Responsibilities regarding the availability and use of additional credit financing within the fund structure
Explanation
It is typical today for funds to be issued with additional interim financing in the form of facilities secured by the undrawn commitments of LPs. Such facilities, which are provided at the fund level (as opposed to facilities at the individual asset level of the fund), are typically set up as a repayable facility from a bank or other specialised lender and used by GP for a number of liquidity efficiency reasons, including reducing the volume of LP drawdowns and avoiding the need to draw down funds from LPs for temporary investments.
This type of financing does not increase the investment capacity of the Fund.
Limited Partners (LP) are the ones who have arranged and invested the capital for venture capital fund but are not really concerned about the daily maintenance of a venture capital fund whereas General Partners (GP) are investment professionals who are vested with the responsibility of making decisions with respect to the ventures that are required to be invested.
LPs need to understand the rationale for using the facility and the key terms associated with it, and may wish to place restrictions on the use of such a facility. As with the general requirements of fund formation documents, the criteria for disclosure of such credit facilities may depend on the jurisdiction and applicable regulatory requirements and should therefore be reviewed by legal counsel.
Typically, the specific terms of the facility are not determined until after the fund is established, so it may not be possible to disclose all of the details in the fund formation documents - in this case, a statement providing an overview of all proposed facilities is all that is available. Once the facility is established,
the LPs will need to be informed of the final terms.
If material, LPs may want to see the impact of the facility on the fund's net IRR and net multiplier in order to compare and evaluate the underlying net performance with other funds.
Occasionally, although rarely in the context of direct private equity funds, a facility is established to increase the fund's investment capacity (i.e., the facility is expected to be long-term and allow the fund to make investments in excess of 100% of LP commitments). In such circumstances, LPs need to be informed of the size and scope of such borrowings and understand the implications. Such facilities result in leverage of the fund (which may have regulatory implications).
Makhmud Efendi
Recommendation
Fund formation documents should address the following issues:
- Intent to use a bridge facility during the life of the fund - if no facility is proposed or can be established, this should be disclosed.
- Reasons for using (and/or restrictions on using) the facility -- for example:
- to reduce the frequency of drawdowns (e.g. to allow a certain number of investments to be made at any one time)
- to finance temporary investments
- to avoid the need for rebalancing among LPs during fundraising by providing funding for all investments between the first and last closing of the fund
- to optimise cash efficiency
- to provide letters of credit/bank guarantees to support the fund portfolio
- to accelerate distributions
The fund formation documents should also make clear that the use of such a bridge facility will have an impact on the net IRR, net money multiple and, if applicable, on the achievement of the hurdle rate for the payment of carried interest.
If available at the time the fund formation documents are prepared, the following should be included:
- Projected size of the facility
- Proposed limits on the duration of the facility.
- Details of the permitted uses of the facility (e.g., for investments, for management fees and expenses, for temporary investments)
If the specific terms of the facility are not determined until after the fund is established, the GP should provide the above details either in the next quarterly report or in a separate communication to LPs. Details of the terms relating to facilities intended to increase the investment capacity of the fund should be disclosed separately from the terms applicable to bridging facilities.
If, exceptionally, a credit facility is to be used to increase the investment capacity of the fund (i.e. the leverage of the fund), a clear statement should be made to that effect and any disclosures relating to that facility should be made separately from the disclosures relating to bridging facilities.
Once the fund is operational, ongoing reporting should ensure transparency for LPs on the use and impact on returns of the facility and include the key terms of the facility as part of the fund summary. For details on ongoing quarterly reporting requirements, please refer to the Invest Europe Investor
Reporting Guidelines.
