With this year’s growing usage of continuation funds (now 20% of all exits through the first half of 2025), there’s been a corresponding jump in the usage of fund financing options tailored to these vehicles.
One of the more popular is the subscription line of credit, or using unfunded LP commitments as collateral to delay the initial funding of the continuation fund. Like a subscription line used on a standard fund to delay capital calls, the CV variant allows sponsors to defer capital calls at closing while still paying LPs who exit from the original investment.
In continuation fund processes, banks are generally willing to lend 20 to 25 percent of value at a cost of about 3 percentage points over benchmarks.
This can lift reported IRRs for buyers by more than 2.5 percentage points in some cases, reducing the amount of time LP capital is deployed to generate an equivalent cash-on-cash return (less the financing cost).
Despite the potential benefit, subscription facilities may not be particularly well-suited to continuation funds.
The majority of original investors often choose to redeem when given the option and those that don’t may not be willing to extend further capital. As a result, there tends to be a smaller and less diversified pool of investors with uncalled capital commitments to lend against.
Even with new investors coming in, the different composition of those investors can be a drag on available terms.
For lenders arranging the facility, underwriting focuses on the quality and concentration of the investor base: With a more varied group of secondaries investors, it’s a different type of risk profile to manage than the original fund (typically highly creditworthy entities like pension funds).
Those characteristics mean a higher cost of debt than standard lines. In some cases, higher interest rates have pushed costs above hurdle rates, which can lead to tougher negotiations on fund terms and governance protections.
One alternative is a hybrid approach, blending elements of a subscription line with a NAV financing (collateralized by the underlying asset).
On its own, a NAV financing for a continuation fund runs into a key challenge — instead of the usual portfolio of underlying assets, there’s only one asset or a very small number of them.
The combination of a NAV loan with a subscription line, however, helps on both fronts…
“Where standalone subscription-only underwriting is constrained by a concentrated, often unrated secondaries LP base, and pure NAV-only underwriting is constrained by a limited number of assets, blended facilities have gained traction,” writes Investec.
“Pricing is generally above traditional subscription lines but cheaper than pure asset-based leverage, with advance rates supported by both the uncalled commitments and the asset base.”
While that sounds like the best of both worlds, complexity does have a limit. With so many moving parts, hybrid facilities tend to be custom and heavily negotiated, without the benefit of market standard terms.
“Thus, while a subscription facility can often be negotiated and closed quickly, a hybrid facility often involves lengthy negotiations in which the facility risks not being in place in time for the ‘first closing’ (when the capital call aspect of the facility is most valuable),” explains a Latham & Watkins report.
That said, it might be a trend worth watching — could growing demand for continuation fund financing solutions lead to a maturation in hybrid offerings?