October 31, 2013
Interviewed by: David Snow
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Capital Commitment Financing: How it Works

Three experts describe how capital-commitment financing can help make the operation of a private fund more efficient by allowing GPs to draw on a line of finance in lieu of a capital call.

Three experts describe how capital-commitment financing can help make the operation of a private fund more efficient by allowing GPs to draw on a line of finance in lieu of a capital call.

Capital Commitment Financing: How it Works

With Experts From Haynes and Boone, SMBC and Century Bridge

David Snow, Privcap: We are joined today by Jeff Tucker of Century Bridge Capital, David Wasserman of Sumitomo Mitsui Banking Corporation (SMBC), and Albert Tan of Haynes and Boone. Gentlemen, welcome to the program. Thanks for being here.

We’re talking about something that you are all deeply involved in, but from different angles, so it’s very interesting. It’s a subscription line of finance, the ability to drawn down capital for a transaction from a fund prior to actually officially issuing a capital call. The first question can be for Albert, since you are heavily involved in helping clients with this facility. What is a subscription line of finance?

Albert Tan, Haynes and Boone: It is subscription financing or capital-commitment financing is a form of bridge financing, effectively for private equity funds. It is widely used particularly for real-estate private equity funds. Effectively, it’s for the investment and business needs of the fund. They can use this particular financing as in-term financing in lieu of calling capital from their investors during the life of the investment period of the fund.

Snow: David, what is the market for this facility?  How big is it, how often is it used, what kinds of groups use it?

David Wasserman, SMBC: As Albert mentioned, it’s typically used in the investment period, o it’s very tied into the funds that are currently in the market and the current fundraising environment. It’s hard to put an exact number on it because there are a lot of different structures and hyper type of vehicles, but we estimate it a bit over $100 billion in total size. The market right now is very liquid. There are a lot of banks that definitely hunkered down and exited the product, coming out of the economic crisis. We’re seeing them come back, especially the money center banks, a lot of Asian banks. European banks are also starting to make move toward it.

Snow: Jeff, your firm, Century Bridge Capital, is a Beijing-based investor in Chinese residential properties and you’re also a user of the subscription line of finance. How has this facility has been useful to your first and its investment program?

Jeff Tucker, Century Bridge: This facility, it’s not a nice feature to have. For us, it’s a necessity. We have limited partners all over the world and we’re closing investments in China, which usually means when we issue a capital call, there’s a 10-business day period for everybody to fund their capital call. Then, we have to go through an additional step: money generally comes into Hong Kong or Singapore before it’s converted into Chinese RMD.

So, you add a few days onto that process and you’re looking at well over two weeks. We had a project we were closing upon recently where the joint venture documents and contracts were signed about four days before a government-imposed deadline when the capital had to enter China. There was no way under that scenario that we could fund the capital on time by issuing a capital call to our investors. So, we used our subscription line and funded it in two days. It was very efficient and they issued the capital call to our investors. As I said, it’s a necessary tool for a fund like ours.

Snow: David and Albert, does this sound like a typical use of this kind of facility?

Wasserman: Absolutely.  We’re delighted we actually provide Jeff a subscription line and we were able to assist him during his investment process. We find that it’s used for both timing of investments, so you can execute on a bid or on an improvement that needs to be done right away. You also see it for the positive carry effect. Typically, a private equity fund will have a hurdle rate of eight to ten percent that is promising to its investors.

By using our facility, which is priced at a much slower discount than the [prefer of return?], they are able to use effective leverage to enhance the returns of the fund during the investment period.

Tan: The fact that Jeff in Central Bridge is sitting with us today means that this is really a global product.  This financing is for not only private equity funds here in the United States but also for private equity funds based in Asia and Europe. The product has migrated down to Latin America as well. It’s a global product that has really evolved over the last 25 years, so it’s a very dynamic market with many more lenders coming into the market in addition to the usual big players.

Wasserman: You bring up a good point: this product originated when it was originally for real assets, real estate being the most prevalent one, migrated over to infrastructure and other real asset-type funds. We’ve seen a transition during the last seven years, and especially during the last three to five, on traditional private equity funds, secondary firms, debt funds. Even CLO managers during their early fundraise using these type of facilities.

Tan: To follow up on the uses of a subscription financing: in addition, for the person of the investments, one of the most beneficial effects is the fund is able to use it for all the business needs of the fund. Payment of fees, of expenses, of defaulting investors that fail to fund on time—the subscription financing can be used to bridge that. It can be used to pay other borrowings the fund may have or for the subsidiaries.

So, there’s multiple use along, consistent with the business purpose of the fund and it is consistent with what the investors of a private equity fund allow the fund to use. The interest, generally, is aligned with the intended purpose of how the investor wants the fund to use capital contributions.  Because this product is viewed as a bridge financing so the fund can use this financing in lieu of calling capital.  So, the intent and purpose is whatever the capital contribution can be used for. This financing can be used in lieu of funding a capital contribution.

