believe it may be just around the corner. It is difficult to see how public markets can continue in the direction they have been headed for much longer. If there is a sustained fall, that may precipitate the need for capital.
After all, as we head into 2021, managers will continue to make investments and to draw down LP commitments, but distributions will be slow, as exits remain few and far between. There will be a pincer movement which will create a demand for liquidity to enable LPs to meet capital calls. We will be there to assist investors if and when that happens.