The Impact of COVID-19 on Subscription Lines of Credit

New Environment

In early February, we attended the 10th annual Global Fund Finance Symposium in Miami, Florida. We witnessed the maturation of our industry before our very eyes with the evolutionary explosion of product offerings and growing confidence amongst participants. At the time, it seemed that this niche corner of the financing market would be forever up and to the right, regardless of macroeconomic conditions.

Boy were we na?ve! Fast forward to early April, and Miami feels like it was a year ago, maybe a decade. The uncertainty of today puts everything into perspective, and then some. Though it was always present, our concern for the health and safety of our families, friends, colleagues and clients has moved to the forefront of everything we do. We are ever grateful for healthcare workers, essential services providers and those working fervently on the response to this global crisis.

Given the market dislocation and the uncertainty around how and when we may see things normalize; we are closely monitoring how COVID-19 is impacting the private capital market. The insights below are based on conversations we are having with colleagues, clients and peers in our industry. We wanted to share with you what we are seeing in the event it might be helpful.

The Background

By our estimates, middle-market private equity funds in the US currently have access to about $300B in committed subscription facilities/capital call lines of credit. These facilities were originally devised as a short-term cash management tool and secured by the limited partner’s commitment to fund their capital calls when called for by the general partner.

Subscription lines are intended to simplify things for the fund and its limited partners; allowing the general partner to act quickly to fund investments without waiting the requisite 10 days for LPs to fund their capital calls. This delayed capital call, or bridge, was usually repaid within 90 days or so. But as private capital proliferated and business models evolved, so did subscription lines of credit.

As the industry has matured, this bridging “tool” serves other longer-term purposes; namely IRR enhancement and flattening the J curve of private equity. Repayment terms have trended higher, with 90 days stretched to 180 and 180 stretched to 365 or longer. In your typical subscription line with a tenure of three years, repayment is due at maturity with auto extensions built-in for at least one more year.

These fund lines of credit have also grown as a percentage of fund size—sometimes reaching 40-50% of a fund’s total size. With the longer-dated repayment terms and larger sizes, some facilities have come to resemble permanent fund-level leverage.

As the industry has evolved, lenders in this space have become accustomed to higher levels of usage and long periods in between capital calls. And to date, knock on wood, these facilities have consistently held up with an impeccable record of performance. 

The Current Environment

Funds with subscription line repayment dates approaching are considering how best to handle capital calls and what guidance to communicate to their LPs. Given the public market volatility and the unknown impact on private portfolio company valuations, there is a lot of planning to do across the GP and LP community.

Over the last couple of weeks, we’ve read industry articles indicating GPs might rush calling capital to pay down their fund credit facilities—whether out of an abundance of caution or at the nudging of the lender. We have also heard chatter that funds might draw down their credit lines without a defined need—just in case—and likely as an extra precaution. We recently read that a couple of LPs in Europe may have started to default on or have withdrawn commitments; the validity of which has yet to be confirmed and, facts and circumstances have not been substantiated.

From our perspective, we are not seeing any of these actions to a degree that rises to a discernable trend. Sure, there can always be outliers, but outliers do not make for a trend or actionable data. We believe these trends have largely not materialized because GPs and LPs are taking the time to be thoughtful and deliberate in their decision making.

The long tenure of a GPs’ partnership structure and their relationship with investors create pause and deliberation. Calling capital earlier than expected or needed and/or drawing lines for the sake of drawing them both seem like rash decisions—uncharacteristic of the private equity industry itself and the investment professionals in charge. There is also a significant difference between an LP defaulting on a contractual commitment versus an LP pressing the pause button before agreeing to make a new commitment to a new fund.

From the GPs we’ve talked to, their most immediate reaction to the turbulence was to stay close to their existing portfolio company management teams and assess the liquidity needs of those companies. Again, in our opinion, this has allowed GPs to get a grasp on their fund’s full picture before communicating and planning for the future with their LPs. This planning includes setting expectations with the LPs on how much and when their capital is expected to be called.

The concern is that if an LP had not previously reserved sufficient liquidity to meet their capital obligations to a fund, and they’ve now suffered a steep decline in their public portfolio, this may be a tough time for 10-day capital call notices.

Where some LPs would previously not have dreamed of defaulting on their commitments, as it would irreparably damage their reputation within the private investment community, the thought of what it may cost them (if required) to create the liquidity needed to answer their upcoming capital calls has certainly entered their minds. They will also be thinking about what their private portfolio will be worth when Q1 valuations come out sometime in May or later.

Thoughtful consideration and communication with LPs during this time is crucial. Even though it could be a difficult time for a capital call, delaying the call may actually be worse for GPs and LPs if the economic impacts are more prolonged than anticipated.

As lenders to funds, we’ve focused both on the contractual commitment for an LP to fund capital calls and on the economic incentive for them to do so. In the environment we’ve been in for the last 10-years, the economic incentive for investors to fund capital calls has not been tested. It is hard to find a private equity fund that isn’t valued at cost or higher. After Q1 numbers are distributed, we may see this assumption challenged.

Additionally, the trend toward a longer tenure for these facilities is proving to make the capital call planning exercise more challenging (or perhaps beneficial) for those facilities that have recently been originated. Repayment on those facilities, depending on where they are in their lifecycle, may not become due for some time—hopefully when public markets and portfolio company valuations have normalized.

For those facilities coming due now or within the next few months, the need for transparency with LPs regarding the timing and amount for upcoming capital calls is underscored. It is imperative that GPs provide LPs expectations for what the funds have outstanding and when repayment dates are coming due.

Instead of the customary 10-day notice, we are seeing funds alert LPs now about capital calls 30, 60 or 90 days out, and additionally laying out expectations for the next few quarters to put things into perspective.

Even so, it may be beneficial for funds whose LPs currently have little to none of their commitment called to date, or funds with subscription lines substantially drawn without a near term repayment requirement, to proactively schedule out smaller capital calls throughout the year in order to avoid calling between 20% to 40% in one shot as the subscription line comes due.

We’re All in This Together

The good news is that, while there are rumblings of unprecedented impact to the fund finance universe, we are not seeing this play out as of now. Banks are not overreacting, LPs are still meeting their capital calls and subscription lines are continuing to perform as expected. If history prevails, this niche sector of the financing markets will again withstand incredible market turbulence.

Across the board, the private equity professionals we have spoken with are heads-down, working with their portfolio companies to see their employees, customers and communities through this crisis. Everyone is giving their best to ensure their stakeholders are well served by their actions and compassion during this time.

Open communication between all parties will go a long way in shoring up the long-term health of relationships. Like many of you, we’re spending our work-from-home time mostly on the phone, Zoom, Skype and in our inbox with our team and our clients, keeping everyone (somewhat) sane and on the same page.

If you have not already done so, now is the time to reach out to your bank to give similar updates as those you are providing your LPs. If everyone is working with the same information, they tend to make the right call.

If we can be of counsel or provide any additional insights to you during this time, please do not hesitate to reach out. We can’t wait to see you again soon!