Drawdown

There are two very different definitions of this term, which is used widely in investment and fund management:

  1. In the hedge fund and broader investment industry, the term refers to the decline, in percentage terms, between an investment’s previous peak and trough valuations; the greater the drawdown, the greater the fall in value
  2. In the world of private, closed ended funds, such as private equity, however, the term is broadly synonymous to a “(capital) call” – the process of drawing monies (capital and loans) into the fund

It is the latter which will occupy us in this article.

The unusual structure of private equity fund investing means that the investors who are Limited Partners in a partnership fund make “commitments” to a fund, with that committed capital “drawn down” or “called” in coordination with the fund making an investment, or incurring expenses borne by the Limited Partners, as detailed in the Limited Partnership Agreement (LPA). It is therefore possible (depending on the investment activity of the fund) that a Limited Partner doesn’t need to pay money to fund its commitment for some considerable time (other than for set up and operating fees). It is not uncommon to have a fund that holds a first legal close on commitments, where monies are not drawn down for several months.

Indeed, it is very often the case that a fund is never quite 100% drawn, because the fund manager will retain some element of the drawable funds throughout the life of the fund to be able to pay for potential or planned follow-on funding rounds, as they arise, or to pay fees/expenses.

During the initial investment period of a private equity fund, it is usual for management fees to be levied on the total amount committed to the fund – not the amount actually drawn and invested. After the investment period of the fund, for example the first five years of a ten year fund’s life, management fees will often be calculated only on the invested amount, but there is considerable variation in this.

So, why does the commitment and drawdown system exist? The investment pattern of a typical private equity fund sees it invest over a period of, typically, 4-5 years. Drawing all of the cash of the Limited Partner’s commitments to the fund INTO the fund on day one would see that cash sitting dormant – and this would crush the IRR. To reduce the amount of inactive cash in the fund, monies are drawn down from investors as close as possible to the time when they are actually to be invested. This also means LPs can use the undrawn monies elsewhere to earn a return before they are drawn down into the fund.

Fund managers communicate the need to draw down funds from the Limited Partners through a DRAWDOWN NOTICE.