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Private Equity Quarterly Q1 2023

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The benefits of financing your individual GP commitment

During 2018–2022, U.S.-based private funds raised a record $1.5 trillion from their limited partner (LP) investors, compared to $928 billion during the 2013–2017 period (source: PitchBook database). Fund managers not only raised bigger funds, but also at a faster pace over the last five years. At the same time, LPs were requesting that general partner (GP) funds along with other firm investment professionals put more skin in the game and commit a higher percentage to their funds. Average GP commitment reached close to 5% in 2021, according to a survey from Investec, up from the historical 1%–2%. Combined, these trends have put greater pressure on the personal finances of investment professionals making personal contributions to their funds.

While raising more capital can potentially generate outsized future returns for fund managers and LPs alike, committing more personal capital to bigger and more frequent fundraises reduces the liquidity of investment professionals. As a result, these investors have sought ways to borrow cash to meet their individual commitment.

This article discusses the mechanics of one borrowing option: a professional loan program (PLP) designed for a group of individual fund participants at a single firm. The relatively low cost of leverage and other benefits has attracted investment professionals to this type of financing.

Historical types of financing

Historically, investing professionals at the firms could use loans that borrowed against their home equity, personal investments or personal finances. These options are still available.

  • The home equity line of credit (HELOC) is a common option to generate liquidity by borrowing against the equity in your home. One of the benefits of this product is the flexibility of the use of funds as well as the longer term of draw and repayment periods. Also, interest on this loan can be tax deductible, and borrowers may draw and repay at their discretion during the interest-only draw period. A point of consideration, however, is that the borrower ties up the equity of their home using a HELOC.
  • Another alternative for borrowers contributing to their funds is to take a margin loan against the value of their personal securities. This lending option is one of the cheaper forms of debt; however, the ability to borrow is dependent on the advance rate available against the amount of liquid assets (e.g., cash and tradable securities). If a borrower’s securities lose significant value, they may have to put up more cash or liquidate some securities through a margin call to fulfill the obligations of the loan.
  • Some borrowers may seek a short-term personal loan to bridge the liquidity gap. This option is based on the individual’s ability to repay the loan based on their cash flow and balance sheet (i.e., liquid assets).
  • Often, senior executives at the firm will create a program where the management company is the lender. While this approach provides easier access to financing for employee participants, the drawback is that it creates a direct liability on the management company for any defaults, thus creating risk. In addition, developing an internal lending program can pose an administrative burden on the firm and owners of the management company, where it is responsible for structuring notes and repayments. As a result, many private equity firms are hesitant to go this route. Another potential risk is that the borrowers will rely on their employer for this financing source.

Professional loan program

The professional loan program (PLP) has been around for more than 10 years and was intended for the sole purpose of helping borrowers finance their committed and discretionary investments. The PLP is a product specifically designed to finance an individual investment through a multi-borrower program for the firm. Its structure was created to mitigate the risk borne by the management company and increase the flexibility of the employee borrowers.

First Republic’s PLP offers many benefits to borrowers. First, the product provides needed liquidity and the potential to increase borrowers’ personal internal rate of return (IRR). Second, the programs are long-term facilities, customized to match the life span of the fund. Payments are matched to contribution and distribution phases of the fund, where borrowers pay interest during the commitment period and pay down principal during the harvest period. Like other banks, First Republic requires that a portion of distributions back to borrowers are first used to repay any outstanding debt. Third, the program can be customized for borrowers who invest in multiple funds. For instance, the program could become a revolving line of credit facility, as in the case of multiple funds where there is not a particular life cycle to match. The program can be adapted by extending the borrowing base and period as more funds are added to the program.

The chart below illustrates an example of how a borrower who uses leverage to fund their capital commitments conserves their personal liquidity and delivers a higher return on investment than their unlevered colleague, all things being equal.

This table is a comparison of the return on investment for a levered versus an unlevered investor in a scenarios where the borrower who uses leverage to fund their capital commitments conserves their personal liquidity and delivers a higher return on investment than their unlevered colleague, all things being equal.

In this example, the fund has a 10-year life cycle, with the first five years as the investment period and the second five years as the harvest period. The borrower takes a loan for 50% of their $100,000 commitment to the fund with an interest rate of 7.75%.

In this simplified example, 20% of investors’ commitments is called at the beginning of each year during the investment period. At each annual capital call, the levered borrower draws down $10,000 from their line and pays $10,000 from their deposit account. In addition, the borrower makes interest payments on their loan balance each year, totaling $11,625 over the five-year period. During the investment period, the borrower is out of pocket $61,625 (i.e., 50% of capital calls plus interest payments), while the unlevered colleague is out of pocket $100,000.

The fund in this example returns three times the invested capital, and 20% of the total returns are distributed annually to investors at the end of the year. Both the borrower and the unlevered colleague receive $60,000 per year in distributions. At the end of the first harvest year or year six of the fund, the borrower repays the $50,000 balance of their loan using these distributions. The borrower pays $3,875 in interest during year six of the fund before they receive the distribution to repay the loan.

