Are sub-lines being misused?

The use of subscription credit lines by private fund managers has come under scrutiny. Real estate equity and debt fund managers should take note of the discussion.

When Oaktree Capital boss Howard Marks puts out one of his regular memos, markets take notice. One of his recent opinings concerned the use of subscription finance lines by private equity funds – and their potential misuse.

Sub-lines are essentially revolving credit facilities provided to private investment funds and collateralised on the right to call capital contributions from investors in the funds. Worries surround the potential for managers to use this source of cheap credit as a way of artificially boosting internal rates of return, and therefore performance fees and reputations.

In May, at the investment board meeting of one of the world’s largest investors – the California Public Employees’ Retirement System – former board member Michael Flaherman, a visiting scholar at the University of California Berkeley, said the lines raise significant concerns of “systemic risk” for the private portfolio.

If such concerns are justified, then the use of sub-line finance in private real estate funds ought to be examined, along with other types of private equity vehicles across asset classes. Indeed, the issue is explored in depth in the latest edition of Real Estate Capital, as part of a special report compiled across titles at parent PEI Media. The coverage provides plenty of food for thought.

The use of sub-line financing is largely accepted as a sensible tool, although many are mindful that managers need to be upfront about how they use it.

Within the property finance sector, opinions on the use of sub-lines are relatively measured, although there is an acknowledgement of their potential misuse. On the positive side, some argue that real estate deals are not done until they are done and can fall through at any time; if a manager uses debt rather than equity to close a deal, investors can avoid having their cash called and then returned if the purchase of a building falters.

As Sally Doyle-Linden, chief financial officer of real estate private equity firm Clearbell Capital wrote in the latest edition of Real Estate Capital: “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.”

Sub-lines can also allow fund managers to make opportunistic property purchases in the early stages of their fundraising without the need to draw on existing investors’ capital. They can help a fund to manage its cashflow, with investors able to spread contributions rather than be called upon at short notice to provide large sums.

However, one real estate debt fund manager pointed out that his investors ask him not to have any sub-lines or indeed any debt against the fund. The manager argued that such facilities help cash management, but added that some fund managers have used them “creatively” to boost IRR.

In line with other sectors, there is a belief that fund-level finance should simply be a short-term tool to help manage cashflow, which in turn benefits the investors. As long as fund managers are transparent about their use, sub-lines need not be a cause of controversy.