The Use of Revolving Credit Facilities by Private Equity Funds
You may or may not have heard of credit facilities before, but asset managers widely use these financial structures to fund their everyday investments. In discussing credit facilities, we’ll touch upon how credit facilities are structured, why asset managers use them over other instruments, and the pros and cons of using credit facilities.
As defined by Cornell’s Legal Information Institute, credit facilities are a “type of pre-approved loan which allows companies and institutions to borrow money on an ongoing basis over an extended period, rather than applying for a new loan each time more money is needed. The borrower can access up to a certain amount and can borrow when they need funds, much like how an individual uses a consumer line of credit.”
While there are various types of credit facilities available, we’ll focus our discussion on revolving, or drawdown, facilities, as this type of structure is most widely used by asset managers.
Revolving/Drawdown Credit Facility: a form of a committed credit facility where the borrower has access to the funds on an ongoing basis if regular payments are made to repay the balance. The borrower will draw on their facility and continue to "revolve" their debt as their debt obligation is repaid. These are called "revolving" because of the cyclical nature of the agreement.
- The borrower’s loan repayment, less the interest, and fees, pays down the outstanding balance and frees up the available funds.
- In many times, the interest is variable, as it is based on a floating rate structure
- Revolving credit facilities often, but not always, have an end date and can last so long as the borrower maintains good credit.
- Revolvers can be either unsecured, or secured by the assets that the borrower uses the proceeds to acquire
When looking at credit facilities, the facility provides the borrower with more control over their debt, such as the amount needed, time to repayment, and applicable uses for the funds. Albeit, these structures do carry risk parameters, such as debt covenants and higher fees.
As explained above, asset managers use revolving credit facilities for their operations. So how do these credit facilities fit into capital calls? Alternative investment managers, such as those with closed-end private market funds or private equity funds, use revolving credit facilities to fund investments before calling capital. If you’re looking for an explanation of capital calls, you can refer to our piece, How do Capital Calls work?
To explain further, let’s use an example. Fund Manager A has a new private equity fund, Fund I, in the process of raising money. As the fund is raising capital, the Fund Manager finds investments that they would like to include in the fund. However, the issue is that Fund I is still gathering investors and won’t be able to issue a capital call to obtain the money needed for the investment. Rather than wait for the fund to get investors, Fund Manager A can draw on a credit facility to invest.
In this case, the credit facility is typically already in place before the fund manager raises capital. Without a credit facility, the fund manager would need to wait for investors to be closed into the fund, issue a capital call, and then wait for the proceeds to be received by the fund. That entire process can take weeks, if not months! In that time, the investment opportunity may have passed.
With a credit facility, a fund manager can act swiftly to make timely investments, relying on the available balance of the agreement vs. outside investors. However, once investors are closed into a fund, the fund manager will issue a capital call and use the investor’s proceeds to pay down the balance on the credit facility as well as subsequent interest accrued.
The credit facility replaces the need for the investor to be the sole source of capital for an investment, which provides the manager flexibility to transact quickly while also alleviating the burden on investors to provide capital on a deal-by-deal basis. Instead, with a credit facility, the fund manager can draw on their available basis and issue capital calls in a scheduled manner to pay down the balance.
Without a credit facility, the fund manager will need to rely on investors for capital to invest, likely requiring more frequent capital calls from investors on a deal-by-deal basis or carrying large cash balances to have deployable cash. Neither option is ideal for investors, as the regular capital calls can be operationally demanding to complete. Those large cash balances create a "cash drag" on the portfolio, resulting in diminishing returns.
What are some of the risks with Credit Facilities?
One of the critical nuances of credit facilities is its potential impact on the fund’s return, both from a fee and timing perspective.
As the old saying goes, "there's no free lunch", and while credit facilities are a helpful instrument for fund managers and clients, there are fees associated with using them. These added fees reduce the fund’s returns. However, one could look at these fees as the trade-off between having a cash drag on the portfolio, the opportunity cost of missing a deal, and the operational intensiveness of frequent capital calls.
Regarding timing, the credit facility allows the fund manager to complete deals before investor capital is called, which impacts how performance is reported, specifically the internal rate of return, IRR. IRR is a performance metric that determines how much the investor has put into the fund, the length of time elapsed, and the present value of the investment. For a more detailed breakdown of IRR, check out our piece, MOIC vs. IRR.
Since the credit facility allows for the manager to fund deals before the capital is called, the credit facility can affect the IRR as the credit facilities delay capital calls, shortening the subscriber’s holding period in the fund. BlackRock quantified the impact of credit facilities on performance metrics. For the funds that employ a credit facility, their IRR on average is +0.5%, and MOIC is -0.02x. The loan terms dictated the difference in performance, which in some cases resulted in up to 2% better performance for those that use a credit facility.
Impact on Investor Cash Flows
For illustrative purposes only. Source: BlackRock, Burgiss Private iQ. The chart above contrasts the cumulative net Limited Partner (LP) cash flows for a simulated fund with (orange) and without (yellow) the use of a subscription line during the investment period of five years. Data set includes over six thousand buyout deals with initial investment dates ranging from 1994 to 2013. More than 95% of the deals are fully realized and each deal has a capital investment of at least five million, denominated in either USD (55%), EUR (39%) or GBP (6%). All included deals were held for at least nine months and the most recent cash flow was registered at July 31 2017.The results discussed here are at the end of the fund and that the impact on performance during the life of the fund, especially during the investment period and while raising the next fund, might be substantially higher. Maturity and size of the loan were six months and 25%, respectively.
Modest Impact on IRR
For illustrative purposes only. Source: BlackRock, Burgiss Private iQ. The table above summarizes the differences in performance between simulations with and without subscription lines. As an example, the average change in IRR is +0.5%, which signifies that the mean performance with and without subscription lines are 16.4% and 15.9%, respectively. Please note this does not mean that a fund with an IRR of 15.9% gets an increase in IRR of +0.5% by using a subscription line as the relation between IRR and delta IRR is not linear but convex. Duration represents Macaulay duration. Data set includes over 6,000 buyout deals with initial investment dates ranging from 1994 to 2013. More than 95% of the deals are fully realized and each deal has a capital investment of at least five million, denominated in either USD (55%), EUR (39%) or GBP (6%). All included deals were held for at least nine months and the most recent cash flow was registered at July 31 2017. The results discussed here are at the end of the fund and that the impact on performance during the life of the fund, especially during the investment period and while raising the next fund, might be substantially higher. Maturity and size of the loan were six months and 25%, respectively. The figures shown relate to simulated past performance. Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy.
In addition to potential performance differences in using a credit facility for capital calls, the credit facility also carries counterparty risk. When using a credit facility, the manager is using the credit in order to make an investment with the intent that the subscribers in the fund will meet their capital call obligations in the future. If a subscriber defaults on their obligation, the manager is now liable for the remaining payment. Defaults are rare but do occasionally happen. In these instances, the consequences are serious and usually lead to legal ramifications.
Conclusion: Overview of Credit Facilities
To summarize, credit facilities are credit instruments that are regularly used by businesses to fund various operational needs. The different types of credit facilities provide businesses the flexibility to engage in an agreement based on their obligations, whether long-term or short-term, covenant-imposed or not. In the case of alternative asset managers with draw-down vehicles, credit facilities are particularly useful in helping managers source new investments before capital is called from investors. The credit facility benefits both the manager and investor by allowing the manager to make timely investments while lessening the operational intensiveness of the capital calls for the investors. In this use case, the trade-offs for using credit facilities are the fees associated with the instruments and the potential for performance manipulation. As with all investments, investors must weigh the risks and rewards before investing.