Over the last few years, the private equity industry has added a new level of complexity for investors. It started to use fund finance, a broad range of financing structures at the private equity fund level, to support funds’ liquidity and help boost their reported returns.
The most popular fund finance instrument with private equity funds focused on buyouts has been the subscription line (or the capital call facility). The line is a senior revolving credit facility secured by the unfunded capital commitments of the fund’s investors. Historically, fund managers have used these facilities sparsely as short-term bridge financing, repaying them in 30 to 90 days. However, over the last few years, the use and maturities of such funding instruments have increased significantly.
To what extent are these facilities used? Given that the market is not public, it is challenging to estimate its size, but Cadwalader, a leading law firm based in New York, estimates that the market is over $500 billion with an estimate of lender commitments increasing by 20% last year in 2018.
The data suggests that banks have embraced subscription financing as a relatively safe form of lending. The creditworthiness of the fund's investors, most of whom are investment-grade institutions, is very high. Moreover, these loans have short maturities, allowing the banks to scrutinise frequently the private equity funds that use them. Banks' confidence in the robustness of fund finance as a business line is arguably backed by the relative rarity of default.
The only large default so far has been that of Dubai-based Abraaj Group in 2018, which acquired a business in Turkey with a subscription line from Societe Generale just prior to its default. Many players in the market would argue that Abraaj’s default, caused by the manager’s deceit of investors and misuse of funds, is a very rare and unusual event.
Banks' confidence in the robustness of fund finance as a business line is arguably backed by the relative rarity of default.
Why do private equity fund managers like subscription lines so much? As it turns out, they do bring some important advantages that can enhance the fund manager’s competitive advantage in the marketplace:
While it is clear that subscription line facilities do bring some clear benefits, investors should be worried about their use. The costs of obtaining and servicing the subscription line are often classified as fund expenses, thus payable by investors. Further, as the maturity of these facilities increases, capital calls will be postponed for longer periods to the extent that an institutional investor may find itself underweight in its allocation to the private equity asset.
Investors’ concerns are reflected in a new set of principles published by the Institutional Limited Partners Association (ILPA) in June 2019. ILPA recommends that subscription lines should be used primarily to benefit the fund partnership as a whole rather than chiefly for the purpose of enhancing the reported IRR to accelerate the accrual and distribution of carried interest. For carried interest calculations where a credit facility is in place, the preferred fund return should accrue from the date that capital is at risk (i.e., when the credit facility is drawn) instead of when the capital is ultimately called from investors. Further, ILPA recommends that subscription lines should not facilitate the provision of fund distributions from divestments and should have limited use.
For example, the lines should be outstanding for a maximum of 180 days (a special permission from investors should be required if the maturity is above one year) and should not be greater than 20% of all uncalled capital. With these limitations, more transparency is also strongly advised. Specific information on fund credit facilities should be disclosed to investors in annual and quarterly reports.
Interestingly, the fund finance market has been evolving recently with the growth of a newer product: net asset value (NAV) or asset-backed facilities. These fund finance facilities are provided to the fund (or to a special purpose vehicle owned by the fund) and are secured against the distributions and cash flows that are coming from the underlying portfolio investments (as opposed to fund investors’ commitments used for subscription lines). The proceeds of NAV facilities are being used to pay the fund investors cash distributions during the mid to later stages of the fund’s term (in advance of a full exit of the underlying portfolio).
An increasing number of new lenders are entering the asset-backed facilities market, as the returns are generally higher than the returns available to subscription lines. These new entrants to the market are not only the existing banks that provide subscription lines, but also credit and special situations funds searching for higher yields.
The availability of cheap loans provided by the banking system has been a major driver of fund managers’ growing use of loans rather than capital from fund investors. The low cost of these financing instruments have been so far offset by the benefits they bring. But if the interest rates rise, investors are likely to question seriously these facilities and put pressure on managers to limit their use.
Florin Vasvari is Professor of Accounting: Chair, Accounting Faculty and Academic Director of the Private Equity Masterclass delivered in Hong Kong.
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