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Editor’s Letter: LPs have mixed emotions about use of popular capital-call loans

As we kick off 2017, I’ve been asking sources what themes they see emerging in the private equity industry.

One of the big themes I keep hearing about is the use of capital-call facilities. Everyone I talk with says that as long as interest rates remain low, GPs will continue to use these loans to fund their equity stakes in deals before calling down the capital from their limited partners.

Interesting divisions of opinion emerged when it comes to these loans: Capital-call facilities engender mixed emotions from LPs, from those who say they are used to artificially boost IRRs and help GPs meet their hurdle rates, to others who say they are a creative way for managers to use LP capital.

Capital-call loans have the effect of boosting IRRs because LP capital is drawn down right away. An analysis of 149 funds of vintages 2003 to 2006 showed a median uplift of 58 basis points on fund IRRs when funds used capital-call loans of as long as a year from the first capital call, my colleague David Toll reported last year, citing a study from Oliver Gottschalg, an associate professor at HEC Paris.

Facilities can stay in place for six months to a year, Toll reported last year. One LP told me she worries about capital-call facilities when they are in place for a year or longer.

“There’s a limit to how long you can bridge financing; there’s also some risk during that period before capital has been called,” the LP said. “I’m not in favor of very long bridge-financing periods. They’re perfectly fine when used in the short term, say three, four or five months.”

A second LP said, however, he has no problem with GPs making use of such loans.

“Isn’t a higher return a good thing? And shouldn’t we be encouraging GPs to be increasingly creative and efficient with the use of LP capital?” asked this second LP.

“This is simply a short-term liquidity strategy that has become popular due to the incredibly low interest-rate environment we’ve seen over the past several years,” the second LP said. “I can promise you that as soon as the cost of this type of capital increases, you won’t see a lot of firms employing this tactic. In the meantime, though, what’s the harm?”

This upward trend is unlikely to change at least until rates begin to rise. About 78 percent of global GP respondents to a recent Investec survey said they use or would consider using a capital-call facility.

“Private equity firms increasingly require innovative and purpose-driven facilities to support the fund’s operating costs and the growth of its portfolio companies,” Simon Hamilton, global head of Investec Fund Finance, said in a statement.

“In addition to this, with a high level of dry powder in the market, and GPs chasing fewer deals, funds will need to ensure that they have the upmost flexibility during a competitive process, and that for every euro, dollar or pound drawn down, they are going to get an appropriate equity return for that money.”

Private Equity Editor Chris Witkowsky reflects at home. Photo by Wendy Witkowsky