There is a huge opportunity for new players to enter the subscription finance market, industry experts say.
This subset of the lending market is used by private equity firms as a bridge between the cash they have on hand and the capital committed by investors, so that they can delay capital calls. The market has become tighter in recent months following regulatory changes, rising interest rates, and the community banking crisis.
“There’s a huge opportunity,” said Scott MacDonald, host of Capital Allocators’ investment management operations podcast. “There’s demand in the market. The supply is going down. Who will be in a position to step in and do it, assuming that the numbers work?” MacDonald also serves as an advisor to Cambridge Wilkinson, which offers fund financing.
As private equity has swelled in popularity in recent years, so has the usage of subscription lines of credit. According to Fitch Ratings’ Greg Fayvilevich, the total subscription facilities market at the end of 2022 was $800 billion in size.
Fayvilevich, the senior director and head of Fitch’s global funds group, said that subscription facilities allow private equity firms to avoid making multiple capital calls from their limited partners. “It makes it administratively easier both for the fund managers and the LPs,” he said.
His colleague Peter Gargiulo added: “To have to go to your LPs to make those calls can be burdensome and can have execution risk. Subscription lines of credit can help ameliorate those issues and make it more efficient.”
Then, there is perhaps the more controversial use of subscription lines: Boosting internal rates of return, which are used to measure private equity fund performance. Delaying capital calls can improve IRR by shortening the amount of time between capital calls and distributions.
But the availability of subscription lines in the market is now at risk.
“I think you’re seeing two different forces at work,” said Sherri Snelson, a partner at law firm White & Case. “One is contraction of actual supply in the market. That’s driven by the banking crisis and the fallout of that.” Earlier in 2023, some providers of subscription financing, including First Republic, Silicon Valley Bank, and Signature Bank, were seized by regulators after experiencing bank runs.
According to Fayvilevich, the three banks had a presence in the market, but theirs was far less significant than that of other players.
However, some other major market players had begun reducing their exposure to the subscription finance market a few months prior to the banking crisis, Snelson noted. Due to changes in capital requirements put in place by the Federal Reserve in 2022, the cost of offering subscription lines of credit had become more expensive.
By late 2022, some large banks like Citi had pulled back their subscription lending offerings, as the Financial Times reported.
There are, however, ways to attract new players into the market.
Fitch and other ratings agencies have launched services to rate the debt offered by subscription line lenders. The introduction of ratings would lighten the capital requirements and thus drive down the cost of offering these loans.
“One of the reasons why these products would attract a higher capital charge is because historically they have been unrated,” Snelson said.
At Fitch, Fayvilevich said his team has already worked to provide ratings on a few dozen transactions. They’re staffing up, anticipating that there is more demand for subscription line ratings to come.
Another idea has been to turn subscription lines of credit into an investment product. “People are trying to find creative solutions to draw in additional forms of capital into this market,” Snelson said.
But it won’t be simple. Most subscription lines of credit are revolvers — loans without a fixed payment schedule. This could dissuade private credit funds and longer-term capital — which usually prefer loans with pre-determined end dates, or terms — from entering the market.
“What we’re seeing now is a trend of banks setting up dual tranches — there may be a small piece that’s a revolver, but there also may be a term tranche,” Fayvilvech said. These tranches could ultimately be bundled together with other loans, essentially creating a new security — and allowing private credit funds and other institutions to buy into the subscription lending market. The advent of subscription loan ratings makes the securitization of the loans a more feasible process.
However, it’s still early days. “Those products aren’t out there proliferating across the market yet,” Snelson said.
