Since Oaktree’s Howard Marks sounded the alarm on subscription line financing, criticism has rained down on an established product. Kalliope Gourntis spoke to investors and managers across the private asset classes about the facilities.
“You ask 10 people a question and you get 10 different points of view,” says Neil MacDougall, managing partner at London-based private equity firm Silverfleet Capital.
The topic of discussion is subscription credit lines: short-term loans used by fund managers to deploy capital quickly when an investment opportunity arises and to enable them to call only the amount of capital actually needed.
“First, it just makes cashflow for a fund work a lot better,” Thomas Draper, a partner at Ropes & Gray, explains. “You don’t have to wait for your investors. You can borrow on one day’s notice and call capital afterwards. It works much more smoothly for transactional PE-style funds.”
Managing cashflow is one of the main reasons the managers, typically general partners of closed-ended funds, cite for using credit lines.
“Let’s say a manager has a deal that requires cashflows to be spread out over time,” a leading infrastructure fund manager says. “Instead of buying a business for $500 million today, the GP is going to put in $100 million, then another $20 million and so on and so forth, as certain milestones are reached.
“In some cases, GPs have a significant number of LPs in their funds, so it doesn’t make sense to make these individual capital calls which would be very modest – or as some people call them ‘nuisance level.’ [Subscription line financing] allows managers to aggregate them and then net out the cashflows and then clean them up periodically.”
It also depends on the nature of the fund, the nature of the investments, the existence or lack of interim cashflows, interest income or distributions, he notes.
Paris-based private equity firm Ardian uses them in the same way. “If we make an investment that requires us to pay in several installments, instead of calling everyone for small amounts, we wait to group these investments, using the facility in the meantime to fund them,” Ardian’s head of infrastructure Mathias Burghardt says. “And LPs accept that.”
Ensuring investors understand how and why these facilities are used requires transparency and communication.
“I think if you are transparent about utilisation, if you do manage communications properly and you do tell people when they will be asked for their money, that should give them greater ability to manage their own cashflows,” MacDougall says.
In addition to being transparent and communicating openly with clients, managers can also use the limited partnership agreement as a framework to set the ground rules.
“This kind of facility, what you can do or can’t do with it, can be crystal clear in the management contract with the LP,” Burghardt points out. “And we certainly have very clear rules in terms of what we should and shouldn’t do with our investors.”
The leading infrastructure manager adds: “Some LPAs specifically preclude the fund from being leveraged, which means these facilities cannot create the unintended effect of increasing risk.”
A UK-based banker also makes that important distinction. “We have a set of criteria to control risk from our perspective. So, first and foremost with these facilities is: we don’t see them as permanent leverage. And I think that’s the important thing. Managers shouldn’t be using these to leverage up the fund,” the banker says.
“We can provide them for longer than a year but we don’t expect any loans to be outstanding longer than that. If you’re drawing down, you should be paying back the clean-down on any draw-downs. You may be able to post letters of credit for longer than that if you need to, but the 12-month restriction around drawings is a regulatory restriction as well. You can go longer, but then I think you start to get much more penalised from a regulatory standpoint.”
It is important to note that Silverfleet and Ardian typically clean down these facilities every 12 months.
“I think you could question the ‘ethics’ of funding beyond a 12-month period. Obviously the longer you build up this stock of undrawn capital, the more Marks is correct,” MacDougall adds, referring to Oaktree founder and co-chairman Howard Marks, who sounded the alarm bell over the ‘fairly pervasive’ use of these products in a memo to clients in April.
Questions raised by Marks’s memo surround the potential manipulation of internal rates of return to improve managers’ performance fees as well as their reputation.
Many managers will admit that the use of these facilities positively impacts IRR, although they will also point out that, for private equity type funds, money multiple is the more important performance metric.
The caveat there is that managers could use subscription line financing to boost their IRRs so they can hit their hurdle rates faster, unlocking their carry. But while the UK-based banker we spoke with also acknowledges that delayed capital calls can improve IRR, he points out that “[enhanced IRR] does not make up for the fact that, if you’ve overpaid for an asset and you don’t deliver, this isn’t going to save you. So, I really think people are focusing on the wrong thing”.
Still, it is hard to ignore statements such as that by Andrew Brown, a senior consultant at Willis Towers Watson, the world’s largest pension fund advisor. “I suspect that all private equity fund managers are looking into this as they realise that without using subscription line financing, they are being left behind when it comes to their [internal] performance [calculations],” Brown told the Financial Times in October.
In May, a UK-based fund manager confirmed Brown’s suspicion, saying his firm was going to use a subscription credit line for its latest fund for the first time because it would be “in the minority” otherwise. According to him, these credit lines are more common in the US and among funds heavily invested in by US public pension funds, whose own managers are compensated on an IRR basis. The fund management firm would be at a disadvantage when compared with other managers if it were deprived of the boost to its IRR these facilities provide.
Another point of contention is the cost of servicing these facilities and what that means in terms of reduced final returns for investors.
“The cost is very, very economical,” MacDougall argues. “And the reason the cost is so low is because the banks know that credit exposure is very, very limited.”
Draper supports this view. “Compared with most credit facilities, the interest rate and fees for capital call facilities are quite low,” he says.
“The rates are based on the creditworthiness of the fund investors, most of whom are investment grade. Legal fees seldom exceed $250,000 for borrower and lender counsel combined, and are often lower.”
In exploring the pros and cons of these facilities and some of the worst-case scenarios presented by Marks in the Oaktree memo, the leading infrastructure manager explains why he believes the worst-case scenario – investors becoming levered and defaulting on their commitments – is highly improbable: “If an investor defaults on a capital call, we basically have the right to take everything they already have in the fund and redistribute it. This is why a lot of banks require that you’ve already called some capital before extending you the line of credit. […] Once investors have skin in the game, it is catastrophic for them to default on their capital commitment.”
It is clear there are rules and conditions in place to ensure that subscription line financing serves as a useful tool for both managers and investors alike. Furthermore, as MacDougall points out, “the International Limited Partners Association is on top of this, wanting disclosure as to the use of drawdown facilities.”
Still, the industry would be best advised to stay vigilant. As Marks stated in his memo: “The key to financial security – individual or societal – doesn’t lie in counting on things to work in good times or on average. Rather, it consists of figuring out what can go wrong in bad times, and of only doing things that will prove survivable even if they materialise.”