Loans to private equity managers cause concern
Private equity executives are increasingly borrowing money from banks to boost the size of their personal investments in the funds they manage, according to research from Investec Fund Finance, the specialist lender.
The benefits for the private equity managers are twofold: investors believe the manager has committed a larger sum of their own money to the fund, which provides reassurance and in turn encourages clients to make greater investments.
Private equity managers also stand to make bigger gains if the value of the fund increases.
But some industry experts are concerned that the borrowed money provides a false sense of security for investors, who have pushed private equity executives to risk more of their own money after some buyout funds ran into trouble during the financial crisis.
Leon Stephenson, a partner in the financial industry group at Reed Smith, the law firm, says there has been a “significant increase” in demand for borrowing facilities from private equity executives over the past few years.
A high-profile example is Tim Geithner, the former US Treasury secretary. Last month he secured a credit line at JPMorgan to finance his personal investments in funds run by Warburg Pincus, his current employer.
Although some fund prospectuses permit private equity executives to borrow money from a lender, investors may not realise that these commitments are being funded by a third party, according to Mr Stephenson.
He adds that there is no guarantee a bank will be able to recoup its money from a private equity manager if he or she runs into financial difficulties, undermining the concept of the fund manager having skin in the game.
“Often there is no direct recourse for the lender against the individual partner, so he or she would not be personally liable for any default under the borrowing facility,” he says.
Private equity executives normally commit anywhere between 0.5 per cent and 10 per cent of the capital raised by a new fund out of their own pockets.
Having their own skin in the game is widely seen as the most effective way for private equity managers to demonstrate they share a common interest with investors in the success of the fund.
Many buyout executives have come under pressure to invest more personal capital, which is increasingly difficult given the large size of many new private equity funds.
Around one in ten of the executives surveyed by Investec said they expected to commit between three and four per cent of the capital of a new fund in 2015. Just one in 25 executives were required to make that same commitment in 2014.
Meeting these personal commitments can be particularly problematic for junior private equity executives.
They often have other financial commitments, such as mortgages and school fees, or they may be waiting to receive their share of profits from other funds that have not yet matured.
Around 50 per cent of UK and European private equity executives did not have sufficient cash to finance their required personal commitments in 2015, up from a third the previous year, according to Investec.
Simon Hamilton, head of Investec Fund Finance, has observed a big increase in borrowing by private equity executives in order to meet this shortfall.
They are turning to specialists such as Investec and Silicon Valley Bank, as well as high-street lenders.
“We have seen a significant rise in our lending activity to managers over the past 3 years,” he says.
Elias Korosis, a partner at Hermes GPE, the $6bn private markets arm of Hermes, the London-based investment manager, is less concerned about these borrowing arrangements.
“Even if there is substantial borrowing, they have to give a personal guarantee. It is equivalent to remortgaging the house,” says Mr Korosis
.
Nonetheless, he believes it is important for investors to be aware of borrowing levels as these could affect the resilience of a private equity partnership.
AP6, the sixth Swedish national pension fund and one of Europe’s most experienced private equity investors, says it pays close attention to the personal commitments made by private equity executives.
An AP6 spokesperson says that too little skin in the game can encourage private equity managers to take unnecessary risks.
But investing personal wealth heavily — including by taking out bank loans — can lead private equity managers to develop a risk-averse attitude that prevents them from pursuing profitable investment opportunities.
“We want management teams to have skin in the game, but there has to be a balance,” says the spokesperson.