(Bloomberg) -- The fund finance market has surged past $1 trillion, according to a pair of new reports, as money managers borrow more to manage liquidity and bridge delayed exits.
Fund finance vehicles lend money to the $16 trillion global market of private credit and equity funds. The vast majority of that borrowing is in the form of debt called subscription lines, which fund managers use to borrow against capital pledged by limited partners but not yet deployed.
The industry's expansion is being fueled by the proliferation of private credit funds as well as a slowdown in dealmaking, which is pushing private equity firms to tap the market more often for cash, according to a new report by Moody's Ratings.
The result, according to a separate report by law firm Haynes Boone, is that a traditionally small market once dominated by banks has seen an influx of new borrowers and investors. Fund finance has grown both more diverse but also more complex, said the firm, which surveyed more than 100 market participants.
Lending products that were once relatively sparse have grown more common in the past few years, including debt known as rated feeder notes, net asset value loans and collateralized fund obligations.
"Fund finance has grown tremendously over the last ten years and there has been plenty of innovation, so you have all these different products now," Haynes Boone's co-head of fund finance Brent Shultz said in an interview.
The size of the fund finance market is notoriously difficult to estimate, as the products are rarely disclosed publicly. About a fifth of participants in the Haynes Boone survey pegged the size of the market at over $1.75 trillion, but a small share estimated it is below $1 trillion.
Fund finance will probably keep growing at a rapid clip, said the law firm's survey, which was conducted in the first quarter of this year. Two-thirds of respondents expect market activity to grow another 5% to 15% this year.
The industry has expanded for several reasons, including the rise of cash-rich insurance companies eager to invest in non-traditional debt that comes with high ratings.
Another driver of growth is the private equity industry's struggle in recent years to sell companies at a profit. Funds that are forced to hold onto companies longer before cashing out have a greater need to tap alternative sources of cash.
"If you can't exit your prior vintage funds, then your limited partners aren't able to recycle capital into a new fund," said Shultz. "The slower exits have driven sponsors to look at other sources of funding."
Monitoring Risk
While banks once served as the primary lenders to funds, the rapid growth of private capital has outpaced banks' capacity, according to Moody's. Now, insurers and private credit funds are some of the market's biggest lenders, blurring the line between the role of investors and lenders in private credit, the report said. Private credit funds are also some of the industry's main borrowers.
As the popularity of the fund finance sector grows, risks need to be monitored, Moody's said. Some banks have begun packaging portfolios of fund finance loans into asset-backed securities to move risk off their balance sheets.
Many fund finance products tout high returns, but their complexity is growing. Novel structures remain untested across a full credit cycle, and recent geopolitical and economic risks have brought private credit markets their first significant stress test, the ratings firm said.
Key credit risks for fund finance products include "potential deterioration in asset quality and the presence of embedded leverage, which could amplify losses in adverse scenarios," Moody's said.
The Federal Reserve has been asking major US banks for details about their exposure to private credit as redemption requests from business development companies mount and the number of troubled loans in sectors like software increase.
(Updates throughout.)
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