Snow: How would a fund manager get started? They need to have committed capital from their investors. How hard is it for them to get up and running with a capital facility?

Tan: The earlier a fund considers the financing in the initial drafting stages of the formation of the fund, the better off the fund positions itself because then the allotted, the lender’s requirement and provision that a fund will need in a fund document can be embedded or drafted in. And, the provisions are generally fairly standard in the sense that large institutional investors, particularly in the real-estate space, are aware of what provisions a lender like SMBC would look for in order to structure a facility of this type. So, at the inception stages in the fundraising and the formation of the drafting of the documents, the offering circular, to include a concept that this financing will be contemplated and that the investors should be made aware that this is something the fund may or will utilize in the course of its investment process.

Wasserman: It’s the same concept as any other debt facility that’s been put in place: communication between the lender and borrower, understanding the needs of the borrower and what the lender needs to be comfortable providing the credit. We’ve been lucky that, with our clients, we have an early stage conversation, as Albert mentioned. With the growth of the product, we’ve also seen opposing council—not only lenders’ but borrowers’ council— become very educated on the product.

As lenders, I don’t necessarily have to ask for these provisions to be kept in the limited partnership agreement anymore. They’re automatically defaulting in there because borrowers’ and lenders’ council become more educated on the process.

Snow: Why do you think this facility has been adopted early by the real assets and real-estate world but hasn’t penetrated the private equity/venture capital world as much as the other asset class?

Tan: My personal theory is that this product started about 25 years ago within the real estate space. As the product evolved over time, it’s become second nature for real-estate operating and real-estate funds. In a real-estate fund without this particular product, you’re effectively competing at a disadvantage with other real-estate funds and it’s always becoming second nature that you need this.  It’s the reason that it may not have transferred to a pure buyout fund or other types of funds, though we have seen it, for example, in infrastructure funds, buyout funds, energy funds and maritime funds. It’s slowly migrating toward other product types.

Snow: David, in your observation of the market, why do you think the subscription line of finance started with real estate and has very gradually moved to other asset classes?

Wasserman: It’s very operational in nature—that’s the explanation. Real-estate funds have requirements that they need to finance construction projects, leasing commissions, tenant improvements, a lot of smaller capital calls that they would typically need. Instead of making these capital calls once per month or once every two months for a de minimis amount, at least from each investor’s perspective, it’s easier to aggregate these requirements of the fund and have one much larger capital call once per quarter or once every six months. That’s transferred over to some real assets a lot quicker than the financial assets.

Snow: Quick question for anyone; maybe Albert. You mentioned the globalization of the usage of this subscription finance facility. Where does currency come into play? How does that make this possibly a more complex undertaking?

Tan: Imagine if you’re working with a large private-equity fund with operations around the world, their currency needs—the more flexibility they have, the better off the financing is for them.  So, it’s always important to match up the underlying currency of the commitment to the underlying currency of the financing.  Generally, you draft provisions to deal with the convertibility issues and it’s fairly straightforward and common to have these alternative currency provisions. That’s generally built in.

Snow: Yeah, and as you work with your firm, Jeff being based in China and operating in…

Tucker: We’re fortunately a U.S. dollar-denominated fund, so our subscription facility is obviously in dollars, as well.  Our currency gets converted in the deal process as we transfer money from usually an offshore Hong Kong entity into mainland China.  So, it occurs after our subscription facility has been called upon if we use it.

Wasserman: The subscription line is, at the end of the day, you are bridging the equity.  So, it’s very important to remember that you need to pay back that subscription line based on the equity you’re going to call. It’s definitely a convenience to be able to convert into a currency that’s readily available.  And firms definitely use that, but when you start using it as your true hedging vehicle, there’s a bit of a mismatch.  Most firms have gotten wise enough to understand that it’s great in the short term to use an alternative currency and use it as a vehicle.  But, in the longer term, you don’t want to hedge your equity through the subscription line.  You’re going to get a standalone effects line if you believe you have currency exposures that you want to hedge against.

 

Expert QA with Albert Tan of Haynes and Boone

How did Haynes and Boone develop a specialty in capital-commitment financing for private funds?

Tan: As one of the first law firms to help structure this particular type of financing, we have had the largest dedicated practice group in fulltime, in structuring and in representing lenders, as well as private equity funds in this particular space.

Over the course of 25 years, we have seen the product evolve from simple financing for one U.S.-based real estate private equity fund at the industry’s inception, to a product and industry that is continuously growing and in money raised in billions of dollars per fund.

We’re able to bring that knowledge in working with the different funds and different law firms over the years that represent the funds as well as the investors.  We have a database of thousands of investors’ names, for analyzing their credit and linkage to the ultimate credit source. Also, we have a database full of precedent documents related to working with the funds and with the investors.

So, that knowledge base provides the advantage in executing transactions efficiently and effectively, to satisfy the interests of all the investors and the fund, as well as the lenders.

 

 

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