There are seven main benefits to using capital call bridge facilities:
1. Immediate access to capital
The key driver for utilizing a bridge facility is liquidity management since managers are able to request and draw capital faster than the standard ten-day timeline. It gives immediate access to capital in a competitive situation and allows managers to be nimbler with their deployment of capital. It is also far simpler to request funds from a single entity (that is, requesting funds from the bank under the facility), as opposed to calling funds from every investor.
2. Bridging both debt and equity prior to putting a senior debt package in place
A bridge facility can be used to cover both the investor equity contributions and that of an external debt provider, such as a bank or debt fund, where senior debt is required in a transaction.
3. Bridges multiple acquisitions
If two deals are closing at around the same time, a bridge facility can avoid having to call capital from investors in short succession. This reduces the administrative burdens on investors and any direct costs to the fund associated with processing a drawdown to investors.
4. Letters of credit/guarantees
Letters of credit and guarantees in respect of portfolio companies can be provided under bridge facilities since the funds are available immediately, provided the terms of the facility are met.
In certain locations, such as some African countries, proof of cash being available is often a requirement to enter an offer for a transaction. Having a bridge facility therefore counts as such and fund managers are not required to call money before a deal is known to be secured. This saves any associated administrative burden.
A capital call bridge facility can also ensure that a transaction does not fall over as a result of having insufficient cash due to investors failing to pay drawdowns on time.
5. Reduced administration costs
By reducing the frequency of capital calls from investors, managers are able to significantly reduce the administrative burden required. The consequence of this is that managers must provide information relating to the transactions, which is usually detailed within a capital call notice.
6. Enhanced IRR
Potentially improved performance is another advantage of a bridge facility. Private equity fund managers are typically required to pay a preferred return/hurdle of 8 percent on drawn commitments from investors. Therefore, if financing is available at a lower overall cost than the hurdle, there is an incentive for managers to utilize a bridge facility to enhance the fund’s performance metrics, such as the internal rate of return (IRR).
The central banks in the US and Europe have set their respective lending rates at record lows since the financial crisis. The differential between the cost of borrowing and the preferred return payable to investors has therefore allowed fund managers to effectively use cheaper capital and deliver superior time-weighted returns to investors.
Fund managers are increasingly looking for opportunities to further improve their performance. In private equity, the most popular performance metric is the IRR, and this comes in two levels:
- Gross IRR, which looks at the cashflows from the fund to the investment and uses the investment NAV as the terminal value in the calculation. The gross IRR is not therefore affected by using a bridge facility.
- Net IRR, which looks at the cashflows from the investor and uses their individual NAV as the terminal value. When a fund manager uses a bridge facility, they can effectively delay drawing cash from the investors and thus improve the IRR.
7. Acceleration of distributions
A bridge facility can be used to allow acceleration of distributions. If a sale has been agreed, but is delayed (for example, due to competition approval), a fund manager could use a bridge facility to make a payment to its investors. There must be sufficient uncalled commitments to cover this scenario, but a fund could use proceeds from the sale to repay borrowings.
Here are four points to consider when deciding whether to use a capital call bridge facility:
1. Cost of the facility
Bridge facilities have their own costs associated with them, from legal fees to the arrangement fee with the bank, and then the interest charges once it has been arranged, split between a utilization fee and a non-utilization fee.
2. Whether the fund can enter into the agreement
A fund’s constitutive documents must be reviewed to ensure that the fund can enter into capital call bridge borrowing arrangements. It has become increasingly common for fund managers to request that their lawyers ensure there is scope for such borrowing under the limited partnership agreement, or equivalent constitutive documents, in the very first drafts.
3. Creditworthiness of investors
The creditworthiness of investors is a critical part of this type of financing. Not all investors are the same from a ratings perspective, and thus will have different applicable percentages when it comes to calculating the amount of credit that will be made available to the fund. Further, the proportion of the fund that each investor makes up is a factor, since this can create concentration risk. If an investor is not externally rated or provides financial information in the public domain, the GP may have to approach investors on behalf of the bank to provide financial information that will allow it to be rated.
4. Powers of the GP
Funds may be prevented or penalized for what would usually be vanilla events, such as distributions or partner transfers. In the event of a default on the facility, a fund may be restricted from distributing to investors. For instance, if one of the investors included in the facility calculation transfers its interest, there could be a requirement for prepayment.
Joe Greenwell is Associate Director for Business Development at Aztec Group, which offers fund administration services, and has over €9 billion assets under administration.
J.P. Harrop is the Group Head of Sales at IQ-EQ (formerly SGG Group), the fourth largest investor services group in the world.
This is an excerpt from The Definitive Guide to Carried Interest (2017), published by Private Equity International, and available for purchase here.