“You ask 10 people a question and you get 10 different points of view,” says Neil MacDougall, managing partner at London-based Silverfleet Capital.
The topic of discussion is subscription credit lines: short-term loans used by fund managers to deploy capital quickly when an investment opportunity arises and to enable the GP to call only the amount of capital that is actually needed.
“First, it just makes cashflow for a fund work a lot better,” Thomas Draper, a partner at Ropes & Gray, explains. “You don’t have to wait for your investors. You can borrow on one day’s notice and call capital afterwards. It works much more smoothly for transactional PE-style funds.”
Managing cashflow is one of the main reasons the GPs we spoke to cited for using credit lines.
“Let’s say a manager has a deal that requires cashflows to be spread out over time,” a leading infrastructure fund manager says. “Instead of buying a business for $500 million today, the GP is going to put in $100 million, then another $20 million and so on and so forth, as certain milestones are reached. In some cases, GPs have a significant number of LPs in their funds, so it doesn’t make sense to make these individual capital calls which would be very modest – or as some people call them ‘nuisance level.’ [Subscription line financing] allows managers to aggregate them and then net out the cashflows and then clean them up periodically,” he continues, noting that it also depends on the nature of the fund, the nature of the investments, the existence or lack of interim cashflows, interest income or distributions.
Paris-based Ardian also uses them in the same way. “If we make an investment that requires us to pay in several installments, instead of calling everyone for small amounts, we wait to group these investments, using the facility in the meantime to fund them,” Ardian’s head of infrastructure Mathias Burghardt says. “And LPs accept that.”
Building trust
Ensuring LPs understand how and why these facilities are used requires transparency and communication.
“I think if you are transparent about utilization, if you do manage communications properly and you do tell people when they will be asked for their money, that should give them greater ability to manage their own cashflows,” MacDougall says.
In addition to being transparent and communicating openly with clients, GPs can also use the limited partnership agreement as a framework to set the ground rules.
“This kind of facility, what you can do or can’t do with it, can be crystal clear in the management contract with the LP,” Burghardt points out. “And we certainly have very clear rules in terms of what we should and shouldn’t do with our investors.”
“Some LPAs specifically preclude the fund from being leveraged, which means these facilities cannot create the unintended effect of increasing risk,” the infrastructure manager explains.
A UK-based banker also makes that important distinction. “We have a set of criteria to control risk from our perspective. So, first and foremost with these facilities is: we don’t see them as permanent leverage. And I think that’s the important thing. Managers shouldn’t be using these to leverage up the fund,” the banker says.
“We can provide them for longer than a year but we don’t expect any loans to be outstanding longer than that. If you’re drawing down, you should be paying back the clean-down on any draw-downs. You may be able to post letters of credit for longer than that if you need to, but the 12-month restriction around drawings is a regulatory restriction as well. You can go longer, but then I think you start to get much more penalized from a regulatory standpoint.”
It is important to note that Silverfleet and Ardian typically clean down these facilities every 12 months.
“I think you could question the ‘ethics’ of funding beyond a 12-month period,” MacDougall remarks.
“Obviously the longer you build up this stock of undrawn capital, the more Marks is correct,” he adds, referring to Oaktree Capital Management founder and co-chairman Howard Marks, who sounded the alarm bell over the ‘fairly pervasive’ use of these products in a memo to clients in April.
IRR trickery?
Other questions raised by Marks’s memo surround the potential manipulation of internal rates of return to improve GPs’ performance fees as well as their reputation.
Many GPs will admit that the use of these facilities positively impacts IRR, although they will also point out that, for private equity type funds, money multiple is the more important performance metric.
The caveat is that managers could use subscription line financing to boost IRRs so they can hit their hurdle rates faster, unlocking their carry. But while the UK-based banker we spoke to also acknowledges that delayed capital calls can improve IRR, he points out that “[enhanced IRR] does not make up for the fact that, if you’ve overpaid for an asset and you don’t deliver, this isn’t going to save you. So, I really think people are focusing on the wrong thing.”
Still, it’s hard to ignore statements such as that by Andrew Brown, a senior consultant at Willis Towers Watson, the largest pension fund advisor in the world. “I suspect that all private equity fund managers are looking into this as they realize that without using subscription line financing, they are being left behind when it comes to their [internal] performance [calculations],” Brown told the Financial Times in October.
In May, a UK-based fund manager confirmed Brown’s suspicion, saying his firm was going to use a subscription credit line for its latest fund for the first time simply because it would be “in the minority” otherwise.
According to this person, these credit lines are more common in the US and among funds heavily invested in by US public pension funds, whose own managers are compensated on an IRR basis. The fund management firm would be at a disadvantage compared with other managers if it were deprived of the boost to its IRR these facilities provide.
