By Boris Mihaylov and Konstantin Barakos
The world of private equity requires funds to react immediately to potential purchase opportunities. But what if an attractive opportunity arises during the draw down period and the funds required exceed the sum of collected commitments? Bridge loans (appropriately labeled yet also known as equity bridge facilities or subscription line facilities/credits) promise a viable solution to bridge the gap between the time money is needed and the time it is expected to be called.
By no means are these temporary funds a novelty. However, recent trends in private equity markets have rendered them imperative to consider as a means to increase flexibility and to improve performance. The current levels of dry powder and excess capital have never been higher, increasing pressure on private equity firms to source productive ventures. Consequently, competition within the private equity markets is swelling. Fears about an approaching recession reinforce the need to deploy capital as soon as possible.
The use of bridge loans increases
The use of bridge loans has become a ubiquitous praxis over the last few years. According to Prequin, more than 50% of private equity funds have used the tool in 2016, as compared to barely 10% in 2000 (see Figure 1). Since the Global Financial Crisis in 2007/08, the presence of bridge loans increased gradually. Meanwhile, this instrument has become a key ingredient in the investment processes of funds on the street. The New York based law firm Cadwalader estimates the market at around USD 500 billion with an increase of 20% in 2018. Bridge loans are used by funds of various sizes, from small- and mid-cap funds to large-cap funds such as KKR, Carlyle and Blackstone.
Figure 1: Percentage of Private Equity Funds Using Bridge Loans
Source: Prequin, June 2019
Why use bridge loans?
There are a few distinct reasons why bridge loans have experienced such a boost in popularity in the recent decade. The major benefit of using these instruments is that they are a convenient and quick source of capital and thus increase flexibility and liquidity. This has manifold implications: They could be used to fund time-sensitive investment opportunities or to fund investments in other currencies. Besides, they generally allow for the delay of capital calls (or for less frequent capital calls): on the one hand, private equity firms can fund short-term obligations with bridge loans and on the other hand, they are better aware of the exact amount of capital required. Calling capital less frequently reduces the administrative burden for both private equity funds and investors.
Another major but controversial benefit of using these instruments lies in the fact that they inflate returns because limited partners‘ equity is used for a shorter period of time. This increases the internal rate of return (IRR), the key concept of measuring performance in private equity. Fund managers use this metric to decide between various investment opportunities while investors use it as an investment criterion to compare different funds. Besides this, it is also used to determine the carried interest – the performance fee rewarding successful fund managers.
Since these loans are typically secured by LP investment, the European Securities and Market Authority does not consider them to contribute to the investment fund’s leverage ratio. This is another reason why private equity firms use bridge loans; they don’t technically increase debt burden because they don‘t increase the fund‘s capacity for investments.
How to issue bridge loans?
Let’s now take a look at how the bridge loan market works. If a private equity fund decides to issue temporary debt, it can do so by entering two distinct markets: the market for traditional short-term loans with maturities of usually 30, 60 or 90 days, or the market for long-term loans with maturities of usually one to three years. The short-term loans are often unsecured. Longer termed facilities are often secured by unfunded capital commitments, by rights to enforce capital calls or by collateral accounts.
There are two kinds of lenders: traditional lenders such as banks and non-traditional lenders such as HNWI, pension funds, insurance funds, sovereign funds and family offices. Non-traditional lenders appreciate these lending opportunities mainly because of the creditworthiness of private equity funds due to their strong asset base and the flexibility of the lending terms. Before issuing a bridge loan, lenders carry out a due diligence, in which they carefully assess the fund’s creditworthiness. In this regard, they put a focus on the strength of the fund‘s investors and the fund‘s ability to call capital from those investors. There is a great variation in loan sizes, ranging from usually €50m to more than €500m. Due to the creditworthiness of most private equity firms and the current liquidity in financial markets, interest rates are relatively low and generally fall below 2%.
Risks for PE funds and investors
The use of bridge loans does also come with certain downsides. Not only has the practice’s overall presence increased, but also the usage of the tool itself. Repayment terms are now far longer and reach lengths in excess of one year, thus having a significant influence on IRRs. As already discussed, this has its upsides, but it also incentivizes funds to excessively use bridge loans for this reason. Above all, the IRR increases only as a function of time and not because the related investments are extraordinarily profitable. Ludovic Phalippou, Professor of Financial Economics at the University of Oxford, expresses his views rather poetically, “the use of credit lines makes it loud and clear that IRR is completely and absolutely ‘IRRelevant’”.
Another important point is that bridge loans do reduce the number of capital calls, but at the same time also increase the risk of investors defaulting on their capital call, because capital calls become less frequent and increase in size. One should also consider that there is not much data on the PE funds’ performance when using these loans in recessions. This is especially important in light of a future market correction.
Another problem may arise from information asymmetry issues as there aren‘t any requirements for private equity funds to submit information on the use of bridge loans.
There are some private equity funds which had a negative experience regarding the use of bridge loans. The story behind the former buyout company Hicks Muse and its investments in technology companies during the tech bubble is a fitting example of the potential risks of using bridge loans. The fund relied on these loans to acquire several companies until it could raise money from investors. However, as the value of the investments plunged faster than the fund was able to raise capital, the firm experienced financial distress. A more recent example is the US-based PE fund EnerVest, which used borrowed money together with capital commitments of its investors to fund investments in energy companies. The fund faced a challenging situation when revenues of its portfolio companies suffered a significant drop due to a decrease in oil prices, leading to insufficient cash flows to service the debt repayments.
Regulation of bridge loans used by PE funds
Bridge loans are neither strictly regulated nor subject to any disclosure requirements. According to ILPA – the world‘s largest trade association influencing the PE industry through its code of conduct, guidance and principles for best practices – bridge loans should be used for the overall benefit of the partnership rather than for the sole purpose of increasing IRR. In June 2019, the ILPA published a report with several recommendations regarding the proper usage of bridge loans. In fact, the ILPA states that the duration of these instruments should not exceed 180 days and be limited to a maximum of 20% of the funds committed. Moreover, as a starting point for the calculation of the preferred return should be taken the moment when investor’s capital is put at risk, thus contributing to a higher level of transparency and consistency over the fund’s lifetime. Finally, the ILPA recommends a quarterly disclosure of information related to the size, terms and costs of the bridge loans.
The use of bridge loans will most likely continue to trend in the coming years. Liquidity is expected to remain high and more non-traditional lenders who are willing to provide temporary funds constantly emerge. It will be interesting to observe the performance of bridge loans during a potential future recession and whether private equity funds will become more willing to disclose data on their usage of these temporary funds.
Editor: Eric Peghini
Authors: Konstantin Barakos, Boris Mihaylov