Over the past decade, fund financing has played an increasingly important role in private equity. Particularly as interest rates around the world have remained low, a wide range of funds have made more and more use of gearing to finance investment activity.
Mostly this borrowing is short term bridging on a revolving basis, giving funds the flexibility to act more quickly than they could if they were drawing capital from investors and therefore greater certainty around the timing of execution of deals. However longer terms are becoming more common and are being used for a wider variety of purposes such as providing lines of credit for pooling investments, or delivering liquidity.
According to Aberdeen Standard Investments, the global demand for fund financing across private equity, infrastructure and real estate is now over EUR350 billion (ZAR6.4 trillion). A growing number of banks and other financing institutions are now providing these facilities across the world.
As this becomes more and more a part of the private equity landscape, it is important for both lenders and fund managers to appreciate what is needed to make fund financing deals successful. As funds generally want to be able to conclude these agreements as quickly as possible, it helps to have an appropriate approach.
A priority for fund managers and general partners is to ensure that the constitution or partnership agreement allows for the kind of borrowing they are looking for. If not, it will require amendments, which would delay the process.
Many established funds, for instance, are not set up to take long term funding. Their documents only anticipated the need for short term gearing to bridge the gap between making an acquisition and drawing down on the commitments from investors. They may, therefore, need to address several issues if they want to engage in longer-term borrowing.
Most important in this regard is the fund's ability to provide security to the lender. Mostly, fund financing has relied on using undrawn investor commitments as security (the so-called "capital call" or "subscription line" facilities). However, increasingly the market is looking to use a variety of hybrid models structured to take account of the fund's assets.
There are a range of considerations that need to be taken into account here. The first is that even if the simplest "capital call" structure is used, is the lender permitted to 'step into the shoes' of the general partner or fund manager to make a drawdown request, either through a security interest in respect of such right or through a power of attorney? Are there any local law risks in relation to a power of attorney, for example is a power of attorney revocable?
The fund's founding documents therefore need to make this type of arrangement possible. They also need to be clear on what the implications are if an investor defaults.
If an investor fails to provide committed capital when a request is made, what are the implications for such investor, and, by extension, the lender's secured asset base? Lenders will focus both on what the triggers are around a default and what penalties can be imposed on an investor in such an event, such as the cancellation of that investor's undrawn capital commitments, its forced withdrawal from the fund or the forfeiture of economic rights.
In a South African context, it is also important to consider how international development finance institutions, who often provide capital to local private equity funds, may view these types of arrangements. For instance, some may not be prepared to agree to a security interest being taken in respect of their undrawn capital commitments and may also have strict requirements over the identity of the person that is able to make a capital call on them. This may require special arrangements, which are not impossible to conclude, but do have to be taken into account when considering whether a deal is bankable.
There are also local funds that have rand commitments (from local investors) and US dollar commitments (from international investors) provided through separate partnerships or entities comprising the fund – for example a fund could comprise a South African partnership with rand commitments, and a Mauritius-domiciled partnership with US dollars commitments. If in an instance like this the lender requires recourse against the fund, considerations must be had in relation to whether it is acceptable to the lender that the recourse is pro-rated across these separate partnerships. If it is not, then a cross-guarantee structure may be required to ensure that the lender will be repaid even if one of the partnerships defaults - can the investors in both partnerships accept that type of arrangement?
As fund financing develops, however, funds are looking at leveraging not just their undrawn commitments, but their portfolio assets as well. Funds at start-up stage are starting to put flexible structures in place right from the beginning.
These master facilities cover the life cycle of the fund. Traditionally, lenders would require that both the term of the fund and the commitment period don't end before the loan needs to be repaid. However, hybrid structures make it possible for capital call facilities to be available in a fund's early stages, but as undrawn commitments fall below the cover ratio the lender requires, the fund can request further funding using its assets as security. This can all be done within a single credit agreement.
For this to be possible, however, the constitution or partnership agreement needs to allow for it. Structuring these documents carefully is therefore critical in ensuring that managers and general partners can access the fund financing most suited to them and their operational needs.