Utilised as a short-to-medium-term substitute for LP capital, the use of subscription lines of credit has grown significantly in private equity funds. As their popularity rises, Executive Director Charlotte Cruickshank highlights the benefits they can offer and why investors should welcome the Institutional Limited Partner Association's (ILPA) updated guidelines for increased industry transparency.
Private capital funds have long used subscription credit facilities as a method of short term financing. It's easy to see why; they offer fundamental benefits to both fund managers and investors. From improving GP liquidity, cash flow management and competitiveness in the bidding process, to reducing the administrative burden of both GPs and LPs, subscription financing can provide a more efficient solution to traditional capital calls.
Combined with relatively low borrowing rates, subscription lines of credit have consequently surged in popularity and fund Limited Partnership Agreements (LPAs) have become less restrictive. GPs are now using fund-level credit facilities in larger amounts and for longer periods. With this, we have seen the development of credit facilities so that now, in addition to covering the working capital requirements of the fund, they also permit their use to fund investments, fees, expenses and other liabilities. One estimate puts the value of outstanding subscription lines at $400 billion globally.
For GPs there is another added bonus. The use of a credit facility rather than investors' capital has a positive effect on the fund's internal rate of return (IRR) - a key component used by many private equity professionals to measure a fund's performance. Not only does this boost their performance, it also reduces the amount of preferred return attributable to the LPs in the waterfall. This will result in GPs receiving their carry sooner than would have otherwise been possible.
Whilst some LPs welcome the use of such facilities and the flexibility they offer in terms of having to fund fewer capital calls, other LPs may prefer to have their capital at work as soon as deals are identified. Investors are also frequently concerned at the cost and systemic risks given their often sizeable exposure to such facilities. Despite a prolonged period of low interest rates, there are other costs associated with such facilities borne by the fund which will not generate additional investor returns, unlike specific investment level leverage.
The push for transparency
As the popularity of subscription lines of credit has increased and their utility has expanded, their effect on IRRs has come under scrutiny. Some claim the IRR 'performance boost' distorts the true performance of the fund but as echoed by ILPA in its third iteration of the Private Equity Principles (PEP) released in June this year, over-reliance on IRR as a measure of performance is ill-advised.
Questions surrounding the use of subscription lines of credit are reflective of the growing demand for data transparency in the private funds industry. Many institutional investors and consultants may lack the expertise, time or resource to judge the true performance of complex, multi-asset portfolios. The use of subscription lines of credit needs to be transparently and fully disclosed. In response to this concern and to foster best practice between GPs and LPs, the ILPA's updated PEPs recommend that:
- Quarterly and annual reporting should include a schedule of fund-level leverage, including commitments and outstanding balances on subscription lines and any other credit facilities in use by the fund.
- LPs should be provided with performance information (ITT, TVPI and/or MOIC) with and without the use of facilities both during fundraising and included in regular reporting over the life of the fund. This allows for performance comparisons on a vintage year basis and relative to other funds.
- The terms for any such subscription lines should be disclosed or available to LPs on request.
Any subscription line facilities used should be reasonable in both size and as a percentage of the total fund as well as duration.
- LPs should be offered the option to opt out of a facility at the outset of the fund, together with a reasonable window of at least 10 business days for LPs to respond to capital call requests.
- At the time of the fund close, or on the occurrence of initiating such a facility, GPs should disclose to all LPs:
- The anticipated size of any facilities contemplated.
- Proposed limits on duration (both clean-up and term).
- Parameters around the intended use of proceeds.
- Protocols for regular disclosure of the total amount outstanding and any costs incurred by the fund related to the use of such facilities, including estimated basis points on the front end, unused fees, and interest rates. Current rates should be explicit.
- How commitment-secured facilities or NAV-secured facilities will be treated in the context of overall leverage limitations on the fund (e.g. facilities to increase investment capacity of the fund versus bridging facilities).
The revised principles are ILPA's latest attempt to bridge LP and GP expectations and whilst for guidance only, they do offer helpful clarity for expectations of the industry. Investors should welcome the additional transparency and the option to opt out. As the guidelines percolate through the industry, GPs can expect queries of this nature when they next fundraise as the terms of the partnership agreements are agreed.
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