European CFOs split on fund leverage

European chief financial officers are split over whether fund leverage should be encouraged or not as the practice evolves and investors are becoming increasingly focused on its deployment.

Half of delegates polled at the Invest Europe CFO Forum in Berlin on Wednesday said fund leverage is both a useful working capital tool and a very welcome way to enhance the returns of a fund, with the remaining 50 percent saying it should be discouraged and reserved for exceptional circumstances.

While fund leverage is not a new practice – one CFO from an Africa-focused private equity firm participating in a panel discussion said his firm has been using fund leverage on and off for 16 years – it has come under scrutiny because some fund managers are perceived to be abusing credit facilities.

“There are examples of GPs making investments, funding them through the credit facility, rolling the loan over and exiting the investment all without drawing down any cash from investors,” the CFO said.

The practice isn’t creating an issue yet, the CFO said, adding there is a chance it could become problematic down the line.

“Investors are still sitting on a lot of cash, are getting distributions and can cover future calls. If we get to a position like 2009 where investors were getting no distributions and capital is still being called up, then it could become an issue and there will be no money to pay back the loans,” the CFO said.

Whether or not investors are in favour of fund leverage was a matter for debate. A second GP, from a Europe-focused private equity firm, said there was support for fund leverage among LPs, but there was a geographical divide in attitude.

“I meet with LPs on an ongoing basis and the use of fund leverage is not a new question. But I’m finding LPs generally fall into one of two buckets; those in the US and ‘anglo saxon’ investors are keen on [leverage] because it can boost IRR, while those in Europe and Asia are much more negative because they want to get their money out of the door,” the GP said.

He added that over the past four years investors generally had been increasingly keen for his firm to use credit facilities because it meant they were only receiving capital calls annually rather than quarterly.

“We succumbed to investor pressure to ramp up our use of fund leverage,” the GP said.
The first CFO shared this sentiment, and said four years ago the firm debated the issue with its limited partners and came away with “a very strong mandate to maximise the facility.”

But the LP on the panel had a different view. While investors generally support “prudent” use of short term fund leverage, because it reduces the frequency of drawdowns, extending the loan period is both increasing their risk exposure, and causing transparency issues, the LP said.

“The risk for the investor begins when the investment is made, not when it gives the fund manager the capital. If a manager takes out a loan for six to 12 months and then pays it back, that’s fine. But LPs in general are not supporting the longer term loans. They may boost the IRR for the GP, but it doesn’t help the investor,” the LP said.