Private equity funds raise capital through fundraising. Fundraising is the process of getting accredited investors to commit capital to the fund. Once capital has been committed by investors, the fund manager will deploy some of the capital to investment opportunities they believe will be profitable. The act of drawing on this committed capital is referred to as a “capital call.” Fund managers will typically not call all the committed capital at once. Rather, the manager will call the capital as needed. Lawyers work closely with private equity funds and are highly involved in the capital raising and deployment process. Private equity has experienced a recent period of dramatic growth and increased activity, which has resulted in a similar increase in hiring and billing for the law firms.
The capital that has not yet been called and deployed is “uncalled capital”, or “dry powder.” Throughout the lifecycle of an investment, fund managers will have multiple options for injecting additional capital into an investment. Primarily, when a fund manager needs to deploy cash, they call on committed capital, or borrow from banks. Over the last decade, record high dry powder and record low interest rates have led to tremendous growth in the private equity industry.
Throughout this period of growth private equity has tripled in size from approximately two trillion dollars to six trillion dollars. Moreover, private equity funds have been the leading driver of increased private credit during this timeframe. This type of private credit, or fund financing, has allowed funds to use short-term loans to generate higher internal rate of return, or IRR.
The demand for this lending has created tremendous growth for fund finance attorneys, as well as new and creative lending structures outside the traditional subscription line lending. The fund finance industry has expanded to now include lending methods such as NAV lending, SMAs, preferred equity, and ESG-linked loans. The demand for subscription lines from private equity funds has reached 20-30 percent of capital raised. The fund finance industry is not expected to see a slow down any time soon; and it is estimated to grow seven fold by 2030.
Having significant dry powder indicates opportunity for fund managers as they have capital to deploy to new opportunities. Capital calls have continued to fall, dropping to a 10-year low of 1.9 times per annum as of 2021. Due to this decrease in capital calls, funds have record amounts of dry powder. Further, as the life cycle of fundraising nears its end, it applies pressure on fund managers to deploy the capital and generate returns for investors.
Inflation and a looming recession create a precarious environment for private equity firms. However, the unprecedented dry powder will allow fund managers to inject additional capital to investments if needed to survive an economic downturn. Further, many do not believe that rising interest rates will have a negative impact on demand for fund finance. Typically, increased cost of capital results in lower demand for lending, however, this increase is being offset by the decreased cost of these transactions.
The current economic outlook is grim as the banking industry is predicting significant economic slowdown throughout Q4 2022 and 2023. However, in a recent survey conducted by Cadwalader, 86% of responding lenders expect that its fund financing activity will remain stable or increase in 2023. Since the Federal Reserve has continued to raise rates to battle inflation (thereby making borrowing more expensive), lenders are anticipating lower utilization of fund financing by borrowers. However, the unique benefits of fund financing facilities should act as a hedge against this decline in utilization. While utilization might decline or hold steady for existing borrowers, the increase in the number of borrowers seeking this funding is expected to increase. Further, it is likely that non-bank lenders will enter the space creating additional liquidity in efforts to capitalize on the increased returns. Given the expected participation by new entrants, as well as the increased liquidity by new lenders, it is likely that fund financing will continue to grow despite economic slowdowns.
While the growth in private equity may taper, creative funding and record dry powder will carry the industry through any economic downturn on the horizon. Since private equity activity is poised to withstand economic uncertainty, law firms will see continued demand for its attorneys that work funds in both fundraising and deployment of capital. Firms, partners, associates, and law students in the space can be comforted by knowing private equity activity may experience a mild slowdown but will not stop.
Jordan Severo is a second-year law student at Wake Forest University School of Law. He holds a Bachelor of Arts in Finance from Rochester Institute of Technology, where he graduated summa cum laude. Upon graduation, he intends to pursue a career in banking law.
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