Subscription credit facilities, or subscription lines, are typically revolving credit facilities secured on the capital commitments of investors. Interest rates on subscription lines are often similar to those for first lien loans. Private equity funds traditionally used subscription lines solely as bridge loans to smooth capital calls for investors and to provide greater flexibility to move quickly to close a deal if needed on shorter notice than the funds could call capital from investors – the loans would be repaid with capital called from investors, usually within a few weeks.
Some private equity funds are now reportedly using subscription lines for longer term borrowing. Such use of subscription lines may result in an increase in the sponsor’s carried interest, because investors often don’t begin accruing any preferred return until they actually contribute capital to the fund. In addition, it allows the sponsor to take advantage of the low rate of interest payable on these loans (compared to the alternatives in a typical LBO such as unsecured preferred equity or subordinated loans on the underlying investment) – in some cases such loans can resemble semi-permanent capital in the investment structure. The practice can be controversial with fund investors because the investors are “on risk” for the equity commitment during the period of the subscription loan, yet are not, strictly speaking, paid a return for their commitment.
Both investors and regulators are beginning to focus more on the practice. Investors are beginning to ask for clarification of when the preferred return begins to accrue if subscription line facilities are used and whether or not the sponsor plans to use subscription line facilities as more than bridging capital in portfolio investments. In addition, the U.S. Securities and Exchange Commission (SEC) is reportedly looking into the issue. The SEC has not as yet provided any further details on their views about the practice. Based on the general principles applied by the SEC, however, it is likely that a focus will be on the adequacy of the disclosure provided to investors regarding the risk, costs and impacts of the practice and management of any conflict of interest.
Private equity fund sponsors should review their fund disclosures surrounding the use of subscription lines to ensure the planned use, cost and impact of the subscription lines is adequately disclosed to investors.