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Burning bridges

by Alice Murray 28 June 2018

Bridge financing has long been a feature of the asset class, and the perks are well known to GPs universally. While LPs are able to carefully plan capital calls, GPs are given the ability to act quickly on transactions and focus on creating value. However, the use of capital call lines is widely reported to skew the IRR performance of a private equity fund, and so the debate rages on: are bridge loans misleading the industry? While the private equity industry continues to mature, banks providing such facilities follow suit, hanging on the coat tails of fund managers. Their presence is set to continue, says Cambridge Associates. “In short, no – their use isn’t going away any time soon,” claims a report released by the consultancy firm. [caption id="attachment_4227" align="alignright" width="300"] The length of time bridge loans are being used for is growing.[/caption] IRR Boost Their traditional use was to ease the capital call process for both GPs and LPs, and were typically repaid within 30 days. This is still the case for many, but the life of these facilities has been dramatically extended by some players in recent years. This can affect IRRs, and in some cases cause funds to move up a quartile, says Cambridge Associates. The firm’s report claims that by using the facilities to make investments and repay the line six months later, they can boost a fund’s net IRR performance by an average of 200 basis points. Depending on the size of the facility, coupled with its terms, it could even boost returns by 300 basis points. Inflating fund performance is not the sole motivation for fund managers, argues Silicon Valley Bank’s Gavin Rees. “Inevitably, the delay in calling capital enhances the fund IRR. However, in our experience, this is not the prime motivation of putting in place capital call lines.” Rees puts their increased use down to the global nature of capital raising. “Increasingly funds raise commitments from investors globally, which makes the co-ordination of investor calls and the costs involved in wiring monies greater. The flexibility afforded by capital call lines means this working capital amount can be reduced benefiting investors and managers alike.” As the noise around fund financing becomes louder, a number of parties have taken a closer look at the situation. Last year, ILPA released a set of guidelines on the use of fund financing by private equity houses. Covering disclosures of usage, IRR calculations and best practices for the size and scope of credit lines, the rules suggest that “the use of lines of credit should accrue to the benefit of the LP.” Furthermore, the rules add that GPs and LPs must agree to “clearer thresholds”, while investors should be provided “greater transparency” related to their impact. “There is a push for greater transparency with the ILPA guidelines,” says Arnaud Garel, Caceis’ group head of business development. [su_quote cite="Arnaud Garel, Caceis"] There is a push for greater transparency with the ILPA guidelines"[/su_quote] Changing metrics Service providers, LPs, associations and academics have looked at ways to strip out the effect of bridge financing. Garel suggests that revealing the performance of the fund with and without the facility would allow LPs greater granularity. This is “theoretical” however, and could pose some challenges. “How do you measure the effect of a facility that has allowed a deal to happen which might not have happened had the fund not had the time to call its LPs? It’s not something you’re going to be able to measure, so obviously you can estimate a theoretical performance of the fund without a bridging line to compare it with the actual performance, but there’s always going to be an element of interpretation.” European private equity firm Dunedin’s finance director Graeme Murray explains LPs are not just asking for IRRs calculative on the date of the drawdown, but are now also asking for figures calculated on the date of the investment being made. To ensure this double calculation becomes best practice, “it can be written into the LPA that facilities may only be used for a specific time period," adds Murray. Fund analytics business PERACS, led by Oliver Gottschalg, suggests an entirely new approach. In a recent report, the company suggested funds should disclose all “bridged” and “non-bridged” cash flows to LPs, enabling all benchmark data providers to then create more accurate performance benchmarks. However, the report doubts managers and data providers will change current behaviours. To fix this, the company proposes using the PERACS rate of return, which calculates annualised returns as a “function” of the TVPI and investment duration. The insight found that by measuring performance through their model, “the magnitude of the average performance distortion” was found to be much lower.