Fund finance: toeing the line

Guidance unveiled by the investors’ trade body on subscription lines comes as the industry is getting to grips with best practice on this now-controversial issue, Thomas Duffell writes.

A brouhaha has broken out over fund managers’ use of subscription credit lines in recent months. The Institutional Limited Partners Association has waded into the debate by issuing guidance to help ensure they are used appropriately.

The private equity investor trade body urged members to take responsibility for checking they are informed about a manager’s use of these lines, specifically any impact they may have on performance. The association asked investors to dig deeper into how they affect firms’ track records, and to compare levered and unlevered IRRs.

Some investors are already taking a firmer role in negotiating subscription finance provisions in their limited partnership agreements. At the Fund Finance Association conference in Hong Kong in June, fund managers and fund formation lawyers discussed how investors are increasingly dictating the time frames in which a subscription line should be repaid. In a hypothetical example explored at the event, should a repayment not happen within a predetermined time frame, an investor will be deemed to have funded its capital contribution for the purpose of calculating the IRR.

The lobby group also called for fund managers to agree to “reasonable thresholds” for the use of credit lines, such as establishing the longest period for which they can be used and a maximum percentage of the uncalled capital that can be borrowed against. Event participants said the length of subscription lines were already trending downward, with more flexible arrangements now having a six- to 12-month timeframe. Best practice today is for lines to reflect between 15 and 25 percent of a fund’s uncalled capital, they noted.

ILPA also reflected on the use of these facilities when exiting investments, which effectively involves managers drawing capital from these lines once an exit is determined and then repaying the lines once it completes. This shortens a fund’s hold period and further boosts its IRR, something ILPA points out should not be permitted. Some of sister publication PERE’s sources have already distanced themselves from the practice, with one arguing investors would question lines used this way.

Tracking changes

The noise around fund managers’ use of these lines has sharpened the industry’s focus on how they are used. Provisions are even being made for the worried. One source said investors that communicate their concern can be given parallel levered and unlevered fund reports, meaning they can use whichever numbers best suits their purpose.

It’s also a reminder that an astute investor’s due diligence process is always being fine-tuned. One real estate head at a US public pension plan said that his chief investment officer circulated the ILPA report as a reminder that it should be asking all GPs about the use of subscription lines. The pension plan has also started periodic lunchtime briefing sessions to review best practices. Having the industry body give official guidance can only help.