Coronavirus & capital calls: Time to draw?

Private equity firms are hoping for the best but preparing for the worst. This means moving fast to secure liquidity, including at the fund level. For LPs trying to stay abreast of what the unfolding coronavirus crisis means for their own exposure, information and oversight are invaluable. Fund documentation drawn up during the sponsor-friendly environment of recent years will be probed for weaknesses by both sides.

"There are likely LPAs [limited partnership agreements] that have become inherently GP friendly and there are probably some clauses that have been overlooked by LPs that could lead to some exotic ways of trying to deal with liquidity problems," says Eric Marchand, a principal and head of Asia Pacific private equity at Unigestion.

A lot of behavior is inherently defensive. Several industry participants claim to have seen an increase in drawdown notices issued by GPs to LPs – not so much in genuine expectation of widespread fund defaults by LPs, but because they must address the possibility that it might happen and they don't want to be last in the queue calling for capital. Similarly, in the interests of prudence, managers are looking into LPA stipulations about putting more money into portfolio companies.

"Given the high level of uncertainty, most GPs are not yet at the stage of pumping more capital into or actively restructuring portfolio companies because they are still trying to gauge exactly what the impact will be for their portfolio and how long that impact will last," says Justin Dolling, a funds partner at Kirkland & Ellis in Hong Kong.

Provided a capital call notice complies with the rules, LPs can do little to stop it, but they can ask questions. And by multiple accounts, they are. One investor relations executive with an Asia-focused manager notes that the flood of inquiries started three weeks ago. Simple requests for capital call forecasts were followed by more detailed questions asking how the capital would be used – new investments, injections into existing portfolio companies, debt repayments, fees or expenses. After that, LPs asked how much of the GP's subscription credit line was outstanding and when it was due.

Credit questions

Subscription lines, or capital call facilities, which are taken out against undrawn capital commitments from LPs, have attracted a lot of attention given their proliferation in recent years. Some sources also point to increases in the level of permitted indebtedness beyond the standard 20-25% of fund size and a lengthening in clean-down periods – anything from three to 12 months – during which individual loans taken out under the facility must be repaid.

A manager with a $2 billion subscription line that is 75% drawn could theoretically call $1.5 billion to pay it off in one go. LPs fear receiving the same notice from a dozen GPs – on top of whatever other calls are made by GPs looking to rescue troubled portfolio companies – at a time when they might be overallocated to private markets due to a collapse in public equities and being starved of distributions.

One school of thought has managers calling capital to pay off credit lines due to concerns that some LPs might face liquidity issues or that banks will refuse to renew facilities. Others give this short shift.

"We continue to see new funds entering into subscription lines and we see a steady flow of requests to extend or increase borrowing facilitates at the fund level. There are often extension options in existing facility agreements," says Paul Aherne, a partner in the finance and corporate group at Walkers Global. "Banks will be careful in their due diligence and look at how the existing facility has been used, but they will want to help where they can. It's very much a relationship-driven industry."

Another potential scenario involves the partial paying down of credit lines in the interests of operational flexibility. GPs are afforded a relatively wide scope as to how they use these facilities: they are revolving credit for working capital purposes, whether that is making investments or covering partnership expenses. They allow managers to aggregate a series of costs into larger tranches that are less frequently called. Credit lines also enable speed of execution, taking two business days to close compared to 10 for a capital call. This is a valuable tool in a crisis.

"To give an example of sensible actions to support liquidity, if you have a credit line of $100 million and you have drawn the full amount, it would be prudent to call some capital from the LPs to repay down to, say, $50 million outstanding so that you have capacity to borrow more in the future," says Thomas Smith, a partner in the finance group at Debevoise & Plimpton. Several advisors add that they have been counseling GPs to avoid fully drawing credit lines, so they have liquidity at hand.

Waived through

There have been situations in Asia where managers have turned to unorthodox financial engineering solutions and executed them without informing LPs. For instance, one GP took advantage of an LPA that wasn't airtight and borrowed money at the fund level to support a struggling portfolio company. The loan was secured against distributions from other portfolio companies and these were held in escrow until it was repaid. This tends to happen with younger, less institutional managers.

Much the same applies to capital calls, with one fund-of-funds LP noting that substandard processes emerge in Fund I but sometimes aren't uncovered until due diligence on later vehicles. In the interim, a GP might be able to call capital without offering much detail as to its use. "They usually do give some explanation, but the level of explanation can range from a mere sentence explaining that it's for an investment or management fees to a full investment note," the LP says.

On a broad level, when a GP wants to put more capital into an existing portfolio company, it may run into three limitations under the LPA. First, almost all funds have a single-asset exposure cap, usually set at 15-20% of the entire fund. A waiver from the LP advisory committee (LPAC) or by a majority vote among all LPs is required to exceed this threshold. However, there is sometimes a provision allowing for an additional 5% exposure – without running the LPAC gauntlet – for bridge financing.

"If a portfolio company has a liquidity issue but the sponsor thinks the need is short-term, most funds can do a bridge financing. The GP usually has to get out of that bridge within 12-18 months," says John Fadely, an investment funds partner at Gibson Dunn. "In normal times, a bridge financing is often used to buy time to put together a co-investment consortium or for short-term liquidity ahead of a fund investment, but in the current environment, bridges could be used more frequently to provide liquidity after the investment has been made."

Second, the right to make follow-on investments often expires two or three years after the end of the fund investment period. There might also be a cap on the aggregate amount – 15-20% of total capital commitments – that can be used for follow-ons. A waiver is required to exceed these limits.

Third, managers can expand the amount of dry powder they have at their disposal by recycling distributions from other investments, but subject to an overall limit. The assumption is that there will be distributions available to recall, which might not be the case for funds just two years into a 10-year cycle. Moreover, some LPAs only allow recycling within 12-18 months of the original distribution, while others require a GP to designate money recyclable on making that distribution.

Marchand of Unigestion observes that recycling is generally easier to push through than the other two options. He recalls a situation in which there was one investment that could really drive fund performance, but more equity was needed. The LPs approved an increase in single-asset exposure, but only after a protracted discussion over the legal wording. By comparison, an amendment enabling the manager to recycle capital – later in the fund life than normal – sailed through.

"The recycling issue was the more straightforward one. Your capital is coming out of the portfolio company, but hopefully you are reinvesting at a high IRR," Marchand notes.

The caveat is the GP wanted to recycle capital from exits that were imminent, not calling back money that had already been distributed to LPs. When pushing for a tweak to recycling provisions, this could be positioned as a planned reallocation of capital into an attractive business. It is very different – especially when there is liquidity pressure – from asking investors to recommit capital that they have already taken out.

Nevertheless, some managers are trying to make changes to LPAs to allow greater flexibility on capital calls and more are expected to follow suit. As one Asia-based GP puts it: "Investors will have to get a handle on the restructuring of limited partnerships – the life of vehicle, recycling provisions, investment periods, and follow-on investment periods. These were all set up under the standard structure, but when the world changes completely, some of these terms aren't in everyone's best interests. Managers will have to look at the framework they have in place for existing funds." 

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• Topics
• Fundraising
• GPs
• LPs
• Financing
• Advisory
• Asia
• covid-19
• coronavirus
• subscription credit lines
• professional services