Minding the capital gap

Credit facilities can help private equity funds smooth over some otherwise potentially rocky cash flow requirements. By Liz Lambert

The private equity industry and its constituents are – unquestionably – booming, both in fund size and international scope. With private equity firms engaging in deals and raising new funds of ever-increasing scale, so too are they increasingly interested in finding ways to bridge temporary capital gaps and add nimbleness to their investment activities.

Over the past 12 to 24 months, we have noticed a growing number of inquiries from private equity firms who are exploring how liquidity facilities could be applied to their funds and management companies. We have also observed elevated interest in specialized structures to manage the risk associated with foreign currency fluctuations, particularly as private equity firms seek to diversify their businesses by making investments in multiple jurisdictions.

This article encapsulates the three types of credit facilities that are most pertinent to the private equity firm, highlighting the structural features and requirements, as well as the applicability, of these facilities.

Capital call bridge lines
The most relevant liquidity facility for a private equity fund is the capital call bridge line. For a private equity general partner, the main attraction of having a capital call bridge facility in place is that it provides for a more efficient capital calling process. More specifically, it allows the fund to make multiple investments prior to making fewer, but larger, capital calls from LP investors. This liquidity facility also provides the added convenience of reducing the risk of calling capital for a deal that does not end up closing and requires the return of capital to the LP investors.

From the lending financial institution's perspective, the typical size of this facility ranges between 10 percent and 15 percent of the total committed capital of the fund. Note that the limited partnership agreement of a private equity fund frequently contains a limitation as to the size of a liquidity facility, usually in the range of 10 percent to 25 percent of total committed capital of the fund. These lines may provide for a sub-limit for standby letters of credit, which are useful as a credit enhancement for long-term lease arrangements for the benefit of the fund's landlord, as well as for the benefit of portfolio companies' financing sources that may require such enhancement.

Availability under the facility is based on a formula tied to eligible unfunded capital commitments, which is the collateral and source of repayment for the facility. These facilities are typically structured as annually renewing revolving lines of credit, with short-term repayment windows driven by the timing of capital call inflows.

Pricing is a function of the quality of the limited partner investor base (for instance, are the fund's LPs institutional and investment grade, or do they consist primarily of individual investors?), management team experience and track record, as well as references. From a financial reporting standpoint, the financial lender will seek annual audited financials and quarterly interim financials of the fund (on a going forward basis if the subject is a new fund), as well as certifications of compliance with the loan covenants and notices of any defaults. Lenders will also require a form of borrowing base certificate with a request for an advance under the facility, which demonstrates availability under the facility based on a percentage of eligible unfunded capital commitments of the fund.

Management company revolving lines of credit
Another type of credit facility with applicability to the private equity market is the management company revolving line of credit, or revolver. These facilities are typically smaller in size in comparison to the bridge capital call facilities, and their primary use is to support the short-term cash flow needs of the private equity management company, pending receipt of management fees from the fund.

The amount of credit available under this revolver is based on a formula tied to a specified percentage of the net management fee receivable. This percentage is typically in the range of 65 to 75 percent of the net management fee. The net management fee is the collateral and source of repayment for this facility, and is due to the management company in accordance with a legally binding contractual arrangement between the fund and the management company.

Most management companies receive their fees quarterly or semi-annually in advance, and as such, the borrowing base formula with the lender will provide for a specified percentage of the net fees due for the successive two to four quarters. These revolvers are ordinarily structured as annually renewing lines of credit, which require interest only payable monthly in arrears. These facilities frequently require that the revolving credit principal balance be paid down to zero dollars for thirty consecutive days, either on an annual or semi-annual basis.

There are some other important factors to consider when establishing a management company revolver. Personal guarantees of partners may be required depending on the mechanics associated with the payment of management fees (e.g., waiver provisions and the impact on actual cash inflow to the management company). You should expect the lender's financial reporting requirements to include annual and interim financials of the management company as well as for the fund, compliance and borrowing base certificates, and periodic management fee schedules. The key benefit to the management company in having a revolver is that it provides short-term cash flow support pending receipt of net fees, which can be very useful especially during expense heavy cycles (e.g., legal and accounting fees).

Foreign exchange facilities
Currency risk management tools are useful for funds and related entities (i) making foreign investments, (ii) selling a portfolio company in foreign currency, and/or (iii) with foreign office locations. Foreign exchange lines of credit are typically structured and approved along with capital call bridge facilities, but can also be established as a stand alone facility for the fund.

Financial institutions may offer specialized strategies and products to minimize the fund's foreign currency fluctuation exposure and potential loss. Examples of hedging instruments include forward contracts, vanilla puts and calls, and zero cost structures.

Financial reporting requirements will be similar to those associated with the capital call bridge facility.

The fund may also seek to manage foreign currency risk exposure on behalf of its portfolio companies. In these instances, the portfolio company may be the counterparty for such a contract, and additional financial and other information will be required by the lender to evaluate the credit of the portfolio company. In certain cases, depending on the financial condition and other indebtedness associated with the portfolio company, the lender may seek credit enhancement with a guarantee from the fund.

In short, the growing need for flexibility and streamlined operations at private equity GPs have resulted in a concomitant increase in firms' interest in credit facilities. Before engaging in discussions with financial lenders, a firm should have already clearly conceptualized how it would like to use a liquidity facility. It is also important to be well aware of the reporting and other requirements that go hand in hand with such facilities. With the right preparation and management, credit facilities can be a useful expansion of the private equity manager's tool kit.

Liz Lambert is a senior vice president at the private equity banking group of Citizens Bank, a wholly-owned subsidiary of The Royal Bank of Scotland Group.

What to expect during initial discussions with financial institutions
There is a select group of financial institutions that provides specialized services to the private equity industry. Certain groups approach the market from the personal banking and wealth management side, while other groups are commercially focused on the needs of the funds. When preparing to meet with a financing source, it would be wise to keep in mind the following pointers when undergoing a credit evaluation:

  • ? Determine the types of services you are seeking from a financial institution (e.g., commercial needs such as capital call bridge lines, international banking products and services, personal banking/wealth management services, or some combination of these offerings);
  • ? Be able to quantify the dollar amount and type of facilities and services you are seeking;
  • ? Confirm what your governing documents (e.g., limited partnership agreement, management/advisory agreement) permit in terms of debt facilities and foreign currency risk management tools.
  • In addition, it will be important to provide the lender with the following documents:

  • ? A detailed listing of limited partner investors and committed capital amounts;
  • ? Copies of the limited partnership agreement and related documents;
  • ? The fund's private placement memorandum and organizational chart;
  • ? Historical financials of fund(s) and related entities;
  • ? Management fee schedule;
  • ? Independent references.