The Enhancer
The Enhancer
The Enhancer
Signature-Guaranteed Credit Enhancement
The Enhancer replaces the need for LPs with signature-guaranteed credit enhancement. A range of structures can achieve this goal for a sovereign fund or pension fund. These include credit default swaps, government guarantees, credit support agreements, and co-investment arrangements for insuring debt or bonds issued by a PE fund or REIT to seed a portfolio.
Ideal for Sovereign Wealth Funds
SWFs, superannuation schemes, and large pension funds are well-positioned to guarantee debt issued by PE funds and REITs for initial capitalization or refinancing.
Using signature-guaranteed credit enhancement, the Enhancer enables the expedited issuance of debt, while leaving the enhancer’s own assets untouched, generating 7% per year without having to advance capital, plus an additional 6% per year after the enhancement period for the duration of the fund. See Table.
Four applications are outlined below:
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Launching new funds,
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Recapitalizing existing funds,
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Permanently financing funds, and
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Converting Subscription Lines to Reduced Outlay Investing.
Launching New Funds
With the Enhancer
Launching a Fund Without LPs
Step 1 - The figure below illustrates how a private equity fund can be launched without LPs by using a credit enhancer to guarantee debt or bonds issued to fund the acquisition of a fund's portfolio. For this example, we'll look at how the math works for a credit enhancer providing enhancement for the fund’s first three years who receives:
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6% per year in credit enhancement fees, and
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7% per year of the fund’s carried interest, for a total of 21%.
Note that the GPs retains 79% of the carried interest at this stage—nearly four times the share they would have under a conventional fund structure.
The Credit Enhancer Guarantees Debt to Seed the Portfolio
Recapitalizing the Fund in Year 4
Step 2 - The figure below illustrates how the enhanced bonds are retired through the issuance of LP units and new debt, releasing the credit enhancer from any further obligations. In this example:
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the credit enhancer acquires the fund’s subordinate LP units—representing 25% of the equity stack—by investing $62.5 million of the $180 million earned in credit enhancement fees during the first three years of an exemplary $1 billion fund.
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The credit enhancer also keeps its 21% carried interest in the fund.
The senior and mezzanine LPs receive preferential returns of 12% and 16%, respectively, while the subordinate LP interest acquired by the credit enhancer receives 35% of the fund’s carried interest.
Under this structure, the GPs retain a 44% carried interest—over twice the share typical of a conventional fund—while the credit enhancer secures a 56% carried interest without investing any capital.
The Credit Enhancer Exits, Buying the Subordinate LP Units
The Math
Because of the GP’s increased carried interest, their annualized return on AUM rises to 7%, compared to 5.5% under a conventional structure. The credit enhancer earns 7.4% per year during the enhancement period and 6.3% per year for the remainder of the fund’s life—all without investing any of its own capital.
The table below summarizes the returns for all the parties involved assuming a portfolio performance that would have generated a 14% ROI for LPs under a conventional 2& 20 structure. A sensitivity analysis is available upon request.
Comparison of Annualized Returns
Tables Are Not Available on Mobile Devices
Assumptions
Recapitalizing Funds
With the Enhancer
Taking Out the LPs
The figure below illustrates how credit enhancement can be used to accelerate the return of capital to investors or to continue a fund without having to sell assets. For this example, we'll look at the math for a credit enhancer paying off the LPs after 5 years who receives:
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4.75% per year in credit enhancement fees for the fund's remaining 5 years, and
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a 30% carried interest in the fund.
Under this structure, the GPs gain a 70% carried interest—more than triple the share typical of a conventional fund—while the credit enhancer secures a 30% carried interest without investing any capital.
The Credit Enhancer Guarantees Debt to Pay Off the LPs
The Math
Because of the GP’s increased carried interest, their annualized return on AUM rises to 6.5%, compared to 5.5% under a conventional structure. The credit enhancer earns 7.1% per year for the remainder of the fund’s life—without investing its own capital.
The table below summarizes the returns for all the parties involved assuming a portfolio performance that would have generated a 14% ROI for LPs under a conventional 2& 20 structure. A sensitivity analysis is available upon request.
Table of Annualized Returns
Tables Are Not Available on Mobile Devices
Assumptions
Permanent Financing
With the Enhancer
Permanent Financing
It's not always necessary to take out a credit enhancer. The table below illustrates how permanently financing a PE fund using the Enhancer can raise a GP’s annualized return on AUM from 5.5% to 7%, while the credit enhancer earns 7.5% per year on the fund's AUM, without investing capital. The returns shown assume a portfolio performance that would have produced a 14% ROI for LPs under a conventional 2 & 20 structure. A sensitivity analysis is available upon request.
Table of Annualized Returns
Tables Are Not Available on Mobile Devices
Assumptions
Converting Subscription Lines to
Reduced Outlay Investing
How Subscription Lines Work
GPs often use their LPs’ capital call commitments to secure subscription lines for acquiring portfolio assets, as shown in the diagram below. Many LPs view this practice unfavorably, arguing the cost of interest erodes their ROI. They prefer their capital to be called as soon as possible, since it typically generates little meaningful return while sitting idle in anticipation of capital calls.
Using a Subscription Line to Acquire Portfolio Assets
How Reduced Outlay Investing Works
FinaTech’s Reduced Outlay Investing solution replaces the use of subscription lines with the intent that the LPs’ commitments will never be called. This allows the LPs to put their capital to work elsewhere while still providing signature-based credit enhancement for the fund. As illustrated in the diagram below, debt or rated bonds backed by the LPs’ capital call commitments are issued in place of a subscription line.
To preserve liquidity if the commitments are called, LPs can obtain a line of credit secured by their investments. GPs could be subject to penalties if they draw on LP commitments—for example, their carried interest could be reduced. This would align the incentives of both GPs and LPs.
Using Reduced Outlay Investing to Acquire Portfolio Assets
The Math
Because of the GP’s increased carried interest, their annualized return on AUM rises to 7%, compared to 5.5% under a conventional structure. The LPs earn 17.5% per year, compared to 14% under a conventional structure.
The tables below summarize the math and the returns for all the parties involved assuming a portfolio performance that would have generated a 14% ROI for LPs under a conventional 2& 20 structure. A sensitivity analysis is available upon request.
Table of Annualized Returns
Tables Are Not Available on Mobile Devices
Assumptions
Reduced Outlay Investing is a form of signature-based credit enhancement. An LP’s capital call commitment is typically not collateralized or tied to specific assets, but is a general obligation of the LP. It can, in some cases though, be advantageous for the fund and the LP to tie the enhancement to collateral, as shown in the illustration below. The economics of this structure is the same as above. See our Double Dip page for more versions of collateralized credit enhancement.
