What have cheap bank loans done to private equity funds?

Over the last few years, the private equity industry has added a new level of complexity for investors. It started to use fund finance, a broad range of financing structures at the private equity fund level, to support funds’ liquidity and help boost their reported returns.

The most popular fund finance instrument with private equity funds focused on buyouts has been the subscription line (or the capital call facility). The line is a senior revolving credit facility secured by the unfunded capital commitments of the fund’s investors. Historically, fund managers have used these facilities sparsely as short-term bridge financing, repaying them in 30 to 90 days. However, over the last few years, the use and maturities of such funding instruments have increased significantly.

To what extent are these facilities used? Given that the market is not public, it is challenging to estimate its size, but Cadwalader, a leading law firm based in New York, estimates that the market is over $500 billion with an estimate of lender commitments increasing by 20% last year in 2018.

The data suggests that banks have embraced subscription financing as a relatively safe form of lending. The creditworthiness of the fund's investors, most of whom are investment-grade institutions, is very high. Moreover, these loans have short maturities, allowing the banks to scrutinise frequently the private equity funds that use them. Banks' confidence in the robustness of fund finance as a business line is arguably backed by the relative rarity of default.

The only large default so far has been that of Dubai-based Abraaj Group in 2018, which acquired a business in Turkey with a subscription line from Societe Generale just prior to its default. Many players in the market would argue that Abraaj’s default, caused by the manager’s deceit of investors and misuse of funds, is a very rare and unusual event.