What Private Funds Should Ask Their Bankers
Most fund managers launch new firms because of their passion and skill for investing. Firm founders are successful investors, but rarely do they have experience setting up the operations of a fund. While new fund managers may be focused on defining their differentiated investment strategy and pitches to institutional investors, a strong administrative foundation can help grease the wheels of the investment function. Given the fast, real-time nature of closing deals and raising capital, it’s important to find the right banker who understands your timelines and can address your needs to keep the operations humming.
Investing experts are often banking novices. The latest Private Equity Quarterly provides a guide to key questions private funds should ask their bankers to determine whether they’re a good fit for their funds’ current and future banking needs.
“Do you work with private funds?”
To set the right foundation for your firm, choose a financial institution and bankers that have experience working with private funds and can keep pace with fast-moving transactions. The unexpected will happen during the life of the firm, and by developing a relationship with your banker, you’ll have an external partner who expedites issues to find faster solutions and ensure the flow of funds. For instance, a true banking partner will provide a single point of contact for high-touch service and a direct phone line or email address for when you need a response in real time. Delays can gum up the gears and interrupt important transactions.
When commencing a banking relationship, the investment firm will need to open deposit accounts for all firm, operational and investment entities, specifically, the management company, general partner (GP) and each of the funds. Each account will track different flows: fees to the management company, carry to the GP, and capital calls and investment outflows for the fund. Most banks specializing in private equity prefer to manage all firm accounts.
When considering banks, it’s important to understand how long it takes to open accounts to ensure that your accounts are set up in time to confirm upcoming transactions. After documentation is received, U.S. banks must undergo a know-your-customer (KYC) and anti–money laundering (AML) review. The guidelines for this process have become more stringent given the sanctions imposed in response to geopolitical issues. Investment funds are expected to perform their own KYC checks, and it’s expected that private funds will be required to conduct this diligence in the future. In fact, the U.S. Representatives House Armed Services Committee passed the ENABLERS Act in June 2022, a bill that, if passed into law, would require investment advisors to comply with due diligence rules under the Bank Secrecy Act. A strong banking partner will be able to walk you through the needed documentation for bank requirements.
“What debt products can streamline the firm’s operational efficiency?”
Operational expenses rarely occur at a regular pace. Many firms, both new and established, opt to use debt to create liquidity to pay for expenses incurred by the management company. This debt instrument, the management company line of credit, is a revolving loan that can bridge operational expenses and the receipt of fee income. Fund managers can use these lines for working capital support or simply to smooth cash flows. Additional management company lines can also come in the form of term loans for larger capital expenditures, such as tenant improvements.
The collateral backing these lines is contractual management fee income. Expect your banker to ask for the limited partner agreement (LPA) or other agreements detailing sources of fee income and the duration these fees will be charged. Loan amounts are derived by client need and underwritten to firm cash flows and expenses.
Related to working capital lines are standby letters of credit, which are used to secure an office lease. These documents guarantee a bank’s commitment to pay the landlord, in the event that the tenant defaults on its rental agreement. These documents follow an industry standard template to which landlords and real estate brokers are accustomed.
“What debt can be provided to increase efficiencies in the investment process?”
Investment opportunities typically materialize on short timelines and sometimes unexpectedly. The 7 to 10 days that limited partners (LPs) typically have to respond to a capital call may be too late for the fund to complete the portfolio company investment. One way that funds can bridge the time between receiving capital calls and investing is by using a capital call line of credit, also known as a subscription line of credit.
Funds’ ability to borrow and any imposed limitations are defined by the LPA. If you believe your fund will use a capital call line of credit, consult with a fund formation attorney to draft an LPA that will allow the fund to borrow. Limitations on funds’ ability to borrow are defined by the LPA and may include an SEC registration requirement (for investment advisors) or limitations on the duration of borrowing due to tax-exempt LPs’ sensitivity to triggering unrelated business taxable income (UBTI).
The line of credit can benefit funds in several ways. First, fund managers benefit by accessing liquidity quickly by drawing on the line, which allows for faster deal closings. Second, LPs can benefit from administrative efficiencies derived from funds’ limiting the total number of capital calls each year. Third, because a line of credit may shorten investors’ holding periods, using capital call lines of credit may moderately boost fund performance, when it’s calculated as an internal rate of return (IRR) based on LP capital calls.
