The use of subscription lines to cover capital calls has evolved from short term bridge facilities (generally paid off within 90 days) into longer term facilities used by fund managers for cash management and greater flexibility in completing transactions, through the avoidance of the immediate need to call for capital from the fund’s limited investors. This expended use of subscription lines, however, has raised certain issues for limited partners in connection with and the alignment of their economic interests in subscription line use with the interests of the general partner. The Institutional Limited Partners Association (ILPA) recently published new guidance in this area: Subscription Lines of Credit and Alignment of Interests: Considerations and Best Practices for Limited and General Partners (June 2017).
Major areas of the ILPA’s concern with the use of subscription lines include:
- Performance Comparability; Claw back Issues. The ability to delay the actual call for capital compresses the J-curve changing the calculation of the internal rate of return (IRR) and related preferred return thresholds. This makes it more difficult to compare fund performance across funds. Also, if the calculations are made from the time of the actual capital call rather than the time a draw is made on the line of credit, the IRR may be greater and preferred return hurdles may be achieved earlier. The early achievement of such hurdles may also lead to claw back issues if the general partner receives amounts which ultimately need to be returned due to poorer fund performance later on.
- Expenses. A subscription line creates direct upfront expenses for the partnership. Poor performing funds may not be able to recoup some of those expenses.
- Liquidity. An event of default on a subscription line related to a manager, or an event affecting the market generally, can result in there being multiple simultaneous capital calls, which may strain some limited partner resources. The expanded use of subscription lines can mask, to some extent, the aggregate exposure of some limited partners.
- Ceding Control to Lenders. The terms of the subscription lines may cede control to lenders under certain circumstances on various fund decisions and assignments. Limited partners may have entered these investments based on their view of the manager, but now some of the manager’s discretion may have shifted to the lenders.
To address some of these concerns, best practices and guidance to limited partners with respect to the use of subscription lines has evolved with the goal of bettering the alignment of economic interests between limited partners, on the one hand, and the general partner, on the other hand. Some of the current best practices set out in the ILPA guidance includes:
- Partnership Agreements: The partnership agreement of the fund should include requirements that (i) IRR and preferred return hurdle be calculated based on the day the subscription line is drawn not the date capital is actually called, (ii) limit the subscription line to a percentage of uncalled capital, (iii) limit the maximum amount outstanding for a draw to 180 days and (iv) limit the maximum time the subscription line may be utilized.
- Disclosure. There should be requirements requiring greater disclosure of matters relating to the subscription line and the status of called capital, including (i) the balance and percentage of outstanding capital, (ii) the number of days the line is outstanding with respect to each draw, (ii) the use of proceeds for each draw, (iii) calculation of the IRR without giving effect to the use of the subscription line, (iv) the terms of the subscription lines and (v) the cost and expenses related to the subscription line.
- Disclosures should be delivered periodically and not based on the when capital was called.
- Managers of funds should provide, during the due diligence process, more information on the use and effect of subscription lines, including their policies on the use of subscription lines and the impact such lines have had on the IRR of their funds in the past.
The foregoing is a summary of some of the concerns the expanded use of subscription lines has raised – it does not discuss all of the new guidance.
So long as the interest rate environment makes the use of subscription lines desirable to fund managers, we expect the use of subscription lines to continue to increase. Whether investors push fund managers to implement some of the ILPA guidance to obtain a greater share of the benefits is an open question. Although the use of subscription lines has become a concern for some investors, as seen by the recent ILPA guidance, our current view is that, absent any pronounced change in the market, there is not enough motivation on the part of limited partner investors to push for major changes for various reasons, including, that better looking IRRs reflect well on the managers of limited partners’ funds and the investors are able to get some benefit from holding on to the cash longer.