I came across two competing narratives on the use of subcription credit facilities for private equity funds: (1) Howard Marks of Oaktree Capital published a memo on subscription lines of credit for closed-end funds and (2) Eileen Appelbaum’s Private Equity’s Latest Con.
Unlike hedge funds, private equity funds call capital from limited partners over time as investments are made, up to the amount of their commitment. Subscription credit facilities allow a funds to use the commitments as collateral for a line of credit.
Subscription credit facilities are substantially different than margin borrowing used by hedge funds. They do not leverage the limited partner’s capital. It acts a temporary substitute for capital, to repaid with a later call for capital from a the limited partners. A $10 million fund can’t invest more $10 million in total, but it may delay calling that capital.
To summarize Mr. Mark’s view of the positives:
- Less frequent capital calls
- Quicker ability to deploy capital from a loan draw
- The use of borrowed money can reduce or even eliminate the deleterious impact on early returns of the so-called “J-curve.”
To summarize Mr. Mark’s view of the negatives:
- Higher expenses for the fund to pay for interest and borrowing expenses
- Lowering the hurdle can increase the GP’s probability of collecting incentive fees and cause the payment of incentive fees to the GP to begin sooner
- Some LPs may actually want to have their capital called and earn their preferred return.
- Complicates the selling of LP interest in a secondary transfer
- Disclosure of LP financial information to the lender
- Possibility of LP default
Ms. Applebaum takes the reduction of the J Curve as a negative and calls it a “sleight of hand.” The J curve is a particular quirk of private equity as it generally requires putting more capital into an investment resulting in a negative return before that new capital starts generating an appreciation for the investment.
Ms. Applebaum and Mr. Marks both agree with the negative distortion of the IRR calculation caused by delaying the capital contributions. Mr. Marks points out that the expenses affect a fund’s overall return and the total amount of IRR. Therefore it also has a effect on the fund manager’s IRR.
Mr. Marks then takes it to the next level by pointing out that IRR is not the single metric that determines a fund’s performance. Investors should also judge a fund by the amount of the capital deployed and the total amount of cash returned to investors.
Some things that funds have done to address the negatives:
- Limit the length a time an investment can be on the line of credit before calling capital
- Eliminating deal-by-deal incentive payments, so that overall fund performance, including the costs of the line, are taken into account
- Reporting overall fund performance along side deal-by-deal performance
Subscription credit facilities provide fund managers with funding flexibility and liquidity, allowing quicker execution. As with any tool, you need to manage the risks.
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