Fund credit facilities: A bridge too far?

A trend that is becoming increasingly popular among GPs across Europe is that of debt facilities extended to private equity funds to cover operating costs and bridge capital until LP draw-down events.

"We've seen a significant increase across Europe in funds looking for and taking on these facilities since the crisis," says Investec fund finance's global head Simon Hamilton. "The very clear things we are seeing is that the majority of funds now have these facilities. The progressive funds have worked out with their LPs where they want to use it and make them more effective."

"This is completely a result of the low interest rate environment of the past few years," says Hamilton. "If you had interest rates of 6-7%, and a GP hurdle of 8%, would it really make that much of a difference? No. Low interest rates certainly are a driver of this. Bear in mind, pre-crisis they were also used pretty extensively, despite interest rates being around 5%."

A credit to the industry
Generally arranged by a bank or syndicate of banks and structured as a revolving credit facility (RCF), these loans are used by a GP's fund to cover operating costs and deal equity between the agreed-upon periods during which the fund draws down committed capital from its LPs.

Typical terms for a fund RCF are 10-20% of the fund's size with a tenure of one to five years, and a roll-over period of six months on average. Repayment periods on debt drawn from the facilities are commonly in step with draw-down dates for LPs – usually six months, though some funds will have roll-over periods of up to a year.

Typical facility tenures are one to three years. Most facilities have draw periods of three to six months, however a portion of the market does stretch to 12 months and beyond" – Malcom Hassan, RBS

"Typical facility tenuress in the market are one to three years. Most facilities have draw periods of three to six months, however a portion of the market does stretch to 12 months and beyond," says Malcolm Hassan, head of funds and asset management at RBS. "What we have seen in the market, and some of our facilities, are ones of up to 12 months and beyond, but it really depends on track record, spread of investors and lastly what the counter-party wants to use it for, whether it be pre-emptive bids, buy-and-build strategies, strategic divisional spin-offs, etc."

Lenient lending
However, recent market chatter suggests some major GPs are asking banks for facilities with roll-over periods in excess of a year, up to as much as three. An extended payback timeframe might bring down costs and work in terms of drawing down capital from LPs, but can also substantially boost the IRR of acquisitions made with and held in the facility during this time.

As an example: on a five-year investment yielding 3x money, delaying LP drawdown and thereby the start of IRR calculations for investors by a year results in an IRR of 31.6% instead of 24.6%. Though the example assumes the unlikely scenario of the entire investment being financed by and held in the facility, multiple deals done this way over time could add up to a not-insignificant improvement in fund IRR.

So far, though, extended-term fund financing facilities are uncommon, says Hassan: "The majority of the whole market stands in 12 months or less. To have it over 12 months is unusual but depends upon the fund's investment strategy. I'd say probably less than 20% of the market will have those types of arrangements that are over 12 months."

However, one industry source – speaking on the condition of anonymity and that the fund not be named, though the GP's identity is known to unquote" – said at least one major Europe-based GP had inquired about a three-year billion-euro facility for one of its funds.

Flash the cash
The majority of funds appear to be using RCFs purely as a means of cashflow management, within typical repayment periods, and credit lines to funds remain an important tool in private equity.

Hamilton says many of the facilities are solely used to more effectively draw down from LPs once a year, and there are cases where LPs will not receive an equity return on their commitment for a period of more than 12 months. In these cases it is easier and more sensible for GPs to borrow the money, as they otherwise create J-curves for their investors – for example, if capital is drawn to pay costs, fees and expenses, before any return is made.

"That's why quite often these funds will bridge at the fund level. It's to ensure that for every euro, dollar or pound they draw down, they are going to get an equity return for that money," Hamilton says.

While most uses of the fund credit lines fall under cashflow management, non-typical uses stray into territory which could be considered financial engineering and leverage on leverage. Financing an equity stake with an RCF over an extended period of time not only improves IRR but also adds a layer of leverage to the investment – akin to taking out a bank loan to use as a down-payment on an auto loan.

Whether certain uses fall under cashflow management or leverage-on-leverage is a matter of debate, but unquote" understands that an increasing number of LPs are concerned about the issue of how fund bridging facilities are being used and have expressed strong opposition to what they see as a type of financial engineering.

Money minefield
Some LPs and GPs reportedly have limited partner agreements (LPA) that limit the creation of such a "false IRR", though it is not clear how commonplace this clause is. If the IRR embellishment manoeuvre is prohibited by a fund's LPA, it raises the question of whether some LPs are encouraging these facilities as a means of eliminating negative NAV in the initial years of their fund investments. If this is the case, it would raise substantial questions of leverage-on-leverage and also whether LPs are then using the undrawn capital committed to GPs on other investments before the drawdown.

Another safeguard in place for most LPs is a general term of LPAs that limit GPs' ability to borrow past 12 months – though LP concerns have emerged regardless.

"In our experience, most GPs are conservative, and where they are going longer than one year, they will speak to their limited partner advisory committee (LPAC)," Hamilton says. "They are very sensitive to this. Their biggest issue is they don't want to be accused of financial engineering by their LPs."

Hamilton says if GPs are in agreement with their LPs, there are ways they can borrow for longer: often the fund will seek the agreement from the bank to borrow for a longer term, on the basis their LPs are comfortable.

Arguably, prominent and high-performing GPs may be able to pressure their LPs, indeed pick and choose investors because of exceptionally strong demand for their funds, when it comes to how they use fund credit lines.

Investec's experience is that LPACs are highly aware of funds when they are borrowing money past one year, and Hamilton says market-leading GPs have not achieved their status by alienating LPs: "My sense of it is funds are highly conscious of the sentiment of their LPs, and they listen to them very carefully. When they're doing things that are longer-term, that can create the perception of leverage-on-leverage, they are doing it often in consultation with their LPs. Honestly, the marginal return the GPs get doesn't make it worth pissing off their LPs."

Further reading

• Fundraising

European GPs making increasingly meaningful personal commitments

• 11 Nov 2015

• Funds

Comment: Improving fund liquidity through fund finance

• 01 Apr 2014

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