The private capital market has been undergoing significant maturation, with an explosion of product offerings and growing confidence among market participants. This upward trajectory was evident at the 10th annual Global Fund Finance Symposium in Miami in early February 2020.
Of course, the world has changed since February, and with the onset of the COVID-19 global pandemic — and related market dislocation and subsequent uncertainty — the fund finance market is likely to see significant impact. First Republic Bank is closely monitoring this space and has compiled insights from clients and peers in the industry.
Read on for key takeaways regarding the future of the fund finance market and how this bespoke financing model may be impacted over the coming months.
Background and benefits of subscription lines of credit
By First Republic’s estimates, middle-market private equity funds in the United States currently have access to about $300 billion in committed subscription facilities and capital call lines of credit.
Subscription lines of credit were originally devised as a short-term cash management tool; secured by the limited partner’s commitment to fund their capital call when issued by the general partner. This form of credit facility serves as a bridge between capital calls and is beneficial for the fund. Under a subscription line of credit model, the general partner is able to act quickly to fund investments without waiting the requisite 10 days for LPs to fund their capital calls. This form of bridge financing is usually repaid within 90 days or so. But as private capital proliferated and business models evolved, so did subscription lines of credit.
As the industry has matured, this bridging “tool” serves other longer-term purposes — namely, IRR enhancement and flattening the J curve of private equity. Repayment terms have trended higher, with 90 days stretched to 180 and 180 stretched to 365 or longer. In a typical money-center bank subscription line, with a tenure of three years, repayment is due at maturity with automatic extensions built in for at least one more year.
These fund lines of credit have also grown as a percentage of fund size—sometimes reaching 40-50% of a fund’s total size. With the longer-dated repayment terms and larger sizes, some facilities have come to resemble permanent fund-level leverage.
As the industry has evolved, lenders in this space have become accustomed to higher levels of usage and long periods in between capital calls. And to date, these facilities have consistently met the mark, with an impeccable record of performance.
Responding to change in the current environment
In the past few weeks, given the current public market volatility and the unknown impact on private portfolio company valuations, many GPs and LPs are just beginning to plan their response.
The current trends are, as of yet, still taking shape. Some industry thought leaders have indicated that GPs may rush calling capital to pay down their fund credit facilities — whether out of an abundance of caution or at the nudging of the lender. Another possibility is that funds may draw down their credit lines without a defined need — just in case — and likely as an extra precaution.
It seems the GPs and LPs are still taking the time to be thoughtful and deliberate in their decision making. The long tenure of a GPs’ partnership structure and their relationship with investors necessitates such a deliberative approach to any decision-making, even in today’s volatile market environment. Many GPs have reported their immediate reaction has been to stay close to their existing portfolio company management teams and assess the liquidity needs of those companies.
At the other extreme, calling capital earlier than expected or needed could be a rash decision that results in consequences down the line. For example, if an LP hadn’t previously reserved sufficient liquidity to meet their capital obligations to a fund, and they’ve now suffered a steep decline in their public portfolio, this may be a tough time for 10-day capital call notice.
Many GPs are taking the requisite time for thoughtful reflection, to allow them the time necessary to get a grasp of their fund’s full picture before communicating and planning for the future with their LPs. This planning includes setting expectations with LPs on how much and when their capital is expected to be called. While thoughtful consideration is needed, it’s also worth noting that delaying the capital call may actually be worse for GPs and LPs if the economic impacts are more prolonged than anticipated.
What to expect over the next few months
In many ways, the new economic realities brought on by the COVID-19 pandemic have upended existing systems and assumptions. That’s true for private equity as well: For the past 10 years, the economic incentive for investors to fund capital calls hasn’t been tested. It’s hard to find a private equity fund that isn’t valued at cost or higher. But after Q1 numbers are distributed, this assumption may no longer be true.
Additionally, the trend toward a longer tenure for these facilities is proving to make the capital call planning exercise more challenging (or perhaps beneficial) for those facilities that have recently been originated. Repayment on those facilities, depending on where they are in their life cycle, may not become due for some time — hopefully when public markets and portfolio company valuations have normalized.
For those facilities coming due now or within the next few months, the need for transparency with LPs regarding the timing and amount for upcoming capital calls is underscored. Instead of the customary 10-day notice, funds are now beginning to alert LPs about capital calls 30, 60 or 90 days out and laying out expectations for the next few quarters to put things into perspective.
Even so, it may be beneficial for funds whose LPs currently have little to none of their commitment called to date, or funds with subscription lines substantially drawn without a near-term repayment requirement, to proactively schedule out smaller capital calls throughout the year. This way they can avoid calling between 20% and 40% in one shot as the subscription line comes due.
The key to success: Information-sharing among all parties
It’s encouraging that, as of now, banks aren’t overreacting, LPs are still meeting their capital calls and subscription lines are continuing to perform as expected. Across the board, private equity professionals are working with their portfolio companies to see their employees, customers and communities through this crisis. History demonstrates that this niche sector of the financing markets can withstand incredible market turbulence.
Open communication between all parties will go a long way in shoring up the long-term health of relationships. Now is the time to reach out to your bank to communicate the same information you’re providing to your LPs. Sharing information among all stakeholders ensures everyone can make the right call.
First Republic Bank is available to provide counsel and insights during this unprecedented time. If you’re interested in learning more, have us contact you.