What Private Equity Partners Need to Know About Financing Capital Commitments

First Republic Bank
May 10, 2017

Whether you’re a seasoned private equity professional or new to the role of general partner, private equity partners are often expected to invest some of their own capital when raising a new fund — and for good reason: Limited partners want to be assured the partners' interests are aligned with theirs.  

The size of the commitment varies from one firm to the next, but established firms typically require that partners each take a one-to-two- percent stake in a fund. At startup firms, that commitment often ranges from five to 10 percent of the fund’s initial assets.

Given the size of most private equity funds, a partner's capital commitment can represent a significant portion of their liquid net worth. For this reason, many individuals will look to finance all or a portion of their capital commitments via any number of funding resources.

Weighing financing options

Private equity partners should first consider what financing options are made available through their firm. At some firms, for example, to reduce the cash outlay general partners may agree to maximize their management fee offsets — sometimes by as high as 80 or 90 percent. Other firms offer in-house financing programs for partners, though this is increasingly less common.

Depending on each unique situation, taking out a traditional loan or borrowing against a partner's net worth, perhaps via a home equity loan or using an investment portfolio as collateral, might be an attractive option.

Finally, select financial institutions offer professional loan programs for private equity general partners looking to finance a portion of their investments.

While the details vary by institution and individual, these loans can offer significant financing for fund capital secured by the fund’s investment, with terms generally ranging from five to eight years in line with most fund cycles. In underwriting these loans, lenders factor for individual credit worthiness — including income, assets and credit history — as well as the performance history and financial strength of the private equity firm.

The ins and outs of professional loans

Professional loans are generally designed to adhere to the life cycle of a private equity fund and are typically structured as a non-revolving line of credit featuring multiple advances for capital calls at a predetermined advance rate.

The loan is prepaid as the fund makes distributions, with a certain percentage of returns on capital and other distributions directed to the loan. Following the interest-only draw period — typically five years — the balance is amortized over the remaining term of the loan. The interest rate is variable and based on the prime rate.

Private equity partners looking to pursue a professional loan should expect to undergo similar underwriting criteria as is required for financing any large asset, such as a home. The lender will consider each partner's net income, liquid assets (which, in most cases need to be near or equal to the loan value) and debt, aiming for an appropriate borrower debt-to-income ratio.

Keep in mind that most professional loans are also predicated on a partner remaining at the firm — meaning that the loan would typically be due and payable in full if he or she leaves the company.

A thoughtful decision

There are several avenues private equity professionals can explore to raise the personal capital they’ll need to invest alongside limited partners. As with any financial decision, it makes sense to consider several options, or even a combination of several solutions. While the decision ultimately hinges on many variables, professional loans can offer a solid return on investment — and help private equity partners take their careers to new heights.

The information in this article is presented as-is.