We’ve received a lot of feedback on capital-call loans over the past few weeks so I wanted to use this column to publicize your views. Keep ’em coming!
Anonymous: Capital-call loans are misunderstood. Capital-call loans are the single largest wholesale transfer of value from GPs to commercial banks in the history of PE. Even the average GP does not comprehend that while the loans increase IRR and MOIC, the cost of the loan also directly reduces the GP carry. Capital-call loans are a testimony by GPs that the [funds] using the loans are likely not able to generate any carry whatsoever, so it’s a meaningless sacrifice to try and maintain their existence with better performance generated by no unique quality to generate profits or enhance performance of their portfolio companies. That fact combined with the “break” in the alignment of interests (see no carry comment above) is why all LPs should vehemently oppose capital-call loans. Currently many LPs and GPs don’t understand the product or its ramifications, so it will continue to be popular … just like the accelerated monitoring fees some sponsors charged for several years.
James: Overall, I see this product as one which creates efficiency for GPs and LPs at a low cost and improves IRRs. They also serve to reduce management fees on called capital which LPs should favor and which offsets some of the interest cost. It reduces costs around the sometimes inefficient capital-call process and reduces excess cash sitting around uninvested at the GP level. Finally, I do agree that the product benefits the GP without, perhaps, a symmetric benefit to the LP in all cases.
Greg: I think the issue tends to be why are the GPs using them? Efficiency for a few months is fine but otherwise they are decreasing the multiple due to the interest cost at a time when many investors are paying interest on their cash. There are better ways for GPs to reduce the J-curve such as fees on invested capital and reduced fees. Many GPs are using these lines just to window-dress returns, and it is becoming a race to see who can have the most flexibility from the lenders and LPs. They also reduce the effective preferred return by inflating the IRRs early in the life of a fund.
The most supportive of these lines are LPs that are judged mainly on IRR even when this costs their investors return. Many LPs could borrow at lower rates than the GPs to fund their capital calls if that was truly an issue. This is mainly about sprucing up returns. Additionally, most GPs do not report their “unlevered” returns, which make it difficult for LPs to compare GPs on a performance basis. These lines are also increasing the leverage in the system as many of these lines are callable by the banks and could end up with very large capital calls in a short period in a downside scenario for investors that could be cash strapped (which we witnessed with endowments and others during the GFC). Finally, imagine if a GP has a write-down to zero within a year and has to call capital for a wipeout. GPs and certain LPs believe this is a free lunch, but is mainly only for the banks and GPs.
Private Equity Editor Chris Witkowsky reflects at home. Photo by Wendy Witkowsky