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Aon Retirement and Investment Blog

Lines of Credit in Private Equity Funds

Short term financing, through lines of credit, has been used by private equity funds for some time. Recently the use of these lines of credit has become more prevalent and the way in which they are used has also evolved.

Traditionally, lines of credit were used by General Partners in order to smooth capital calls as Limited Partners generally do not want to deal with the administrative burden of filling multiple capital calls during a quarter. The General Partner would therefore borrow funds in order to finance investments and then make one large capital call each quarter. As such, the usual practice was for lines of credit to be cleared every quarter or at least every six months.

General Partners have started using lines of credit to finance operations and initial investments before making the first capital call to Limited Partners or extending the time between interim capital calls, while also extending the length of time credit facilities may be used, some now pushing out to 18 months. Financing investments and subsequently calling capital from Limited Partners at a later date serves to increase the fund level internal rate of return (IRR), presuming investments are generally positively performing. IRR is calculated as the discount rate that equates the net present value of an investment's cash inflows with its cash outflows. Moving the cash inflows to a later date and leaving the cash outflows at the same date means that the discount rate will be increased. Overall the multiple of invested capital (the proportion of dollars received to dollars invested) will be lower as the fund is paying interest on the borrowed capital. However, in the current low interest rate environment, this impact is minimal. Depending on where cash is held before it is called, and after it is distributed, the overall effect on a client’s portfolio may be positive or negative.

There are multiple issues that investors should be aware of in relation to lines of credit when conducting diligence on funds/managers. Some of the key issues are highlighted below:

  • It is important to strip out the effect of credit lines when examining the performance of prior funds as usage will increase the IRR performance of prior funds both on an absolute and possibly on a relative basis. Eliminating the impact of the credit line gives a true measure of how successful the General Partner has been at investing and generating returns. A second facet of this consideration is that benchmark returns are often based on net fund level data and as such one must be careful to make sure comparisons are fair. It is important to be aware that when benchmarking funds that do not use lines of credit, or if the line of credit has been stripped out, one may not be comparing apples to apples. Definitions of vintage year can also vary between funds and benchmark providers and the use of lines of credit can change the vintage year of funds if it is based on the date of the first capital call.
  • Linked to the previous issue, higher IRRs in funds can cause General Partners to earn carried interest earlier than they perhaps would have if they had not used lines of credit. The hurdle rate, over which General Partners receive carry, is usually based on the net fund level IRR. One way in which this can be mitigated is to implement a hurdle that is measured against a combination of net fund level IRR and multiple. This type of hurdle condition is not common and investors should therefore also look for strong Claw back clauses (linked to the earning of carried interest) to further protect themselves. If a fund is exceeding its hurdle by more than a small margin, the amount paid out as carry will not be impacted; the first payments will simply be accelerated.   
  • Lines of credit are generally secured on the future capital contributions of Limited Partners meaning that the lender of the credit facility is concerned with the credit quality of Limited Partners. As such, limited partnership agreements may include clauses giving the lender the right to block transfers of interests in the fund (or secondary sales) which may reduce liquidity for Limited Partners.
  • Since General Partners are pushing back and grouping capital calls, the proportion of original commitment called at any one time can be larger than has historically been the case. If multiple General Partners behave in the same way, an investor may have a substantial liability that could be called at a single point in time. This will factor into the liquidity management for some investors.
  • For investors that are subject to U.S. tax legislation, the generation of both Unrelated Business Taxable Income (UBTI) and Effectively Collected Income (ECI) can be increased dramatically by the use of lines of credit. This can subsequently cause an increased administrative burden, particularly for tax sensitive/exempt investors. As such, investors that are UBTI/ECI sensitive should place extra emphasis on analyzing how much future income may be generated in this manner.
The traditional use of lines of credit made sense and was reasonable. As the use of lines of credit has become more prevalent, helped in part by the current low interest rate environment, investors should be aware of the possible implications for portfolios and their administration.

Tom Wyss is a Senior Consultant on Aon Hewitt’s private equity team in Chicago.

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