Bringing Fund Financing Facilities to The Table
Capital V #10 | Private Equity Means Luxembourg
Fund financing facilities, subscription lines, equity bridge financing – whatever the name used – are loans provided by a bank, usually for less than 364 days, and secured on the limited partners’ uncalled capital commitments. These loans have been a hot topic in the fund industry over the past few years but are by no means a new feature, especially in the U.S., where such facilities have existed on a huge scale for almost 20 years. Despite the established nature of financing facilities, some limited partners may be reluctant to use them owing to complexity, transparency and risk concerns. Let’s examine whether such concerns are justified.
Financing facilities are used to finance projects or to make cost payments, and provide a high level of flexibility to fund managers, enabling them to use the capital within two to three days. Managers with no such facility in place will often have to wait 10 to 15 days (the time needed to call in investor capital) before they have the necessary funds in place. This, together with a decrease in the administrative burden of making capital calls from tens or hundreds of Limited Partners (“LP”), permits the execution and deal-winning process to be shortened, which is key in today’s fiercely competitive fund management environment.
Fund financing facilities are not always standard cash drawdowns, and can offer flexibility to suit the requirements of an investment manager’s strategy. For example, greenfield infrastructure funds commonly use letters of credit (LoC) as a guarantee for third-party developers, without needing to make a cash disbursement. The terms of these LoCs are defined when drawing up the facility agreement and may then be easily implemented at the closing of the investment, whatever the currency needed.
Another benefit for the LP is in the context of private equity funds of funds. Managing capital calls from the various underlying funds may result in an administrative nightmare owing to unaligned capital calls from underlying invested funds. A financing facility makes future capital calls predictable for limited partners by netting the yearly investments for underlying invested funds into one capital call. Nevertheless, many limited partners have reservations about these facilities as fund managers are incentivised on an Internal Rate of Return (IRR) basis and these facilities can lead to inflated IRRs. Delaying capital calls from limited partners does improve the IRR at exit as the cost of the facility is cheaper than the rate expected by LPs. In other words, without financing facilities, an investment over five years with a multiple of 1.5 will have its IRR calculated over a five-year period, while with a such a facility in place during the first year, the IRR will be calculated on a four-year basis, thereby increasing the IRR as a result and with limited partners’ cash at work only over a four-year period.
In conclusion, while fund managers demonstrate full transparency around financing facilities that are only used to levels agreed in a fund’s constitutive documents, the industry needs to find a way to communicate more clearly how, when and why they are used.