No credit where credit is due

The scarcity of lines of credit has hit the operations of small firms especially hard, and those without strong existing ties with banks will likely have to survive without credit sources until 2011.

Private equity firms often rely on lines of credit to smooth the cash flows of their management companies. For example, lines of credit can be used to pay expenses while limited partners respond to capital calls at varying rates of alacrity. Some firms have even used lines of credit to close deals. These credit lines are often secured by the capital commitments of LPs. A bank that trusts the integrity of a GP organisation will be more likely to extend credit based on LP relationships. Or at least, that used to be the case.

Many private equity firms have had to adjust as lines of credit previously offered by lenders such as Bank of New York Mellon and Silicon Valley Bank have largely dried up. But while larger firms with long-time relationships with financial institutions enjoy credit advantages, smaller firms will likely have to do without through the next year and into 2011, according to banking sources.

Raj Marphatia, a partner in the private funds group at Ropes & Gray, says lenders that are offering subscription lines of credit want large loan-to-value ratios due to the risk that if a fund defaults, it will be unable to repay its loan by selling off illiquid portfolio companies. From many lenders, he says, “you can only get a loan-to-value ratio of 10 to 15 percent right now, which is a small amount of capital and probably not anywhere what the GP needs.”

A vice president at one of the world’s largest banking corporations agrees that while there are not many banks willing to offer facilities like subscription debt, firms with strong preexisting relationships with a lender are in a better position to continue securing credit lines. “The big names are still able to tap that market, but the guys who are having major problems now are those that never really had relationships with banks, or kind of spread their business around too thin and really played the competition angle,” he said.

In other words, large GPs with strong relationships have an advantage over smaller firms that spread their business broadly.

“A lot of banks don’t necessarily feel that this is one of their VIP clients,” says the VP of the latter type of firm. “The smaller guys are trying to shake trees to find money, but we no longer live in a world where capital is unbounded, so all banks are making decisions: Do we have the ability to take on a new client and it going to be a one-off of, is it going to be a relationship?”

He adds that certain LPs in a fund may raise a red flag among lenders. “Inspection of the investors has become a lot more diligent,” he said. “Whereas before people would just rely on a sponsor rating, now I think people have a lot more peccadilloes on certain investors, whether it is who is signing on the dotted line of the investor consent or just the financial wherewithal of the entity itself. It’s different from institution to institution, but certain people are a little more concerned about that.”

The VP also predicts that the current situation will likely not see improvement until 2011, even though the economy has shown signs of improvement. The truth is, most lending policies have already been set. “Until we see the fundamentals improve, even though this is the best time to do the deals at the very bottom of the market, you at least want to see an uptick before you put money out the door.”

Until that uptick happens, many managers of private equity firms will have to more carefully plan their capital needs and pray that the LPs will rapidly respond to meet these.