“There’s already too much debt being used in underlying companies and to also use debt at the fund level is wrong,” he said in an interview on December 15 when he looked back on 2016.
Most private equity firms have a fund overdraft for practical reasons. A firm can draw capital from a fund overdraft at their convenience without having to make new capital calls.
Firms have also realised that they can inflate returns if they borrow money for longer. The performance of most buyout funds is measured by its internal rate of return, which factors in both timing and performance. By using debt to make acquisitions, they can postpone the use of investor cash and delay the point when the IRR clock starts ticking.
A vast majority of buyout firms use or intend to adopt fund overdrafts, according to the Investec Fund Finance GP Trends report, which was published in November.
Some investors like fund overdrafts because their own performance is measured in IRRs, but other investors disapprove as these facilities reduce overall distributions due to the interest firms have to pay on the debt they use.
Gale said: “It’s fool’s gold. There’s no justification for it. It is not sensible – especially in an environment where interest rates are likely to rise.”
He added that it’s a “symptom of where we are in the cycle” as there’s “so much debt available”.
Gale said that Hermes tries to discourage firms it backs from using fund overdrafts, but said that if managers use it, Hermes “cannot do anything about it”.
He added that “everyone is using it [fund overdrafts] now”, comparing the widespread use of debt in private equity to unabated mortgage lending before the global financial crisis.
“It’s only something you will notice afterwards and then everyone will say: why was that allowed to happen?” he said.
As well as using more fund-level debt, some firms have been tweaking other fund terms in their favour in the past year.
Gale said he does not approve of such adjustments. He said Hermes GPE would walk away from managers that would lower the threshold that determines when it can start taking a cut of profits, which is also known as the hurdle rate.
By lowering their hurdle rate, buyout firms will receive their share of profits sooner. Firms often take 20% of the fund profits – or carried interest – once the hurdle has been reached.
“It’s a premium product with premium fees and carried interest should be a special reward for a special performance,” he said.
Advent International dropped its 8% hurdle rate on its latest fund this year, while CVC Capital Partners is preparing to lower the hurdle on its next fund to 6%.
Some buyout executives believe the 8% hurdle rate is too high. The figure became the industry standard during an economic environment when inflation and interest rates were about 8%. If investors house their cash in a buyout fund, that fund would have to outperform inflation and interest rates in order for the manager to receive profits.
However, interest rates have been at historic lows following the financial crisis and a number of firms have warned that private equity returns will drop.