Wibke Pendse, Market Manager, Private Equity Services
Private equity and venture capital’s key differentiator is the unique alignment created from investor to manager to portfolio company. This precious calibration is often touted as the driver behind the asset class’s ability to win deals, successfully grow portfolio companies, and ultimately deliver outsized returns.
The golden thread from which this unique and vital alignment suspends is the GP commitment. Only through having skin in the game can all parties be truly aligned.
However, swelling fund sizes, the quickening of fundraising cycles and growing popularity of multi-strategy funds are increasing the pressure on GPs, especially younger and more junior team members, in terms of how to finance these rapidly growing, yet vital commitments. For many, the solution lies in GP debt facilities; both personal and corporate level loans, tailored to specifically enable that all important skin in the game.
“We see a particular need for this product from the principal layer of the firm, as they are often given the opportunity to buy into a fund, which they want to do for career progression purposes. But, they are also likely to be getting married or buying houses; because of where they are in their lives, they are likely to be facing huge demands on their cash reserves,” says Wibke Pendse, Region Manager West Coast for SVB.
“And this is also a concern for the more junior partners; the principals being promoted to partner are often being offered bigger stakes as part of that development,” adds Mary Toomey, Managing Director with SVB Private Bank. “With fund lifespans of 10 years, it takes time to build up liquid reserves to support these commitments.”
Furthermore, senior partners are also exploring funding options due to the strength of the fundraising market. “Fundraising has been so strong for a few years now and we’re seeing funds getting larger and larger. On top of that, the time between fundraising is getting shorter. The days of a five year gap between funds are no longer; we’re seeing a lot more three year cycles on average,” observes Pendse.
“Many of the more well established firms are also raising multiple funds at the same time, with varying strategies or targeting different stages,” says Toomey.
To compound both factors, the average size of GP commitments has been steadily increasing. “It used to be 1%, which we still see with larger players. But today, more often it’s 2%, which furthers the need for external support,” says Pendse.
With new challenges and difficulties facing the way in which investment teams ensure their skin in the game, it’s important to think about how and when solutions should be sought.
Toomey and Pendse both recommend speaking to lenders as early on in the fundraising process as possible. “We try to discuss all of the possible solutions a firm and members of the management team might need at the start of the fundraising process,” says Pendse. “At SVB, our best approach is for the Private Bank and the Global Fund Banking team to work hand in hand so that we can deliver a holistic solution, covering both fund and personal needs.”
Not only do earlier conversations lead to highly tailored solutions covering both personal and corporate financing needs, they also allow for more accurate terms in the LPA. “It helps to discuss financing options at this point as we can provide guidance as to how provisions of LPA can be drafted so they reflect the use of these products,” says Pendse.
This time it isn’t personal
The partnership between SVB’s Private Bank and Global Fund Banking offerings are only available in the US. For fund managers in Europe and Asia, GP commitment solutions are typically focused at the corporate level. However, some US managers prefer to borrow only against the manager, rather than on a personal basis as well. Says Pendse: “We also provide a solution to finance the GP commitment by either lending to the GP and management entity to the fund. There are US firms that prefer this approach because it’s typically structured with no recourse to the partners, who are ultimately benefiting from the product.”
Furthermore, opting to use solely the corporate solution can better suit certain team members. “The people often in need of this financing – the newer partners and principals – they might not have built up a balance sheet, so financing to the management company can be more attractive to them rather than a personal loan,” points out Pendse.
Of course, taking on any form of debt comes with risk. For those taking on personal loans, it is important to think about the lengthy lock-in periods of funds. “If a team member were to leave the firm, we typically include a departing partner clause in the loan agreement, whereby the loan needs to be repaid or restructured,” explains Toomey.
On the corporate side, the considerations are similar. “Ultimately, it’s the management company, either as guarantor or borrower that is responsible for this obligation. When a firm decides to use this solution they need to be mindful of how they structure it internally – as to how each individual benefits. We’ve seen clients use it differently with each team member, with what happens when people leave and how it’s repaid,” says Pendse.
Beyond careful consideration of internal arrangements and structures for these facilities, firms must take note of wider industry trends and demands.
There are of course other ways of financing GP commitments, including loans from senior partners who have accumulated more wealth; using one’s carry or, fee waivers. The use of carry and fee waivers have been widely criticised in recent years, with ILPA’s private equity principles clearly advising against their use.
GP commitments are the crucial mechanism for alignment in private equity and venture capital, so to use future profits or fees arguably goes against the spirit and nature of the asset class.
The combination of personal and corporate borrowing however, still puts the onus on investment team members for their commitment to the fund. Furthermore, the use of financing to facilitate personal commitments can be a tax efficient use of debt. “Using loan proceeds to help fund a portion of the capital call generally allows for the interest to be classified as investment interest expense, which is deductible from investment income,” points out Toomey. “We advise clients to use their cash for expenses, such as taxes and school tuitions, and reserve borrowings to where it can be traced to a taxable investment to best optimize for tax efficiency.
“It can be very advantageous for investing professionals, of all levels, to work with the private bank for the most tax efficient and flexible financing solution that is tailored to their unique balance sheet, income and overall financial condition,” adds Toomey.
Despite the GP commitment being a commonality between all managers, each firm is unique in its team composition, fund size and structure, strategy, heritage and LP base. It is therefore very much a matter that must be addressed at both company and personal level, where solutions must be tailored to ensure both needs are met. But most important of all, the key objective of GP commitments – to facilitate that all important alignment – must always be front of mind when seeking a solution.