Since March 2020, the frequency of certain fund-raising activities may have been disrupted due to the health and economic uncertainty impacting the main providers of private capital in the world of Private Equity investment funds. Some operations have been delayed, and others significantly slowed down. But for one thing, this phenomenon is absolutely not widespread, and for another, it has only affected a relatively small number of situations.
However, certain reflections and stock-taking have been undertaken to prepare for a possible lack of liquidity. We have put together a few situations based on past experience and concretely reflected on solutions or measures we can implement in advance.
2. Optimising the Fund’s cash management and investment capacity
Investment funds benefit from particularly flexible cash management features, compared to companies, and can implement a number of preventive measures to optimise their cash resources. On the one hand, the management fees paid to the fund manager can be financed, from a certain period, via the income from the Fund’s portfolio, either upon receipt of the corresponding cash or by recalling temporary distributions notified as such by the fund manager to its investors. In addition, the fund manager can usually expect to be able to recycle some of the proceeds, as long as the aggregate amount actually invested by the Fund does not exceed a certain percentage of the Fund’s total commitments (between 100% and 120% depending on the investment strategy). The advantage of this practice is that all of, or even somewhat more than, the amounts intended for investment are actually put to work. As long as the limit remains within market standards, the Fund’s risk profile is not particularly increased.
3. Use of co-investment
Beyond the fact that a growing number of private investors are showing a real interest in taking advantage of co-investment opportunities that may be offered by fund managers, co-investment can help streamline future investment resources from the start of the investment period. However, co-investment is not necessarily suitable for all investments and is not intended to be used late in the game; nevertheless, it remains a way to optimise an investment fund’s financial resources, and is highly prized by investors when offered without management fees and/or carried interest deductions (market practices vary).
4. Loans taken out by investment funds from credit institutions
As observed in recent years, investment funds tend to rely on lines of credit, generally granted by the fund’s depositary for practical reasons relating to securities taken by the lender. Such lines of credit involve short-term repayments (within at most twelve months) by calls for funds from investors and must always be covered by the uncalled commitments of the fund. As a general rule, such lines of credit are only used during a fund’s investment period (5 out of the 10 or 12 years of life provided for in the LPA) and normally do not exceed 40% of the total commitments of the fund. However, this financing structure does not solve the liquidity problems that a fund may encounter during its last years of life. Lately, we have been seeing the development of financing structures, offered by credit institutions, that are no longer based on uncalled commitments, but rather on the net asset value of the fund. Such solutions generally represent from 10% to at most 15% of the fund’s NAV, and their cost for the fund (while not prohibitive) is higher than that of the credit lines mentioned above. In addition, the asset manager must check whether its license (AMF for French AIFMs) allows it to leverage the funds it manages, insofar as the loan debt is no longer covered by the uncalled commitments. Finally, a legal review of the fund’s regulations or articles (and side agreements) will be essential to verify the fund’s capacity to subscribe to them, and communication with investors is recommended in order to verify whether the use of leverage (even if minor) is likely to have a regulatory impact.
5. Increasing the size of the fund or using preferred securities
Increasing the size of the Fund via capital increase is a solution that is theoretically available, but requires a broad consensus of investors, including those who do not wish or are unable to participate in such a capital increase within the investment fund, insofar as those not participating would find themselves mechanically diluted. However, the fund’s risk profile would not change, since no dedicated class of shares would be issued for the benefit of those participating in the capital increase (existing or new investors). Such an operation would require consultation with the investors and generally a qualified majority vote to amend the existing legal documentation (creation of an additional subscription period, possible adjustment of the management fees for new subscriptions).
Finally, there is another solution we are aware of, which is not yet commonly used on the French market. This consists of issuing a preferred share class for the benefit of a third party investor, which would receive a preferential return before the original investors would resume receiving their share of the fund’s income, alongside this new investor, according to a renegotiated distribution waterfall. Such a scheme would represent a higher cost than the credit lines mentioned above, but would allow somewhat more additional financing. Finally, the risk profile of the original investors would be increased depending on the financial conditions of the operation. Adjustments to the existing legal documentation would be quite significant and a broad consensus among existing investors would be essential for the implementation of the operation.