Low cost
Another point of contention is the cost of servicing these facilities and what that means in terms of reduced final returns for investors. “The cost is very, very economical,” MacDougall argues. “And the reason the cost is so low is because the banks know that credit exposure is very, very limited.”
Draper supports this view. “Compared with most credit facilities, the interest rate and fees for capital call facilities are quite low,” he says. “The rates are based on the creditworthiness of the fund investors, most of whom are investment grade. Legal fees seldom exceed $250,000 for borrower and lender counsel combined, and are often lower.”
In exploring the pros and cons of these facilities and some of the worst-case scenarios presented by Marks in the Oaktree memo, the infrastructure manager explains why he believes the worst-case scenario – LPs becoming levered and defaulting on their commitments – is highly improbable: “If an investor defaults on a capital call, we basically have the right to take everything they already have in the fund and redistribute it. This is why a lot of banks require that you’ve already called some capital before extending you the line of credit. […] Once investors have skin in the game, it is catastrophic for them to default on their capital commitment.”
It is clear there are rules and conditions in place to ensure that subscription line financing serves as a useful tool for both GPs and LPs alike. Furthermore, as MacDougall points out, “the International Limited Partners Association is on top of this, wanting disclosure as to the use of drawdown facilities.”
Still, the industry would be best advised to stay vigilant. As Marks stated in his memo: “The key to financial security – individual or societal – doesn’t lie in counting on things to work in good times or on average. Rather, it consists of figuring out what can go wrong in bad times, and of only doing things that will prove survivable even if they materialize.” ?
For richer or poorer
The use of a subscription credit line improves the IRR but diminishes the investment multiple, according to analysis by TorreyCove Capital Partners. The scenario assumes 100 percent debt financing of fund assets for two years, which is extreme. None of the GPs pfm has spoken with say they would leave a facility outstanding for more than 365 days.
SEC homes in on IRR calculations
Private equity firms should review their internal rate of return calculation methodology as the Securities and Exchange Commission turns its attention to disclosures, lawyers say.
The regulator is scrutinizing IRR calculations after concerns about inconsistent methodology among firms, law firm Jones Day said in a client note.
“Inclusion or exclusion of capital from reinvestment, capital from subscription or other lending facilities, or capital from the fund sponsor or other entities that do not pay fees or carried interest can all affect the resulting IRR,” the note said.
Apollo Global Management was subpoenaed for information by the SEC in December over disclosure of IRR calculations for private equity funds, according to the firm’s 10-K filing. The nature of the regulator’s concerns is undisclosed and the investigation ongoing.
Fund sponsors must ensure reported IRRs provide “a fair and accurate reflection of investment performance,” the note added.
The SEC requires investment advisors to deduct fees, commissions and other expenses from their calculations, so investors are provided with net, rather than gross, performance results, it added.
“In light of the increasing prevalence of, and attention to, subscription line financing, firms that use these credit lines may wish to review the effect of subscription line financing on their IRR calculations and whether any specific disclosure is advisable,” law firm Davis Polk said in a client update.
Some GPs ‘abusing’ credit lines, says LP
The increasing use of long-dated credit lines by fund managers is of major concern to Olivier Carcy, global head of private equity at Indosuez Wealth Management.
“More and more GPs are using credit lines extensively and I would say, to some extent, abusing the use of these credit lines by carrying investments for a long period of time,” says Carcy.
“GPs are pushing hard to increase credit lines in their funds, extending sometimes maturity above one year, for an amount that could reach 30 to 40 percent of the fund.”
Carcy, who manages $3.2 billion allocated to private equity, says credit lines “are very useful and make sense to manage short-term cashflows” but adds that, in his view, these should not extend beyond one quarter.
“As long as it remains a pure short-term working capital facility to ease the life of everybody, I’m fine with it. As a fund of funds manager, we even have one in that context to avoid multiple drawdown to our own investors.”
However, those extending beyond this introduce a new risk into the fund, he adds.
“We are happy to invest in PE funds as long as they remain not leveraged. I mean I’m not buying a CLO, I just want to be unlevered exposed to the underlying assets. We feel that this leverage may create some risks and a certain disalignment of interests.”
What’s more, if LPs’ credit rating is being used to secure a loan that benefits the GP, the LPs should be compensated for it.
“Credit line providers use the credit rating of the LPs, and I do not think, as LP, I’m remunerated for that. As an LP, I should be remunerated for this credit risk that I guarantee with the other investors,” he says.
“My job is to deploy capital, and ultimately to be invested, so why [should I] have to support, even as part of the cost of the fund, some additional indirect costs, when I would prefer to put more money at work into the fund?”
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