Benefits & Risks of Bridge Financing in Private Equity

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The success of private equity hinges mainly on the speed with which decisions are made to invest. Faster decision making is a possibility due to the deluge of data and systems that facilitate assessment and analysis of a potential investment. However, it is the speed with which decisions are followed up by investments that make the difference.

Bridge Financing in Private Equity is the all-important X factor that helps manage the gap between the time funds are necessary to the actual receipt of funds from investors. The private equity landscape is highly competitive, and it is this availability that helps funds succeed. 

Equity Bridge Facilities have witnessed a massive spike, swelling from 10% private equity funds to 50% in two decades. This has been further fueled by global economic crises that carved out an increased role for bridge funds.

What are the specific benefits of EBF?

Equity Bridge Facilities offer funds greater flexibility, which helps control profitability. As a  result of EBF, capital calls from investors are delayed, which, in turn, improves the internal rate of return. For instance, bridge financing of private equity brings down the period between the call for capital from investors and the assets’ disposal. Consequently, the value of time used in working out the IRR is reduced, which improves the internal rate of return.

Equity bridge facilities have been in practice for a long, but the recent spike and renewed interest are attributed to the increased competition in private equity markets. Consequently, the emphasis is on infusing capital at the earliest and has been deployed as a tool by funds of all sizes – small, mid-cap, and large-cap.

Reasons for the overwhelming popularity

The reason for the overwhelming popularity of equity bridge facilities is the flexibility and convenience of access to funds. Investments are all about liquidity and complete flexibility to make the right decisions. The ability to cater to short-term obligations through bridge facilities makes this an excellent choice for managing capital requirements.

Additionally, the cushion of EBF helps funds work out all capital requirements. This is a great advantage as there is complete predictability, along with flexibility and convenience.

Among the reasons for the popularity of EBF is the ability to show higher returns as the partners’ fund is effectively used for a shorter time. Specifically, returns, specifically the Internal Rate of Return, serve as the basis for measuring private equity’s performance served.

When the period of use is cushion funds’ performance bridge financing, the IRR is inflated. This is then used as a metric for other dimensions. Bridge financing is secured by LP investment and is therefore not considered as a contributory factor to the investment fund.

Consequently, this impacts the fund’s leverage ratio, as bridge finance does not increase the burden of debt of a fund.

Bridge financing process

The process begins when the private equity fund looks at raising temporary debt. The options available for private equity for quick debt includes traditional short term loans and long term loans.

Short term loans typically have shorter maturity, for instance – three months, whereas long term loans have a maturity that extends up to 36 months. The difference between the two loans is the nature of loans – the former is unsecured while the latter is secured.

The lenders who extend the loans typically belong to two categories – traditional and non-traditional. Financial Institutions such as banks are conventional lenders, whereas high net worth individuals and various funds comprise the non-traditional lender category.

The reason behind non-traditional lenders entering the space is the credibility of private equity funds and the terms of the lending, which are not too rigid. Additionally, private equity funds have a credible asset base, which serves as a cushion/security for the loan. Both categories of lenders typically carry out due diligence before lending.

The criteria for assessing the loan include the type of investors associated with the fund and the ability to raise funds from the private equity fund investors. The loan amount greatly varies and entirely depends on the fund and the requirements of the fund. As a consequence of the equity fund’s credibility, and the availability of liquidity, the interest rates of such financing are low.

Risks associated with bridge financing

Despite the low-interest rates and flexible terms of bridge financing, the option comes with certain risks. Due to its seeming popularity, it is now increasingly being used as an option, resulting in evolving changes. For instance, the repayment terms have now extended and are averaging more than one year, which has begun to impact the internal return ratio. 

Among the drawbacks associated with the bridge, financing is that the availability of easy loans reduces the number of calls for capital. Consequently, investors are now known to default on the calls for capital, as the frequency with which capital calls are made have reduced. Additionally, the size of capital calls have increased, and this is another reason for defaults.

From a statistical or analytical point of view, bridge financing reduces the ability to process information, as private equity is not bound by any requirements to make submissions about the manner in which bridge financing is used.

Instances of equity bridge financing turning into bad experiences 

There were instances when equity firms ended up with bad experiences as a result of bridge financing. One such example is that of a firm that availed bridge financing for acquiring multiple tech companies, relying on the funds until the capital was raised through the investor route. Unfortunately, the fund’s value crashed when the firm was unable to raise adequate funds in time.

Consequently, the private equity firm experienced losses that were debilitating in nature. Other textbook examples include a private equity firm that combined the bridge finance with investors’ capital. This was then used for investing in a string of companies in the energy sector that appeared promising.

However, due to a sudden twist in the trends, oil prices dropped rapidly, resulting in reduced revenue. Consequently, the private equity firm’s debt repayment obligations were not honored, which put the firm into an existential crisis.

How is bridge financing regulated?

Bridge financing used by private equity firms is not regulated closely. Similarly, it is not under the obligation of disclosure, and this gives greater flexibility. However, there is a code of conduct in place for private equity firms, and all firms are expected to follow the laid down accepted principles and best practices governing the use of bridge loans.

One of the guiding principles in the use of bridge financing is that it is to be used only to improve the private equity firms’ partnership and should not be used for artificially inflating IRR. The code of conduct stipulates that the maximum size of bridge financing should not exceed 20% of the funds, and the duration needs to be restricted to within six months.

Other points include a voluntary disclosure of details of the bridge financing, including the terms, size, and financing implications. Disclosure of information about the funds is likely to impact the performance of the funds, as usage will then become effectively regulated.

Bridge financing will continue to remain a strong prospect, considering the liquidity and the readiness of non-traditional lenders to fund PE. However, the real test of the bridge financing’s efficacy and suitability will emerge during any possible recession in the future.

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