Fund finance – friend or foe?

The use of fund-level leverage in private equity has become a hotly debated topic, sparking diverse opinions among managers, investors, and stakeholders. While the practice has evolved over recent decades, with subscription line and NAV facilities becoming more common, it remains controversial due to differing approaches to risk and value creation. As Paul Cunningham, CFO of Helios and a speaker at the upcoming SuperReturn CFO/COO event, will explore, the conversation around fund-level financing isn't as binary as it may seem. Instead, it requires a nuanced understanding of how leverage can be used wisely, particularly in emerging markets.

There has been much written and discussed in recent years about the increasing use of fund-level leverage (i.e. the use of debt at the level of the private equity fund rather than at the portfolio company level). This is a controversial topic that elicits differing views among private equity managers, investors, and other stakeholders. The variety of opinions on the subject may stem from differences in investment philosophies, risk tolerance, regulatory concerns, and the impact that leverage has on fund performance and investor returns – or it may arise from a misunderstanding of how it is used. Over the last two decades, the use of subscription line, or capital call, facilities has become almost standard practice with little to no pushback from most stakeholders. However, the use of NAV facilities, where the security is taken against the fund’s assets rather than LP commitments, still presents challenges.

There have been several attempts to introduce guidelines that either impose limitations on the use of such facilities or enforce what can seem to be very onerous reporting requirements, even down to restricting the calculation of carried interest to unlevered returns. However, it has become clear that none of these attempts have gained sufficient traction to become widely adopted. Why is that? The answer, I believe, is the same reason this remains a controversial subject – it comes down to the differing views and expectations of stakeholders.

There is also an overly simplistic view of the debate, which assumes there are only two sides to the argument, where either:

• The GP/manager seeks to create value through operational improvements in portfolio companies, rather than relying heavily on financial engineering. The accepted view is that these funds take a more conservative approach to leverage, focusing on growing businesses organically or through strategic acquisitions. For such managers, fund-level leverage may not align with their core investment philosophy, as they prefer to focus on long-term value rather than amplifying returns through debt; or
• The GP/manager views leverage as an essential tool for enhancing returns. These funds often operate under the assumption that borrowing at the fund level can provide greater financial flexibility and magnify the potential upside for investors. Managers who are more aggressive in their use of leverage may be more comfortable with the risks associated with fund-level debt and see it as a means to amplify returns, especially in favourable economic conditions.

These two different approaches should be clear to any prospective investor, and simple due diligence should enable LPs to determine whether a particular manager’s approach aligns with their risk appetite. It is not clear how much additional guidance is required to support that choice.

But is there a third option, where the GP/manager takes neither an ultra-conservative nor an ultra-aggressive approach, but instead where the use of fund-level financing may be appropriate? This is where the experience of an emerging market-focused fund like Helios presents a very different scenario.

Many sceptics of fund-level financing talk about increasing the risk to levels they would not be comfortable with, but to date, there has been little discussion about the use of acquisition financing, or certainly not in the same context as fund-level financing. There is an assumption that a NAV facility would be layering on an additional debt burden over and above acquisition finance. But what about managers who potentially fall into the first category above, with little to no portfolio-level debt, but out of necessity rather than for purely philosophical reasons? For many emerging (and even more so for frontier) market managers, acquisition finance may either not be available or may be very limited. It may well be that an EM portfolio is levered at 1–1.5x EBITDA, compared to 6+x as may be seen in more developed market funds. There is a significant difference in layering on a fund-level NAV facility in the former scenario compared to the latter.

In these situations, it is important to look at the bigger picture to truly determine where this fits within a stakeholder’s risk appetite and how that risk is managed.

It goes without saying that leverage, by its very nature, increases the risk of an investment, as it magnifies both gains and losses, and more risk-averse investors or managers may be wary of fund-level leverage because it exposes the entire portfolio to downside risk. However, where the manager takes a prudent approach to leverage levels, a portfolio approach may well lead to tighter pricing and significantly reduce the risk of a single asset breaching covenants and being “lost to the banks”. There is, in fact, a strong argument that, when used wisely, NAV facilities may represent a lower risk than traditional acquisition financing.

The debate around fund-level leverage is far from straightforward, as it involves a variety of viewpoints shaped by investment philosophy, market conditions, and risk tolerance. While some managers favour conservative strategies, focusing on operational improvements, others embrace leverage as a means to amplify returns. However, there is also a balanced middle ground, where fund-level financing can be applied carefully, particularly in emerging markets where acquisition finance may be limited. When used prudently, fund-level leverage can offer financial flexibility without significantly increasing risk, as long as it aligns with the fund's strategy and the investors' risk profile. The challenge lies in understanding the nuances of this tool and applying it in ways that support sustainable, long-term growth.