What have cheap bank loans done to private equity funds?

Six reasons why fund finance is increasingly popular among private equity firms and why investors need to watch it closely


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:

  • Fast access to liquidity
    A subscription line supplies liquidity to the fund faster than calling investors’ capital contributions, thus being especially beneficial for time-sensitive fund investments. Under the subscription line, borrowed funds usually can be made available within a day while under the limited partnership agreement, capital calls may take at least ten to fifteen working days.
  • Bridge financing
    A subscription line can bridge permanent asset-level debt financing if the fund is unable to secure that financing before the consummation of an investment. The fund can show the seller of an asset that it has access to liquidity to finalise the transaction, prior to being able to secure commitments from asset-level lenders. Therefore, subscription lines can give the fund a stronger bargaining power when negotiating for asset-level financing with other lenders. For example, a real estate private equity fund could use a subscription facility to bridge the period between the acquisition of a property and the incurrence of a more permanent mortgage.
  • Cheaper financing
    Incurring debt under the subscription facility is usually cheaper than alternative asset-level financing. As a result, many funds may be incentivised to leave the subscription facility outstanding for a more extended period. For instance, subscription lines with tenors of one to three years are priced at around 160bp while five-year loans at the portfolio company level can be priced at more than 300bp.
  • Easy access to alternative currencies
    For funds operating or expanding globally, subscription lines can offer ready access to alternative currencies, eliminating the need to call capital in one currency and converting it to another. This improves the speed of capital access, lessening the impact of short-term exchange rate exposure and reducing the administrative burden.
  • Smooth capital calls
    A subscription line can provide smooth capital calls to investors. It avoids frequent and small capital calls for working capital and other similar needs, like the payment of management fees, relieving the fund and its investors from the administrative burden caused by these capital calls. The subscription facility also helps with capital contributions made by investors that join the fund later during the fundraising period and who need to provide true-up capital contributions. The true-up process ensures that capital contributions made by the first set of investors are rebalanced so that new investors have their pro-rata interest in the fund. The process adds significant back-office costs for the fund and its investors. With a subscription line facility available for the fund’s capital needs before the final fund closing, the fund may be able to eliminate or reduce needs for true-up requirements.
  • Improve the fund’s reported internal rate of return (IRR)
    The use of subscription facilities means that the fund delays capital drawdowns from investors, shortening the holding period of investors’ money and thus increasing the fund’s reported IRR. In fact, if the subscription line is used to make investments and is repaid twelve to fifteen months after making the investments, the capital drawdowns from investors might even experience a positive IRR on the first day of the capital call thus eliminating the well-known J-curve effect that is specific to private equity funds at the beginning of their life. The subscription line can also increase reported IRRs if it can be used to post collateral on hedging agreements during the fund’s life. The funds can thus avoid the drag on IRRs caused by keeping investor’s capital as collateral on hand to settle hedging agreements.

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 Singapore.

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