The use of subscription lines of credit (also referred to as subscription facilities, capital call facilities and subscription lines of financing) has come under fire by private equity investors over the last few years. These lines of credit, which typically clear within 90 days, were initially intended to be short-term capital bridging facilities. Often used to reduce the administrative burden on limited partners, subscription lines decrease the frequency of capital calls and allow general partners to close investments more quickly. Some fund managers have moved subscription lines beyond their original scope by stretching their duration well past 90 days and in some extreme cases, up to five years. This behavior can increase reported fund internal rates of returns (IRR), because IRR is a time-weighted measure and the calculation does not begin until capital is called. Using a subscription line delays the capital investment by a limited partner; thus an underlying investment can begin to appreciate before any capital is actually called from a fund’s investors. Depending on how aggressively lines of credit are used, their use could boost performance by hundreds of basis points and could even be the difference between a fund exceeding its hurdle rate and the manager collecting carried interest, or not accomplishing either goal.
Because of this potential for fund-level performance engineering, it has become much more difficult for limited partners to compare the performance of one manager to another, or to its appropriate benchmarks – primarily because the success of the underlying investment activity is obscured by the impact of the leverage used. Further, because most mainstream private equity benchmarks are based on the aggregate performance of comparable funds, it’s nearly impossible to even determine how much leverage is embedded into those benchmarks.
Other issues with the aggressive use of these lines include, but are not limited to, the following:
- Potential for limited partners to pay general partners a higher level of carried interest versus an unlevered fund, given the fact that general partners earn incentive fees based on IRR.
- Lower net performance multiples, as the cost of a subscription line is a direct fund expense.
- Potential to generate unrelated business taxable income, which could present problems for tax-exempt investors.
- The possibility that a systematic market event that triggers the simultaneous calling of subscription lines across firms could cause liquidity issues for limited partners.
Understanding the source of investment performance is more necessary than ever, and the Institutional Limited Partners Association has worked extensively with the limited partner community to raise awareness of the potential issues with the use of subscription lines. Given the lack of reporting uniformity across the industry, however, it is incumbent upon limited partners to work directly with their current and prospective managers to understand how reported returns are generated. Taking into account the potential for misinterpreting the strength of a manager’s reported IRR, perhaps limited partners should pay more attention to net total value to paid-in multiple (TVPI), which measures an investment’s remaining value and returned capital versus invested capital, and distributions to paid-in multiple (DPI), which measures returned versus invested capital. After all, while time-weighted return is a good indicator of value when used properly, TVPI and DPI should be used in conjunction with internal rate of return because “you can’t eat IRR.”
* 2017 analysis assumes 4-year investment period, 8-year fund term, 4-year wind-down, 1.25% management fee, 20% carry, 8% preferred return, 100% catch-up, 2.8% cost of leverage, 0.25% undrawn cost and 2.00x gross TVPI.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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