The Institutional Limited Partners Association wants to make sure fund managers are transparent with investors about their use of capital call credit lines and, in particular, about the impact that the loans have on IRRs and investment multiples.
The Washington-based trade group for limited partners is crafting guidance on best practices in the use of these credit lines, which enable fund managers to close on deals without immediately drawing capital from investors.
It is not clear when the guidance will be published. Jennifer Choi, managing director, industry affairs for ILPA, said the association already knows it would like to see more detail about the use of capital call credit lines embedded in limited partner 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.
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, has exploded thanks in part to Libor being so low historically. VCJ affiliate publication Buyouts reported more on capital calls last year.
“Almost all the mid-market funds are doing it,” said an LP at a large institution about capital call facilities.
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, according to the Buyouts PE/VC Partnership Agreement Study for 2016/2017.
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 rate for generating carried interest sooner.
Critics of the practice point out that, in fact, investors may realize lower returns on an investment multiple basis because of the interest paid on the loans. Also, they say that 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, a 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.