Behind closed doors: an LP perspective on financing

Hypothetically, you are considering commitments to two GPs. They are identical in every way apart from one has a conservative 30-day credit facility used only to smooth the acquisition process, while the other has a 24-month facility that it intends to use aggressively. Which do you choose?
We’d have a preference for the former, because you could reasonably argue that if the latter has had that facility in place for a while, then the two “identical” IRRs are not comparable like-for-like. If one was generating net 15 percent with the cash called on day one, then their performance is technically better than the one that has been delaying its capital calls.

And what if the second manager’s facility was a new feature, not a factor in their historical track record?
That is essentially what is going on right now – managers that were not previously doing so are using credit facilities to delay capital calls. We wouldn’t have an objection to the introduction of a longer credit facility, assuming the track record was comparable like-for-like.

However, I think we would object to the 24-month timeframe. You want to know at the end of the year what cash you are paying out, and [a 24-month facility] would make it very difficult to forecast our own cashflows. We already have a couple of managers who are drawing on an annual basis and it is a bit of a pain if they both decide to draw in the same week of December. Suddenly you need to pay out $30 million in cash.

What are the fee implications of these facilities?
If you are already paying management fees on committed capital, then it is straightforward; it makes no difference. Obviously there is a fee implication for cost of the facility – there will be a charge for organising the facility, a utilisation fee for capital used as well as an unutilised facility fee. All of these are wrapped up and charged to the fund. A lot of LPs are currently looking at the cost to the fund and asking whom the facility really benefits.

So is there consensus among LPs as to whether the extended use of credit facilities is genuinely in their interests?
Opinions are very diverse. Even among what you might call “real” LPs – pension funds and insurance companies – some are vehemently against it as they see it as a simple manipulation of the IRR by the GP to get over the hurdle rate more quickly. Others meanwhile see it as an efficient use of their capital; why have your money shoved into an asset that won’t perform for at least a year when it could be sitting somewhere else earning a return?

So yes, it improves the IRR from a GP’s perspective, but it also improves it from an LP’s. There isn’t a consistent view that it benefits the GP more than the LP.

Beyond any possible complications for LP cash management, what sort of risk does this practice introduce?
From a lender’s perspective, they are lending perhaps 15 or 20 percent of the entire fund and saying it needs to be paid off every year. The chances of that ever defaulting is absolutely minute. I wouldn’t quite say it was free money, but it is pretty low risk.  

What worries me from an LP perspective is the question of where this is going. Private equity has always been able to say it differs from, say, hedge funds because we have had a clear model that has excluded leverage at the fund level. At what stage – particularly in the eyes of the regulator – do these funds become geared?

Photograph: Kasra Kyanzadeh