If you’re currently working for a Venture or Private equity firm, you know that the primary goal of your firm is (or should be) crystal clear – To earn an outsized return for your Limited Partners (and as a byproduct of that, earn yourself a lot of $$$ through management fee stacks and carry!!!).
Savvy investing, portfolio management, and a
dash great deal of luck will all contribute to the success of a fund. Additionally, many financial and administrative tools play a big role in how effective and efficient a firm is. One of these tools is debt financing at the fund level.
Over the past few years, I’ve had dozens of conversations with Venture Capital and Private Equity CFO’s related to borrowing at the fund level to support operations. While the basic premise of fund borrowing isn’t novel by any means, there are number of things to consider and understand before entering into a borrowing arrangement for your fund(s).
First off, here are the general reasons for signing up for a fund line of credit.
1) Making time sensitive investments: For most CFO’s, the following drill probably sounds familiar – It’s Thursday afternoon, and you get a call that an investment opportunity has surfaced and needs to be funded by Monday. What do you do? You can call capital, but most fund agreements allow LP’s 10 days to contribute capital after a call is made. A fund that is composed of mostly larger institutional LP’s might be in ok shape, but most funds have a LP base that’s comprised of Institutional investors, Family Offices, and High Net Worth individuals. In these situations, Fund lines serve as an administrative tool to bridge between the investment and the capital call coming in.
2) Managing the frequency/size of Capital Calls: From my personal experience as someone who has made small LP allocations into Venture, most LP’s hate (hate,hate,hate) fund managers that manage capital calls ineffectively. I once worked with a firm (who will remain anonymous) that ended up calling capital 26 times in a single year! Capital call lines allow managers to aggregate investments to decrease the frequency of calls. Most Capital Call lines have 90-180 day repayment terms, allowing managers to call capital just a few times a year if preferred.
3) IRR enhancer: As the IRR clock starts once capital is called, the ability to use leverage to defer calls creates for a small bump in IRR . Candidly, I don’t believe this strategy really is that compelling and in almost all cases, shouldn’t be the primary reason for taking on debt at the fund level. Once you net out interest expense, the IRR bump is fairly marginal and doesn’t address for what’s most important for LP’s; Money coming back being a multiple for money in.
The only exceptions are if the leverage is longer term in nature (i.e. over 180 days, which most VC funds cannot take on – more on that later) or in the case of PE funds, if the fund leverage is to backstop debt to a portfolio company and is in place for >12months. While not a core product, many banks are starting to provide “IRR enhancement” lines – Primarily to PE firms, these lines allow funds to reduce the amount of equity infused into an investment by increasing the amount of debt at the company. The debt is structured to be lent to the fund directly (and then funneled to the company), or to the portfolio company directly while the fund acting as a guarantor (where the portfolio company takes on the interest expense). These loans are usually paid back within 1-4 years, through 1) an exit of the portfolio company, 2) take-out financing by another financial institution to the company directly secured only by company assets, or 3) by calling capital. This application of fund debt can be very compelling if available and allowed by your fund documents.
Okay, those are some of the typical application of how Fund debt is utilized. Now what are the issues to consider before signing up for fund debt?
- Fund restrictions: Most fund agreements are explicit on allowances for fund borrowings. Most agreements I’ve seen allow for short-term borrowings, but typically contain restrictions (duration of how many days each debt draw can be outstanding, borrowing as % of the fund, etc.).
- Tax implications: For tax-exempt LP’s, there’s a four letter term, and its called UBTI. UBTI, or Unrelated Business Taxable Income can result from borrowing at the fund level to acquire company securities. The good news its that nearly all tax advisors agree that if borrowings are paid back within 30-60 days, there is very little risk that the borrowings under a line would result in a taxable event for LP’s. Always best to reference the fund agreement and/or your tax advisor.
- Regulatory implications: While Private Equity funds are now registered through the SEC, many Venture Funds have escaped having to register through the SEC VC exemption clause (don’t get me started on this as I think it’s a little silly that VC funds have to register at all..systematic risk? Riiiiiight). One of the tests of the VC exemption has to do with fund borrowing, which requires that:
“The fund does not borrow or otherwise incur indebtedness (including guarantees) in excess of 15% of the fund’s aggregate capital commitments, and any such borrowing or indebtedness has a non-renewable term of no longer than 120 days.”
If your fund wasn’t required to register because of the VC exemption, be aware that taking out a line can impact it if the line size/borrowing patters fall outside of the above.
- Terms: Fortunately, standard Capital Call lines are fairly inexpensive, with interest rates typically a small spread over prime (Prime is currently 3.25%), with nominal fees (usually about 20-25bps of commitment per year in the form of an upfront fee or unused fee). IRR enhancement loans, as described above, are often a bit more expensive given the duration risk lenders take. Collateral for these funds usually includes a secured right in the right to call capital on behalf of the GP during a default that has occurred and continuing (through my experience, I’ve never actually seen this exercised), but doesn’t usually include portfolio securities.
Fund debt is pervasive in today’s market (over $30B in commitments to funds are in place today) as it’s an easy thing to secure and can play an important role in fund management. It’s pretty straightforward, but I’m always happy to answer any specific questions. Just email me at firstname.lastname@example.org. Good luck!