Many private fund managers are expanding their use of subscription lines of credit in their funds. This phenomenon has prompted a surge of debate, primarily because this practice can artificially enhance the performance of private funds. The investor lobby group, the Institutional Limited Partners Association (ILPA), following consultation with interested parties, has now issued its guidance on best practice for the industry on the matter (see full text here).
Subscription lines are credit facilities secured by the commitments of investors. Private fund managers traditionally used them as bridge loans to be able to close a deal in a timeframe that was not compatible with calling capital from investors. More recently, some private fund managers are taking advantage of the low rates of interest payable on these facilities and using subscription lines more extensively and for longer term borrowing. The by-product of this practice is that it delays the calling of capital from investors, which can shrink the fund's J-curve and therefore potentially enhance the fund's internal rate of return (IRR).
Many investors broadly favor the use of subscription lines, as they appreciate the benefit of managers being able to react swiftly to investment opportunities as well as preferring the reduced number of capital calls to be met. Furthermore, certain categories of investors, like US public pension fund managers that run portfolios of private fund investments, are typically incentivized on the basis of the IRR of their own investments, and so likewise benefit from the higher IRRs. However, other investors are more reticent about their use, pointing to a number of issues including the additional expenses linked to such subscription lines and the dampening effect that they can have on the multiple on invested capital.
The ILPA presents a number of the pros and cons of the use of subscription lines in their guidance as well as setting out best practice recommendations for fund managers and investors to follow. The key recommendations are as follows:
- the preferred return should be calculated from the date when the subscription line is drawn, rather than the date when capital is ultimately called from investors to repay the borrowing;
- lines should have "reasonable thresholds" for their use, such as:
- caps at 15-25% of unfunded commitments;
- a maximum of 180 days outstanding; and
- lines should only be secured against investor commitments, not underlying assets of investors or the invested assets of the fund;
- limited partnership agreements should include additional disclosure on the timing, use and IRR impact of lines;
- fund managers are encouraged to provide detailed information on their use of subscription lines and their effect on performance to investors as part of the due diligence process as well as part of an ongoing process during the life of the fund; and
- investors are encouraged to request detailed information on the use of subscription lines during the due diligence process and consider the impact of this information when benchmarking performance of fund managers.
Although most investors and fund managers are already attentive to many of the points raised in the ILPA guidance, it will likely shape and focus future discussions on the use of subscription lines. In addition to this there have been reports that the U.S. Securities and Exchange Commission (SEC) is interested in the findings of the ILPA guidance. From past practice, the SEC is unlikely to curtail the use of subscription lines, rather, it will focus on the adequacy of the disclosure provided to investors and the management of any conflicts of interest. It will be incumbent upon all market participants to keep abreast of developments in this space and in particular fund managers should be sure to scrutinize their practices and policies when coming to market with a new fund.