LPs scrutinize capital call credit lines as popularity ‘explodes’

The Institutional Limited Partners Association wants to make sure fund managers are being transparent with investors about their use of capital-call credit lines and particularly about how the loans affect IRRs and investment multiples.

The LP trade group is crafting best-practices guidance for use of these credit lines, which enable fund managers to close on deals without immediately drawing capital from investors.

When the guidance will be published is unclear. But Jennifer Choi, managing director for industry affairs at ILPA, said the association already knows it wants to see more detail about the use of capital-call credit lines embedded in LP agreements.

One of the questions LPAs could address is how long the credit lines can remain outstanding before being replaced by LP drawdowns. “What’s happening is these are being used more and more as almost working capital,” Choi said. Ideally, she added, the credit lines should be replaced within a year.

ILPA also wants to make sure that fund managers disclose the degree to which fund IRRs are boosted by capital-call lines, she said.

Choi noted that ILPA is not making a judgment on the use of capital-call bridging facilities. But in response to requests from both fund managers and investors, the association wants to lay out best practices, she said.

Popularity

The use of these bridging facilities, which general partners can obtain from banks at interest rates of around Libor plus 175 to 300 basis points, Buyouts reported last year, has exploded thanks in part to Libor being so low historically. “Almost all the mid-market funds” are using them, an LP at a large institution said.

More than two-thirds (69.6 percent) of North American buyout funds have the ability to obtain short-term loans to fund a deal before drawing LP capital, the Buyouts PE/VC Partnership Agreement Study for 2016/2017 shows.

GPs say they draw on such loans to make the capital-call process more efficient. Instead of taking a risk that an LP misses a funding deadline, GPs pull capital from the credit line and collect from LPs later. Banks are able to quickly extend lending facilities for capital calls, in some cases on the same day the GP applies, said Craig Bowman, a partner at law firm Debevoise & Plimpton.

Fund managers aren’t as quick to talk about another big advantage of using them. Capital-call loans juice the net IRR on a deal by, in effect, shortening the hold period of the investment. As a result, GPs may be able to meet their hurdle rates for generating carried interest sooner.

Critics of the practice point out that investors may in fact realize lower returns on an investment-multiple basis because of the interest paid on the loans. They also say investors may not realize the extent to which their returns have been affected.

Investors also may be subject to data requests by lenders trying to determine how good a credit risk they are. Some may not be comfortable providing this level of information about the organization, said Andrew Ahern, partner at Debevoise & Plimpton.

“It can be costly for LPs to provide additional information to the banks. Some LPs are coming in saying, ‘I’m not providing any more documentation,’” Ahern said.

Along with being subject to data requests, LPs may find themselves subject to capital calls directly from banks in the event something goes wrong with the GP, Ahern said.

And of course, if the market turns down as these lines are extended, LPs may have to fund a capital call, plus interest, on a deal that is marked to zero.

More disclosure

As the use of such lending facilities grows, some LPs are trying to tighten terms of their usage.

While LPAs generally enable GPs to use this type of credit facility, LPs now are looking to include more limits.

“You’re seeing more attention paid to it and more disclosure by the GPs, particularly at the advisory-board level,” said Sam Green, PE investment officer for the Oregon State Treasury. “The provisions were pretty wide open. They allowed the GPs a fair amount of discretion as to who they’ll do this with, under what terms they’ll do it with, how long the facilities could remain outstanding on any particular company. The terms around it are tightening a bit.”

Descriptions of how GPs use capital-call credit lines have started showing up in due-diligence materials prepared for public pensions.

Investment documents from the Connecticut Office of the State Treasurer, for example, showed that mezzanine shop Ironwood Capital’s fourth fund would use a capital-call facility for the first year of the investment period. Fund IV would increase the length of the facility to 364 days from the 90-day term that was included in the prior fund, the documents showed.

One LP said Ironwood’s commitment to use capital-call facilities for the first year of the fund’s investment period was slightly unusual. “I’m used to hearing that [the] GP may use facility versus this, which seems more definitive,” the LP said.

Ironwood declined to comment.

Action Item: Check out Ironwood’s Form ADV here: http://bit.ly/2nnmT13

Photo of Jennifer Choi courtesy of ILPA