- ILPA recommends GPs cap facilities at 180 days
- New guidelines emerge after LPs, GPs express need for clearer parameters
- Capital-call facilities can boost IRRs, affecting waterfalls and hurdle rates
The Institutional Limited Partners Association thinks private equity firms should be more up front in describing how and when they use lines of credit secured against their funds to buy new companies, a practice that’s grown increasingly prevalent among new funds in recent years.
The trade association, which represents more than 400 PE investors, released a set of guidelines for LPs and general partners detailing how the credit facilities should be used, and what information should be made available to fund investors. ILPA also recommended a variety of ways in which LPs can request more information about these lines of credit, known as capital call facilities, to determine whether they’re being used to goose net internal rates of returns or accelerate fund distributions.
Among the suggestions: GPs should cap the duration to their lines of credit at 180 days and facilities should be used to fund only 15 percent to 25 percent of a fund’s uncalled capital. Also, GPs should secure these facilities with their LPs’ commitments to the fund, rather than with the fund’s assets.
Private equity firms should also outline their internal policies for using the facilities, as well as provide specific detail about how they can be used, how much of fund’s uncalled capital they can represent and the maximum period they can be utilized, according to a copy of the ILPA report.
“What we heard at the time was a very clear need for LP-led guidance on reasonable parameters,” said Jennifer Choi, ILPA’s managing director for industry affairs. Choi added that in the early stages of compiling its guidelines, ILPA engaged with GPs who conveyed the “need for clearer parameters.”
Firms use capital-call facilities or bridge lines to ease the process of drawing down capital from their investment funds. After they call the necessary capital from their fund investors, the firm uses the LP money to pay down the short-term loan with which they’d purchased their new portfolio company.
Almost 70 percent of North American buyout funds can obtain these short-term loans before they draw investment capital from their LPs, according to Buyouts PE/VC Partnership Agreement Study for 2016-2017.
However, firms have been extending the duration of these loans well beyond the typical 90-day period that had been considered customary, according to the report. More recently, ILPA reported seeing lines of credit that extend a year, two years or longer.
This effectively boosts a fund’s performance by shortening the period between when LPs invest and when they’re delivered a return. That, in turn, can influence how and when a fund manager collects carried interest, or whether LPs need to claw back returned capital from the general partner.
ILPA recommended GPs calculate their hurdle rates — the minimum return the fund manager must hit before collecting carried interest — using the facility’s draw-down date rather than when LP capital is called.
Legal, tax and liquidity considerations arise as well. GPs making full use of their facilities may call massive amounts of capital from their LPs at once, rather than throughout a fund’s multiyear investment period. Terms of the facilities may give the lender some measure of control over the fund’s investment process, and investors may find themselves exposed to taxes they hadn’t had to pay with shorter-duration facilities.
Choi said that she doesn’t expect a great deal of pushback from the GP community, but that some firms may take issue with certain specific recommendations and guidelines.
The American Investment Council, which represents more than 30 of the PE industry’s largest firms, hasn’t explored issues relating to capital-call facilities but expressed a willingness to collaborate with ILPA moving forward.
“We were not consulted by the ILPA on these guidelines, but our member firms always welcome the input of their limited partners. We look forward to the potential for collaboration on this topic,” said spokesman James Maloney.
Action Item: More on the ILPA guidelines http://bit.ly/2sV8MDv
Photo of Jennifer Choi courtesy of ILPA