Amid full asset prices, a growing wall of dry powder and mounting pressure for sponsors to deploy capital, significantly more cash is going back to investors than is being drawn down. Compounded by the low-interest rate environment, there remains a desperate need to generate yield.
Investors are now asking for their capital commitments to be used more efficiently to deliver the required returns. This has paved the way for an explosion in the use of LP-backed bridging facilities and has seen this type of specialist financing move into the mainstream from its niche market roots.
From a risk-management perspective, sponsors can use bridging facilities to draw down in any currency to proactively manage their portfolios. In fact, this type of non-speculative foreign exchange hedging is now much more important than it has ever been before, notably for US dollar and euro-denominated funds.
Also, with less opportunity for earnings multiple arbitrage, there is a renewed and refreshing emphasis on private equity to add real value to its portfolio companies. Unfortunately, for GPs, the internal rate of return hurdle demanded by investors remains fairly constant with only limited examples of it being lowered or removed.
The challenge is all the more pressing as certain groups of institutional investors, such as sovereign wealth funds – which have a lower cost of capital – start to consider direct investment opportunities.
Therefore, there is now an increasing use of short-term credit facilities to manage investor cashflows and ultimately delay draw downs, to once a year in many cases, and GPs are widely considering options for the intelligent use of debt to protect and enhance returns.
The dynamic environment has also forced private equity houses to change how they make transactions. We increasingly see buyers writing ‘all in’ equity cheques for assets, funded in the first instance by bridging facilities.
By deferring the portfolio company level debt financing, managers are giving themselves, say, six months to add value, whether organically or through acquisition, and ultimately taking a better business to the debt markets.
Overall, the fund financing market has grown substantially and we expect to see this trend continue into 2017.
In fact, it has the potential to be twice as large as its current size if the increasing use of facilities across the spectrum of private market asset classes continues on trend.
But, while the financing mechanics of transactions and funds might change, the pressure for returns and to deploy capital in the right opportunities is unrelenting. Good private equity managers are used to overcoming challenges and we have seen in recent years the asset class’s ability to adapt in times of extreme uncertainty. No doubt it will find a way to continue delivering on its commitments to investors and the management teams of the trading businesses it ultimately supports.
Robina Barker-Bennett is global head of financial sponsors at Lloyds Bank Commercial Banking