The dividing lines of fund finance

When it comes to the use of subscription credit lines, private equity firms will not be able to please all the LPs all of the time.

Earlier this year, a senior partner at an A-List private equity group in New York called us to complain about “increasingly negative” media coverage of the proliferation of fund-level financing facilities in private equity.

“The minute I walk into an LP’s office, depending on where they stand and what they’ve read about financing, I can be on the backfoot trying to explain the approach we take at our firm,” he lamented. Then the conversation turned to Howard Marks, which wasn’t surprising: a few days earlier the Oaktree chairman had stoked the debate by suggesting excessive fund financing might, in a downturn, become a source of stability-eroding default risk. Wasn’t this, our caller asked, a claim PEI should take a look at as part of a wider assessment of industry practice? We thought so, too.

What we found was an issue as divisive among limited partners as any we’ve covered during our 17 years of publishing PEI. This is not because investors seem genuinely worried about the possibility of fund level leverage triggering the next financial crisis (they don’t), but because GPs who use long-dated lending facilities to postpone capital calls can make their performance look better than it otherwise would.

LPs who, like these managers, strive to maximise IRR tend to welcome the approach. Plus they may feel able to redeploy funds that would otherwise have been drawn to earn a return somewhere else.

But if you are an investor who focuses on the money multiple, and all you can do with your uncalled cash is park it in a zero-interest bank account (or worse still, your banker charges you a fee for holding it) while footing the extra cost of the facility – well, then you will be less inclined to applaud GPs for perfecting the art.

Some practitioners we’ve debated the topic with argued it has been unhelpfully overblown. They argue that facilities weren’t invented yesterday, virtually everyone uses them nowadays, the reportable performance differential they create is typically not large and the known number of actual credit defaults on portfolio-level debt appears to be zero – so what’s the big deal? Did ILPA really need to arrive on the scene in June and publishing guidelines on responsible usage?

Other folk who see a trend towards facilities being employed for ever-longer periods of time insist that guidelines were exactly what was needed. In an increasingly frothy market, the notion of GPs doing deals for 12 months or more without drawing down a dime is disturbing to many. That’s what sparked this controversy in the first place.

As our reporting for this year’s Fund Financing Focus series has made clear, managers who have their clients’ best interests at heart will need to tread carefully to not upset anybody. Says an industry veteran in Hong Kong: “We haven’t used any facilities at all. Half my investors tell me to keep it this way. The other half aren’t happy.” Now there’s a dilemma. When what’s at stake is the goodwill of the investor base, GPs know they have their work cut out.