Subscription lines of credit are in the spotlight this summer in the light of new guidance published by the Institutional Limited Partners Association (the “ILPA”) at the end of June in response to increased focus by investors on the expanding use by fund managers of their subscription lines of credit. A copy of the Guidelines may be found here.

Background

Subscription lines of credit (also known as equity bridge facilities or capital call facilities) are bank facilities used by fund sponsors to manage cash flow needs of the fund; they are secured by the commitments of the LPs in the fund. Traditionally, they have been used by managers as a form of short-term bridge financing. They are put in place so that a GP does not need to issue a capital call to investors each time the fund requires cash to finance an investment or pay fees and expenses. Instead, the fund can borrow from the facility to meet the immediate cash need and thereafter issue periodic drawdowns to LPs to pay off these borrowings.

These bridge loans enable managers to close an acquisition in a time frame where it would otherwise not be possible or practical to do so if it was necessary to draw down capital from investors. GPs only need to draw down money from LPs when the debt needs to be repaid. From an LP’s perspective, this practice also offers the advantage of reducing the administrative burden of responding to multiple capital calls.

In the past few years, fund managers have been taking advantage of low interest rates by borrowing more extensively and for longer periods of time. Subscription lines of credit are now often used to manage the overall cash position of a fund in addition to simply bridging investments. This increased usage has prompted discussion about the use of subscription lines of credit. Following consultation with LPs and other interested parties, the ILPA has produced the Guidelines, based on what it sees as the best practice for the industry on this subject.

Set out below is a summary of the Guidelines and the concerns they are intended to address. Please note, the ILPA is an investor lobby group, and its suggestions have been prepared on the basis of what would be in the interests of LPs.

LP Concerns

The Guidelines list a number of LP concerns with the use of credit lines. The key ones are summarised below:

  • Comparability of Performance - one of the key benefits to GPs of using credit lines is that it improves the fund’s IRR. The delay in issuing drawdowns shortens the “J-Curve”. This is particularly acute in the early life of the fund. The use of credit lines by some funds and not others, and differences in use across funds, thus distorts an analysis of the comparative performance of various funds.
  • Clawback Issues - as a result of the compressed J-Curve, there is an increased risk that a GP will receive more carried interest than it otherwise would. This may result in it needing to be clawed back at a later time.
  • Expenses - the use of credit lines is an additional expense to the fund. Borrowing money from banks incurs an upfront fee and interest. This ultimately reduces the profits of the fund.
  • Legal Risks - Unmonitored use of credit lines leaves LPs at a legal risk. The terms of a subscription facility may grant the lender discretion over fund management decisions and the assignment of fund interests. For instance, there may be covenants which limit LP transfer rights or prevent the GP from approving secondary sales. There may also be implicit joint and several liability for LPs if there are outstanding liabilities at the end of the life of the fund, which may require LPs to cover more than their pro rata share of any balance, should another LP default.

Considerations and Suggestions

As a general recommendation, the Guidelines state that the use of lines of credit should accrue to the benefit of LPs. GPs and LPs should agree clearer thresholds for the reasonable use of such lines, and LPs should be given greater transparency on their impact.

Specific recommendations include:

  • Preferred return should be calculated from the date on which the subscription line is drawn, rather than when capital is called from investors to repay borrowing.
  • Managers should disclose to LPs as part of their quarterly reports detailed information on the credit lines (including costs and terms) and their impact on the performance of the fund (for instance, IRR with and without the use of lines).
  • Lines should have reasonable thresholds for their use, such as:
    • A cap in relation to a percentage of unfunded commitments (e.g. 15-25%).
    • A maximum of 180 days outstanding.
    • Should only be secured by LP commitments to the fund and not by the underlying assets of individual LPs or the invested assets of the fund.
  • As part of the due diligence process, fund managers are encouraged to provide detailed information to investors on the fund’s use of subscription lines and their effect on performance. This should also be an ongoing process during the life of the fund. Equally, LPs are encouraged to request detailed information from managers on the use of subscription lines and to consider their impact during the due diligence exercise.

Comment

A well-managed subscription line of credit can work to reduce administrative burdens on GPs and LPs and to expedite transactions and can be a useful addition to any fund manager’s toolkit. However, overuse may have led the industry to re-evaluate the principle purpose for such credit lines. At present, the predominant concerns appear to be for greater transparency about the use of such credit lines, and the effect they have on the performance metrics of a fund. Increasingly, caps on the duration of such credit lines are being introduced to provide additional comfort that the facilities are not being misused. These measures may also assist in mitigating any cumulative institutional liquidity risk so as to secure the future of these facilities for use in the appropriate circumstances.