Subscription-Secured Credit Facilities
July 24, 2018
By Bonnie Sussman
We have seen an increasing number of managers utilizing subscription-secured credit facilities over the last few years. As reported by eVestment, two-thirds of managers now use credit facilities and, as reported by Reuters, “Fund financing is one of the fastest growing areas of the syndicated loan market….”
So, what are subscription-secured credit facilities? They are loan facilities from banks to close-ended funds, backed by the commitments of the funds’ investors. Investors are legally committed to the funds in the amount of their unfunded commitments. Historically, such credit facilities were mainly used to bridge the time between a capital call, which can take multiple weeks, and funding an investment. These loans were typically repaid back within 90 days from the drawdown date. More recently, however, due to relatively low interest rates, these credit lines have developed beyond a bridging function.
Subscription-secured credit facilities are beneficial to both fund managers and investors.
Benefits to fund managers:
- Managers can bridge the time between a capital call and making an investment.
- Managers have more flexibility to execute deals and pay fund expenses without making frequent capital calls.
- The fund’s Internal Rate of Return (“IRR”) is enhanced by delaying capital calls. Capital calls can drag the IRR by holding onto cash (I will go into more details later).
- Timing and amounts of capital calls are more predictable and exact. This allows funds to not carry excess cash (and drag IRR).
- For general partners, the preferred return calculation (similar to the IRR calculation, see illustration below) is accelerated causing an earlier payout of carried interest.
Benefits to investors:
- Many institutional investors can have numerous capital calls across their private equity investments. The use of credit facilities reduces administrative headaches of funding multiple and frequent capital calls.
- Investors have the opportunity to make short-term investments with their uncalled capital.
However, despite the benefits, it is important to note some of the downsides to credit facilities:
- Additional expenses are incurred, such as interest and borrowing costs.
- The final benefit mentioned for managers could be a downside for investors. The investors may pay carried interest earlier due to the preferred return calculation being accelerated.
- The first benefit mentioned for investors could also be a downside. Investors may take on more investment and liquidity risk by mismanaging and over-utilizing their uncalled capital.
Internal Rate of Return
IRR is an important performance metric in the private equity space. As noted above, funds using credit facilities tend to report higher IRRs relative to similar funds not utilizing such lines. See below for a simplified illustration:
|Date||Description||Fund A*||Fund B**|
|01/01/18||Capital call for investment||$ (1,000)||Drawdown|
|01/01/18||Capital call for management fees||(20)||Drawdown|
|01/01/19||Capital call for investment||$ (1,000)|
|01/01/19||Capital call for management fees||(20)||(40)|
|01/01/19||Capital call interest||(55)|
|01/01/20||Capital call for management fees||(20)||(20)|
|01/01/21||Capital call for management fees||(20)||(20)|
|01/01/22||Capital call for management fees||(20)||(20)|
|12/31/22||Distribution from sale of investment||1,800||1,800|
|*Fund A does not utilize a subscription-secured credit facility
**Fund B utilizes a subscription-secured credit facility
U.S. GAAP requires disclosure of the inception-to-date IRR. It is calculated based on the cash inflows and outflows and the ending net assets at the end of the period.
As shown in the above illustration, the investment, management fees and distribution amounts are the same for both funds. Fund B, with a credit facility, pays interest, which is an additional expense. Even though it incurs $55 of additional expense, the IRR is still higher when compared to Fund A. This is driven by the deferral of capital contributions in the early years where the dollar is more heavily weighted.
Since not all managers utilize subscription-secured credit facilities, IRRs have been difficult to evaluate as U.S. GAAP does not require disclosure of unlevered IRR. However, we have seen many managers disclose both levered and unlevered IRRs on their financial statements. This is an additional disclosure by the fund to be more transparent to the investors. Investors should look beyond traditional IRR calculations to measure a fund’s performance.
In June 2017, the Institutional Limited Partners Association (“ILPA”), a trade association for institutional limited partners in the private equity asset class, issued a white paper called “Subscription Lines of Credit and Alignment of Interests, Considerations and Best Practices for Limited and General Partners.” They provided recommendations on the use of subscription lines, which include the following:
- Within partnership agreements, waterfall provisions should specify that the date used to calculate the GP’s preferred return hurdle aligns to when the credit facility is drawn, rather than when capital is ultimately called from the LPs.
- Managers using credit lines should disclose to their LPs the following as part of quarterly reports:
- The balance and percent of total outstanding uncalled capital. Such disclosures should be provided as part of a holistic reporting of the total debt/credit in use by the fund.
- The number of days outstanding of each draw down.
- The current use of the proceeds from such lines, i.e., solely to bridge capital calls (and the nature of those capital calls), or for other purposes (such as accelerated distributions).
- Net IRR with and without the use of the credit facility.
- Terms of the line (upfront fee, drawn and undrawn fees, etc.).
- Costs to the fund (interest and fees).
- Managers are advised against using these facilities to cover fund distributions in anticipation of, but prior to, a portfolio company exit.
- Disclosure of investment details in the underlying portfolio should not lag the execution of a deal due to capital calls delayed by use of these facilities. Reporting should be on a mutually agreed and reasonable basis, regardless of the timing of the capital call.
- Provisions addressing use of subscription facilities within partnership agreements should delineate reasonable thresholds for their use, such as:
- A maximum percentage of all uncalled capital, e.g., 15-25%. Subscription facility exposure should be considered and reported holistically, taking into account the more traditional limitations on fund borrowings for any other purpose.
- A maximum of 180 days outstanding.
- Maximum period of time for which such lines can be utilized, aside from agreed upon parameters related to the maturity of such facilities.
It seems that subscription-secured credit facilities are here to stay and their use will continue to grow. As noted above, these credit facilities offer flexibility to both fund managers and investors by better aligning capital calls with a fund’s actual need for cash and allowing investors to minimize administrative work, while maximizing potential return. As the use of these facilities grow, fund managers and investors will need to collaborate to ensure transparency and comparability between funds.
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