Everything in moderation

Investors are broadly happy with the benefits that subscription lines can bring their funds, but the facilities may contain restrictions they need to be aware of. Andy Thomson reports.

When Howard Marks, co-chairman of Oaktree Capital Management, issued a memo in April exploring the use of subscription credit lines by private fund managers, investors paid attention.

Investors that Real Estate Capital’s sister publication Private Equity International spoke to can see pros and cons for the financing method.

Jeremy Golding

Jeremy Golding, founder and managing director of Munich-based fund of funds manager Golding Capital Partners, says he is seeing subscription lines used extensively in both private equity and private debt funds, even by those at the small- to mid-cap end of the market. “Some GPs may be more cautious than others, but these days nearly everyone will use such a facility if they can. It’s a good tool; financing is cheap and it’s a sensible way to leverage if used in moderation,” he says.

Golding highlights cash management, arguing that fewer but more sizeable capital calls make life easier. He also points to improved IRRs and the reduction of the J-curve as compelling reasons for using subscription lines.

But there’s no such thing as a free lunch.

“Any financing still has to be paid for regardless of how low interest rates are, so you end up with a trade-off between higher IRRs at the outset and lower multiples over the long term.”

Golding also has reservations about the way in which the true performance of a fund may be obscured. “Comparing like with like becomes more difficult. A manager may have delivered a 200 basis points better return than expected, but was that through smart deal selection or simply down to the use of leverage?” asks Golding.

Indeed, some investors are now inclined to discard IRR as a standard measure of performance. “We are… focusing more on investment multiple, both the unlevered and levered equity multiples in addition to the distributions to paid-in capital,” says Anthony Breault, senior real estate investment officer at the Oregon State Treasury. “With greater use of subscription lines in the levered strategies, it is becoming less relevant to use IRR as a metric to determine performance.”

Time critical

Another bone of contention is the tenor of the subscription line, which can vary greatly from a month to – in at least one case – years. The longer the subscription line is in place, the greater the possibility that an investor commitment does not get fully drawn down.

“There is one concrete example I am aware of where more than the raised fund volume was deployed by the fund while only 65 percent was called from investors,” one European institutional investor confides.

Peter Schwanitz, managing director and European co-head at Portfolio Advisors, the investment advisory and portfolio management firm, says: “For investors that are not able to run an over-commitment strategy and/or are facing negative interest rates, it would be better to have the committed capital at work in the LP investments than the use of subscription lines. However, notwithstanding investors desire to put capital to work, subscription lines in today’s low interest rate environment should enhance LPs’ net IRRs.”

Another potential issue is investors extracting themselves from funds they no longer wish to be in. Experts advise investors that may want to consider secondaries deals to examine the small print of proposed fund financing facilities with care given that, under certain circumstances, they may face difficulties in transferring.

“LPs will tend to have side letters with certain rights and some will ask for information about fund financing. But are they so familiar with fund finance that they know the facility agreement may put restrictions on secondaries transactions?” asks Kate Ashton, a partner in the London office of law firm Debevoise & Plimpton. She points out that facilities are generally secured against a set percentage of commitments made by the so-called “borrower base” of the fund, which normally comprises the most creditworthy investors.

If numerous investors within the borrower base want to exit the fund at the same time, it could result in the facility not being sufficiently secured. “If the borrowing base starts to get close to the amount borrowed under the facility, a transfer by an LP could ultimately lead the borrower to end up in a default scenario,” says Ashton.

But can the provider of the facility prevent such a transfer? Until recently, the answer would probably have been no, but things may now be changing – with providers of subscription lines increasingly looking to take control of the issue.

“The bank may ask for an express covenant restricting LP transfers [above an agreed transfer threshold] without its consent,” says Tom Smith, a partner and colleague of Ashton at Debevoise & Plimpton.

Unless investors successfully push back against such covenants, they may discover that strategic flexibility and improved IRRs for the manager may come at a price for them.