Credit facilities are not controversial when used for their original purpose: allowing general partners to deploy capital rapidly and efficiently rather than waiting for LPs to respond to capital calls. It is only when these facilities are used for longer periods of time – with a resulting effect on internal rates of return – that they become an issue. “That to me is a massive problem,” said Brady Hyde, former portfolio manager of private equity investments at UPS Group Trust. “We wouldn’t invest with the manager.”
The use of a facility does boost IRR to a certain extent. A model by private equity advisor TorreyCove shows that if a $100 million fund uses 100 percent debt financing for the first two years, and realises $200 million at the end of year six, the credit line offers an IRR boost of 300 basis points and negatively affects MOIC by 0.12 turns, compared with not using any facility. These findings underscore the need for greater transparency, such as reporting net IRR both with and without the credit line.
LPs are divided on the issue. Those that favour IRR as a metric – either for the sake of their own personal compensation or for the sake of comparing private equity with other asset classes – are more in favour than those that focus on multiple of invested capital.
The Institutional Limited Partners Association issued a nine-point guidance on the use of these lines in June, which recommends partnership agreements “delineate reasonable thresholds for their use”, including setting a maximum of 180 days outstanding. However, the organisation is said to be in the process of revising these guidelines after industry feedback, so this could change.
There are tax consequences for tax-exempt LPs. If a fund purchases an asset with a credit line, the income from it may make a tax-exempt investor taxable. However, there are ways for fund managers to mitigate this.
It’s difficult to get a sense of the scale of their use, but Jeff Johnston, chairman of the Fund Finance Association, tells as that “virtually every one” of the firms in the top 100 of the PEI 300 uses a subscription line.
Subscription lines may put a block on attempted transfers of LP interests – something many LPs may not be aware of until they attempt to implement one. As the security for the facility is the LPs’ uncalled capital commitments, some facilities contain covenants that place limitations on LP transfers.
There are some strategies and asset classes for which subscription lines make more sense. For example, Johnston says the longest, deepest penetration has been in the real estate sector. The use of these lines arguably makes the most sense for secondaries funds, as the nature of the strategy means they could get calls from hundreds of different LP interests they own to fund capital commitments at any moment, one banker told us. As those calls can happen on a near-daily basis, a secondaries fund would have to sit on a large cash reserve, which would drag down returns.
The risk of default is “minute”, one LP told sister publication Private Equity International, based on the credit-worthiness of the limited partners, the size of the facility – typically around a fifth of the total fund size – and repayment term, typically a year.
LPs may be tempted to add leverage to their portfolios. If capital that should have been drawn down is left on investor’s balance sheets, “it means we will be underweight [against] our target and have to make a decision as to where we put that money”, according to Prudential Portfolio Management Group’s alternatives head Michael Howard. “If you redeploy it elsewhere then your programme is levered.”