The vast majority of private equity funds today are using some form of capital call financing facility to support their operational and investment needs. Without a doubt, an important reason for this is because such facilities have a positive impact on the funds’ returns. Hybrid solutions that marry finance secured against undrawn commitments with finance secured against portfolio assets as the fund matures are also growing in prominence.
Both the primary and secondaries fund managers that we speak with in the market are increasingly voicing frustrations about how quickly capital call facilities can become “maxed out”. Rapid capital deployment can render these facilities ineffectual in as little as a year, leaving managers with the time-consuming and costly task of heading back out into the market to find an alternative debt solution.
An unwanted distraction
Funds use capital call facilities as bridging finance, allowing them to execute investments with speed and agility before co-ordinating capital calls with their limited partners at a later date. The return boost provided by such financing lines, meanwhile, is also increasingly key.
The structuring of these facilities varies depending on the quality and diversity of the underlying investor base, and typically include a qualifying limited partners (QLPs) coverage test requiring somewhere between 1.1 and 1.5 times undrawn commitments.
This means that where the general partner is deploying at exceptional speed, the capital call facility might only be available for a fraction of the fund’s full investment period. This can create a liquidity hole that will impact every facet of the fund, from the ability to complete a deal, to operations, administration and ultimately returns.
At this point the manager is faced with the task of securing replacement facilities better suited to that period in the fund’s life cycle. For a secondaries fund, with a mature and well-diversified portfolio and strong cash flow visibility, this may involve a pure NAV-backed structure. For a primary fund that is less mature, meanwhile, it is likely to involve a hybrid line secured against a combination of portfolio assets, remaining undrawn commitments and possibly recyclable distributions. These structures continue to support the operational, administrative and investment needs of the fund while enabling it to continue deploying capital at its desired pace, and enhancing returns.
Time and tide
A significant challenge is that on average it takes 14 weeks to put in place a facility, from sounding out the market, to selecting a lender, negotiating term sheets and ultimately implementing a facility. Some of our clients in the US suggest that the entire process, from start to finish, can take as long as nine months – and typically costs between $100,000 and $500,000 in total legal fees.
What’s more, it is reasonable to assume that the facility will need to be replaced on multiple occasions as the fund’s asset profile shifts. Managers can find themselves spending a significant portion of a five-year investment cycle negotiating financing terms. This represents a huge opportunity cost.
While financing solutions can undoubtedly be used to generate alpha, the private equity investor’s primary role is to create value through smart investment and astute custodianship of its underlying portfolio. Returning to the negotiating table for fresh debt is a massive, unwanted distraction.
The long-term solution
The fund finance market is beginning to respond to the challenges that managers are facing in maintaining efficient and relevant fund facilities throughout the life cycle of the fund. And we are seeing real enthusiasm from clients for long-term solutions that can support the fund, not only through the initial investment period, but also beyond. With around $300bn in assets (PDF)* currently held, arguably, outside the investment period, these nuanced and flexible facilities are becoming a meaningful liquidity tool for the fund to comply with underlying investment needs and related business plans, thereby supporting alpha generation.
These investors are looking to put in place a master facility, from day one. This master facility enables them to request capital call facilities in the early days of the fund. And then, when the undrawn commitment ratio falls beneath the coverage test in place, they are able to request a hybrid or NAV-backed facility, all within a single credit agreement.
This flexible structure allows key terms of additional facilities to be varied with only small amendments required to existing credit agreement documents without the need for the amendments to be documented. This implies there can effectively be numerous borrowing entities all supported by the same overarching legal agreement. The facilities can be used for multiple purposes, and at varying quantums, repayment structures and terms.
The benefits of such an approach are clear and the flexibility and longevity offered is being welcomed by both primary and secondary managers, who are increasingly seeking to differentiate themselves not only through their investment prowess but also clever capital structuring and use of liquidity.
By thinking long-term, managers are able to ensure their operational needs are met without interruption, even through sometimes volatile markets and unpredictable rates of deployment. They are able to more fully invest the capital in their funds and enhance the returns they are delivering to their limited partners. Crucially, managers can also avoid the undesirable distraction inherent in the protracted and costly process of negotiating fresh fund finance facilities.
We increasingly hear from private equity fund managers that deployment is rendering capital call financing facilities irrelevant whilst the fund is still in the early days of its investment period. While the supply of NAV-backed and hybrid structures is growing, securing these facilities can be costly and extremely time-consuming, taking managers away from critical investment activity.
An emerging solution
Managers are asking for flexible, long-term solutions that can enable them to evolve from a capital call to NAV or hybrid facility within the context of a single credit agreement, both within and beyond the investment period. Whilst providing continuous operational support, such solutions allow for maximum deployment and returns enhancement, whilst minimising the resource required from the fund manager.