The call-out box shows the calculation for return on investment.

During the life of the fund, the borrower pays $15,500 in interest payments and is out of pocket $65,500, compared to their unlevered colleague, who is out of pocket $100,000. Both receive $300,000 in total distributions, and the net gains for the levered investor equal $184,500, compared to $200,000 for the unlevered colleague. However, the return on investment is much higher for the levered investor.

For both investors, the final value of investment equals $200,000. The levered investor received $300,000 in distributions, less $50,000 of loan repayment and $50,000 of cash investment. The colleague’s final investment equals the $300,000 distribution, less the $100,000 cash investment. For the levered investor, the cost of investment equals $50,000 of their own capital plus $15,500 of interest payments. Thus, the return on their investment equals 305%, compared to only 200% ROI generated by their colleague’s $100,000 investment in the same fund.

Product differentiators

The differentiators among banks offering this product include length of loan terms, minimum loan amount per borrower, and expertise and capability to service the program and client. It is in the borrower’s best interest to have a product that closely mimics the investment and harvest period of the fund. This way, during the investment period, the borrower makes interest-only payments on any amount drawn on the line of credit to finance their portion of the capital call. When the borrowers receive distributions during the life of the loan, a portion of these distributions will go toward paying down any outstanding balance.

Often, banks require a minimum borrowing amount per participant, ranging from six- to seven-figure amounts. Firms that want to encourage participation from individual fund participants who are earlier in their career will benefit from finding a program that is more flexible in the minimum borrowing amount. Some firms even use First Republic’s PLP to encourage employee retention and high-quality recruiting.

The expertise of the bankers and their understanding of private funds is important to the borrower. First Republic works hand in hand with the borrowers’ finance teams by monitoring and facilitating all payments. First Republic takes standing instructions from each individual borrower on how they want to handle payment of their capital calls. Once the program is set up with standing instructions on how to make payments, borrowers do not need to spend time manually making transactions during each capital call. First Republic and the fund finance team will manage this process together. Building a proprietary software system has helped us facilitate these transactions to our clients’ advantage.

In fact, because of our expertise and operational capabilities, some investment professionals open accounts with First Republic to manage their capital calls, even when they don’t borrow through a PLP.

What to expect in the underwriting process

The underwriting process for the PLP considers the fund as well as individual borrowers. The first step in this process is the program level approval, and after the loan program documents are executed, the individual borrower approval process begins. Below is a summary of First Republic’s underwriting process.

Program level approval and documentation

  1. Term sheet: First Republic and the client (the private investment firm) will agree upon and sign the term sheet before draft documents are prepared.
  2. Needs list: First Republic will ask the client for supporting documents, including financial statements and formation/governing documents for all related entities.
  3. Program underwriting: First Republic underwrites the aggregate exposure for the loan program and obtains formal credit approval.
  4. Documentation: First Republic provides draft loan program documents for the client to review (master agreement, loan agreement and any ancillary documents). The client provides questions and comments, and First Republic will review.
  5. Program closing: Once the loan program documents are agreed upon, the client and First Republic will execute the loan program documents.

Individual borrower loan approval and booking

  1. Borrower introduction: The client provides the lender with a list of interested and eligible participants and contact information. First Republic will schedule a time to present the loan program to the firm’s employees.
  2. Application: Loan application packages are sent to the individual borrowers, including a copy of the loan agreement and checking account opening paperwork for new clients.
  3. Borrower underwriting: Upon receipt of borrowers’ applications and supporting documents, First Republic underwrites the loan.
  4. Booking and funding: Upon approval of the loan, borrowers execute the loan addendum. First Republic books and funds loans upon receipt of a signed addendum and any required approvals by the client or guarantor.

Things to consider about the PLP

While it is common for private equity firms to use some type of borrowing program to help participants finance their individual capital commitments, it’s important to find the right lender for you and your firm.

First, find a lender that understands your industry and has experience servicing these types of loans to private funds. First Republic services thousands of borrowers and facilitates several hundred thousand capital calls each year. This includes some of the top names in private equity and venture capital. Second, your lender should be able to facilitate capital calls and distributions for borrowers (and non-borrowers) to enhance the ease of use by each investment professional committed to your fund. Finally, look for products that have the flexibility to suit the needs of the individual investors in your funds, even those who are earlier in their careers and may have liquidity constraints.

The views and opinions of the third parties quoted in this article are not necessarily those of First Republic Bank and should not be relied upon as such. The content of this publication is for information purposes only and should not be considered as legal, financial, accounting or tax advice, nor as an investment recommendation or an endorsement of any investment fund. First Republic Bank makes no representations, warranties or other guarantees of any kind as to the accuracy, completeness or timeliness of the information provided in this publication. You should consult with your own professional advisors to fully understand and evaluate the information provided in this publication before making any decision that could affect the legal or financial health of you or your business.

This is not a loan approval or commitment to lend. Loans are subject to First Republic Bank's underwriting standards and verification of documents provided. Terms and conditions may apply. Ask your banker for details.

This information is governed by our Terms and Conditions of Use.

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