Except for a couple newsworthy instances, subscription lines have proved to be a very safe risk for banks because they’re secured against LP commitments in a fund. The surety of repayment is based on the contractual agreement that LPs will make their capital calls. That is, the collateral backing the loan is the uncalled capital from LPs. Consequently, these lines are typically limited to closed-ended funds with no redemption rights. In other words, LPs’ ability to divest their interests in a fund would create significant risk for a lender.
How do banks determine the creditworthiness of LPs? Some of the larger banks in this market prefer an LP roster of institutional investors and will discount the calculation of uncalled capital by LPs that don’t fit that category, such as high net worth investors. By contrast, other banks, including First Republic, look at the LP base as a whole and will accept high net worth LPs if their source of wealth can be identified and underwritten. Showing a history of recurring LPs across your funds and a track record of these LPs making on-time capital calls will improve the credit profile of your application. A deeper dive on how banks review LP commitments as a borrowing base can be found in First Republic’s Capital Call Facilities Primer.
Not every fund’s borrowing need is the same, and a fund’s financing requirements often change over time. It’s important to choose a banker that shows flexibility and an ability to modify your loan as the fund becomes invested and your borrowing needs change. In addition, look for a bank that shows a speed of execution you’d expect from your industry peers.
“How can you assist with the GPs’ commitment?”
LPs look more favorably on funds where managers commit a significant portion of the fund using their own resources. LP and GP interests are more aligned when GPs have “skin in the game,” and the ILPA Principles recommend that GPs contribute “substantial equity interest” in their funds. In fact, a 2021 Investec study shows that GPs are committing even more — roughly 5% of committed capital, on average, compared to the expected norm of 1%–2%. However, not all GPs can or want to access this amount of required liquidity.
Many banks specializing in private equity, including First Republic, offer loans to finance capital commitments to all employees contributing to the fund. First Republic’s Professional Loan Program (PLP) can provide debt to benefit all participating employees, regardless of title, at the discretion of the client. PLP loans are made to the individuals participating in the program with support from the firm backing the program. Terms and rates are uniform for each particular fund program, with some banks, including First Republic, offering rate discounts to certain participants based on the scope of the client relationship.
Many firms view this loan program as an employee perk and will offer it to attract and retain talent as well as provide equity alignment. The popularity of this product is driven by its ease of use by clients. In addition, the robust fundraising cycle over the past few years has created liquidity challenges. More frequent fundraises at subsequently larger amounts require increasingly larger GP commitments over a shorter time period. For fund participants who don’t wish to participate in the firm’s PLP, First Republic has created Capital Management Service to assist these employees with capital calls and distributions. This client service provides automatic processing of capital calls and direct deposit of distributions.
How capital calls are executed in the PLP
In this scenario, a 10% capital call has been issued on a $500 million fund. Ten employees participate in the PLP, which stipulates a 50% advance rate for each participant on their respective fund commitment. Exhibit 1 shows the payments made from the deposit and loan accounts for this capital call for selected participants in this program.
“How does a banking partner help you scale your business?”
Aside from loans and deposit products, how can a banker work with you for your business? One way is to provide the same exceptional service to members of your team and not just to your fund. Financial needs of GPs and their team members often change throughout critical stages of their personal and professional lives. Look for a bank that can provide this personal service to your team members, including full access to private bank, mortgages, personal lines of credit, wealth management services, etc.
In addition, many banks specializing in private equity deliver services beyond banking. It’s important that your banking partner also offer banking services to portfolio companies, for instance. Moreover, an experienced banker is well-connected in the private equity ecosystem and gives referrals for service providers, supports professional networks, and hosts events to encourage high-quality peer exchanges and best practice education.
One sought-after client benefit that’s grown in popularity is cybersecurity training. Private funds, including venture and private equity firms, are often targets of cyberthreats because these firms support a small staff relative to the amount of capital they manage. Investment managers typically have streamlined operations, which often doesn’t include the infrastructure to support the latest cybersecurity threats. Ask if your bank helps their clients understand the safeguards they can put in place to buffer your firm and employees from online attacks.
We’re here to help.
This article aims to provide an overview of ways that your banker can help smooth the working of your firm and its investment activities. The key characteristic of a good banking partner is one that has flexibility to address your specific needs based on their expertise in the industry and an understanding of your sense of urgency with a solutions-oriented approach.
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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.