How Bridge Loans Distort IRRs

Encouraged by low interest rates and restrictive credit markets, general partners seeking alternative sources of debt are turning to bridge loans. In fact, approximately 70 to 75 percent of mid-market buyout funds have used bridge loans, according to Buyouts Magazine.

Private equity firms use bridge loans to finance the equity (and sometimes debt) portions of deals in their early stages, typically keeping bridge loans in place for six months to a year before replacing them with investor capital, and sometimes permanent debt. Bridge loans enable private equity sponsors to close acquisitions quickly, without relying on investor capital. Limited partners can also better anticipate capital calls.

Perhaps one of the greatest advantages to bridge loans is the boost to fund IRRs by injecting debt and delaying the use of investor capital. But does this jump in fund IRRs accurately reflect the true nature of performance over the life of the fund?

The answer is no, according to Dr. Oliver Gottschalg. Dr. Gottschalg recently investigated bridge lending’s effect on fund IRRs by analyzing 149 funds from vintages 2003 to 2006 to determine if these facilities fundamentally changed fund performance. He calculated fund IRRs based on their original capital calls and compared them to IRRs for funds using bridge loans. He found that over 90% of all median fund IRRs increased, and the median uplift was by 58 basis points. Importantly, however, the effect was not uniform: 10% of funds had an increase of more than 255 basis points and in extreme cases, fund IRRs were impacted by over 1,000 basis points. These extreme cases show once again the oversensitive nature of IRR. The PERACS Rate of Return, which more accurately measures annualized absolute performance , confirms the median uplift of 58 basis points, for none of the funds, the simulated bridge loan moves the needle in terms of PERACS Rate of Return more than 500 basis points according to his calculations. At the same time, he also concluded that bridge loans my dampen investment multiple because of fees and interest payments associated with the bridge loans.

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