Lending 101: When the Loan Sponsor is a PE Fund

In the capital market world, it is very common to see financing provided to PE funds for M&A and other purposes. Depending on the situation, these financings can be provided at three different levels: 1) Directly to the fund (usually by way of capital call or general corporate purpose loan); 2) to a Holdco created to house the debt for a specific purpose, or 3) directly to one of those investees of the PE fund, the Opco. We will focus on Scenario 2 today.

If PE Fund ABC wishes to acquire some equity interests of a Targetco, they then create a holding company, Finco, to hold the shares of Targetco. Financings will then be provided to Finco for the share purchase. The typical security package of Finco would be equity interest of the Targetco as collateral and potentially a credit enhancement with a parental guarantee from Fund ABC.

In such senario, other than evaluating the quality of the collateral (e.g. does it provide sufficient coverage to the debt amount; is there market for such equity interests and how liquid it is etc), we need to ask how good Fund ABC's guarantee is? Can we assess it like how we assess other corporations, i.e. evaluating the Fund's profitability/leverage/liquidity? The answer is: It depends. We need to first look at what life stage is this fund at. Whether the fund is at an early or matured stage will result in a different assessment.

For an early stage fund with significant unfunded capital commitments and low internal rate of return (i.e. generating insignificant dividend income), our guarantee lies with the size of the uncalled capital. These are capital commitments that are pledged by the fund investors, ready to be called anytime to be utilized by the fund. The larger the unfunded capital, the lower the amount of the existing debt at the Fund level, and the stronger the guarantee. At the same time, we want to ensure that the fund does not guarantee a ton of debt elsewhere (this is usually indicated in their audited financials).

For a matured stage fund, we can look at it like a regular corporate credit. By this time, it should be generating predictable recurring returns that can be relied upon for debt servicing and repayment. Combined with the low leverage that they would need to maintain and a strong liquidity/Net Asset Value, the guarantee will be a credible one.

Of course, we also need to account for the Fund's past track record, investment style (prudent vs aggressive), investment experience and horizon, asset diversity and quality, and other factors to make a much more wholesome assessment for a PE sponsored financing.

One last point to note is that, when repayment is based on the guarantor, instead of the borrower, we need to view the guarantor and the borrower as the same borrowing group. This means that the guarantors ideally will need to be subject to the same restrictions we place on the borrowers (e.g. limitation on debt, restriction on change of control, limitation on asset sales etc).