by Steven Stubbs, Aoto Kenmochi, CFA, and Raman Kalra Ph.D., Fitch Ratings
Fitch Ratings has observed a dramatic increase in the amount of outstanding U.S. asset-backed commercial paper (ABCP) that is being secured by unfunded capital commitments (UCCs) to private equity funds. As of December 31, 2006, over $5.4 billion of outstanding Fitch rated ABCP was secured by UCCs. This represents a 175% increase from January 2006 when only $1.9 billion of outstanding Fitch rated ABCP was secured by UCCs. As illustrated in the chart on this page, the amount of outstanding ABCP secured by this asset class has expanded at an average monthly rate of 8% during 2006.
This growth can be attributed to the expansion of the private equity business as a whole, as it has been widely reported by the financial press that private equity funds had raised over $400 billion of capital during 2006. However, the growth is also the result of an increased use of ABCP facilities to supplant traditional bank lines. Fitch anticipates a continuation of the growth in the use of UCCs as collateral for ABCP funding during 2007. Fitch has reviewed a number of UCC transactions funded through ABCP conduits in the past and is currently reviewing a number of securitizations of this type that are anticipated to close during the first quarter of 2007. Fitch's outlook has been confirmed by market participants who agree that this method of financing for private equity funds will continue to expand in 2007.
Capital commitments to private equity funds
A capital commitment is an investor's commitment to make a capital contribution to a private equity fund. Securities law limits the private equity investor base to qualified institutional investors and accredited investors who are considered sophisticated enough to invest in private equity funds. Private equity investors frequently include institutional investors, endowments, pension plans, family offices, funds of funds and high-net-worth individuals. The investors are referred to as limited partners (LPs), as private equity funds are customarily structured as limited partnerships with the fund manager acting as the general partner (GP). The legal relationship of the GP and LPs, as well as the terms and conditions of the partnership, are set forth in the limited partnership agreement.
Under the terms of a subscription agreement, the various LPs agree, or "subscribe," to contribute capital to the fund when requested by the GP. Unlike hedge funds, which typically have a "lock-up" period of only twelve months during which investors are prohibited from making redemption requests, private equity funds prohibit capital withdrawals by LPs for up to ten years. This gives GPs the flexibility of investing in long-term positions without having to manage short-term liquidity for funding capital withdrawals by LPs.
The goal of a private equity fund is to acquire businesses, increase their profitability, sell them for a profit, and make distributions to the partnership. Private equity funds typically invest in the privatization of publicly traded companies, leveraged buyouts, leveraged buildups and venture capital investing.
As investments are identified by the GP, it will request or "call" capital that has been committed to it by the LPs. A capital call is accomplished by the GPs by sending the LPs a funding request which sets forth the amounts required to be contributed by the LPs. Private equity funds differ from hedge funds which are fully funded at inception, as GP's will only call capital when an appropriate investment has been identified. Once a capital call has been made by a GP, the LP has a set time frame (in most instances 15 days) with which to contribute the requested capital.
The portion of the commitment that has not been funded by the LP is considered to be an "unfunded capital commitment" and may be securitized as described in more detail below. Following a capital call by the GP and a contribution by the LP, the portion of the LP's unfunded capital commitment is reduced by the amount contributed by the LP. This amount is then considered to be a "funded capital commitment" and is no longer available to be securitized.
If an LP should fail to meet a capital call, the GP, after any cure periods have elapsed, may declare that the LP is in default. The partnership agreement sets forth remedies for such default, which are usually quite severe. Penalties usually include the LPs forfeiture of 50% to 100% of its contributed capital, the loss of its right to share in investment distributions, and exclusion from participation in future private equity funds. Further, a defaulting LP will be responsible for all expenses incurred by the fund that are related to such default.
Rather than forfeit its contributions and suffer other penalties, an LP that is unable to meet a capital call would be more inclined to seek someone to purchase its interest in the partnership rather than default. This, in turn, has lead to the creation of an active secondary market for limited partnership interests that is estimated to be equal to roughly 2% of all capital commitments to private equity funds. Active secondary market investors include institutional investors, endowments, pension plans, family offices, funds of funds and high-net-worth individuals. LP interests have historically been sold at a discount to fair market value; however, recent demand for these interests has given rise to their sale at premiums.
A private equity fund's GP must approve the sale of a partnership interest and, in many instances, may assist a defaulting LP in locating an interested party willing to purchase the LPs position. Because of the secondary market, it is widely held that instances of actual default on a capital call have been historically low. This is a key consideration when analyzing risks to transactions involving UCCs as will be discussed below. As private equity funds are usually oversubscribed, the sale of a partnership interest may be completed quickly if the GP is familiar with the prospective LP.
Securitization of unfunded capital commitments
The securitization of unfunded capital commitments through ABCP conduits gives private equity funds an additional source of financing and is fast becoming a popular alternative to bank lines. These ABCP facilities are typically sized to be around 25% of the fund. Lines provided though ABCP, as well as traditional bank lines, serve two main purposes: gap financing and leverage. The primary driver of this form of lending line is to provide immediate liquidity that enables the fund's GP to quickly act on its investment opportunities, rather than waiting for a capital call to be funded by the LPs.
In addition, often the GP will not call on the LPs right away to repay the borrowing in order to benefit from relatively cheap financing, and, in effect, leverage its investment position. This application of leverage, however, must be used by the GP in a sensible manner since it would not be in the interest of LPs whose earnings would be diluted as a result. A GP risks its reputation by engaging in such a practice excessively and may inhibit its ability to obtain future capital commitments. Many partnership agreements also include provisions stipulating a required schedule of capital calls by the GP. Because of these limitations, ABCP facilities generally are not used extensively for the purpose of leverage.
In a typical UCC transaction, LPs make commitments to invest in private equity funds. These UCCs are, in turn, pledged to ABCP conduits by the fund's GP. In exchange for the pledge of the UCCs, the GP will receive funding from the ABCP conduit which is equal to the dollar amount of the UCCs multiplied by a predetermined advance rate. The type of LP making the commitment determines the applicable advance rate. Unrated LPs usually have advance rates of up to 65%. In most instances rated LPs will have advance rates of up to 90%, but they will vary depending upon the rating assigned to the LP.
Advances made to the GP by the conduit are used to make private equity investments of the types described above and the ABCP conduit will fund its advances through the issuance of ABCP. Advances to the GP are repaid from the eventual funding of the capital calls by the LPs and the repayment of the conduit is senior to all other payment obligations of the fund.
The main risk to ABCP investors in this type of securitization is a capital call default by an LP. A default by an LP can potentially result in the GPs inability to repay the ABCP conduit. To mitigate this risk, UCC deals are structured with overcollateralization and exposures to LPs are diversified. In addition, as discussed earlier, the secondary market provides an out for a potentially defaulting LP. Fitch's research indicates that UCCs, as an asset class, have historically strong performance as defaults have been minimal.
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