Fund managers must be transparent about what the use of line financing means for investors, says Sally Doyle-Linden, partner and chief financial officer at private equity real estate firm Clearbell Capital.
Subscription line financing – a credit line provided to private investment funds based on the right to call contributions from a fund’s investors – is well established in the real estate sector, and used in many forms.
In a welcome move, banks have recently made the credit line accessible earlier in the fundraising process. Previously, you could not draw on the credit line until capital is called from investors. Now, fund managers find themselves able to make opportunistic investments during the early fundraising period more easily, without needing to draw on investors’ capital. As such, as the banks make this form of credit increasingly accessible, we are seeing subscription line financing become ever more prominent.
But, as this financing grows in favour, is it is starting to be abused?
In our view, the benefits of subscription line financing are clear, as long as investors understand the terms applicable to them.
First, line financing helps with the management of a fund. Rather than investors being called upon to provide capital at the drop of a hat, line financing enables fund managers to produce longer-term timelines and to spread out required investor contributions. This enables investors to have a better handle on what capital they need to provide and when and is particularly important for investors with capital in funds across regions and currencies, where forex considerations are at play.
Second, cashflows can be better controlled. If a fund draws down money from investors to complete a deal which ultimately falls through, fund managers end up sitting on cash until they can repay investors. The credit line acts as a middle man, removing the risks associated with cash being passed back and forth until a deal’s outcome is known.
Third, fund managers can draw on a credit line with 24 hours’ notice. When you compare this with an average notice period of two weeks if looking to drawdown from investors, it is clear that certain opportunistic deals require this speed to be done at the best price.
A final consideration is that the credit line helps equalise the fund. If you draw capital from existing investors to purchase an asset, you ultimately have to pass part of that cost on to new investors brought in during the fundraising process. The credit line avoids having to balance the books between new and old investors while fundraising.
Yet, while we acknowledge the benefits of a credit line for investors and indeed their demand for one, it is key that fund managers are transparent about what the use of line financing means for investors and how their fund is represented.
For example, some managers have been accused of using the credit line to skew gross IRR, a key marketing tool. If you buy an asset on the credit line and don’t draw equity immediately, fund managers can distort internal reporting, inflating investment level returns.
Marketing on a gross basis with the benefit of a credit line, can enable fund managers to market a higher IRR of around 20 percent, when, in reality, an investor is only set to get a net IRR of, say, 14 percent.
While different investors look to different measures as a benchmark of success – with some preferring to focus on net over gross returns – it is important they understand the possibility of IRR being inflated in this way.
Our sense is these accusations are somewhat overblown, given underlying profit is not affected by these calculations and investors’ final expected net returns remain unchanged. But clarity should be provided to ensure all are on the same page.
Perhaps a more worrying for investors would be where fund managers put a number of acquisitions on the line over a period, then make one significant capital call from investors for this total sum. In this instance investors are hit both with a surprise and a significant bill due for payment at short notice. Whilst this is a risk, it is not a trend we are seeing in the real estate sector at present as most funds limit the hold period on the line to six months.
Ultimately, subscription line financing is crucial for the smooth running of a fund. As long as investors are clear on the terms, subscription line financing has benefits for both manager and investor.