Subscription credit lines are becoming an increasingly effective – and attractive – way for private equity firms to enhance their performance by boosting their internal rate of return or “IRR,” an important metric that PE firms use to market their funds. The strategy, which is legal and largely cosmetic, uses short-term bank loans to minimize the amount of time that investors’ money is deployed, thereby boosting annual results. In fact, a recent study shows that the technique can make returns look better by 25% or even more.
The strategy is not new, but a longer period of available short-term lending has changed the game. Short-term loans can span a period that is as long as 2 years now, up from 6-12 months in the past, thanks to eager lenders offering low interest rates. Moreover, debt is proving to be very useful to combat rising deal valuations, as it shrinks the portion of the cost that has to be covered by equity money, alleviating the burden on investor capital.
Not everyone agrees on the propriety of this strategy, however. Some are happy that firms are pursuing innovation and taking advantage of cheap credit to maximize returns. Others are angered by the use of financing to manage, or massage, returns in a way that makes it more difficult for investors to compare performance across funds and allows funds to compensate themselves earlier.
How do PE funds earn money sooner using this kind of financing? Most firms retain 20% of profits after hitting a decided hurdle (typically, an 8% return). IRRs can be significantly higher if firms leave debt in place and delay taking investor money for a couple of years. By boosting IRRs, PE firms can push returns over the hurdle, entitling them to receive their 20% share of the profits sooner than they otherwise would. Adding to this dynamic, investors are not in a strong position to negotiate the hurdle with PE funds being in such high demand. In fact, some PE funds have recently been raised with hurdles below the traditional 8%.
Until lending interest rates rise, it seems safe to say that the industry can expect to see the continued use of short-term debt to boost private equity performance.
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