The Institutional Limited Partners Association (“ILPA”), the body that represents the international limited partner community, has recently issued a best practice guide to assist both investors and managers1 with the use of subscription lines in a fund context (the “Guide”). The Guide is the result of a collaboration between ILPA, investors, managers and other industry advisers and has been issued in response to investors’ increasing focus on the area2 in light of the trend of managers looking to expand the use of such facilities.
The Guide includes nine recommendations as well as a list of recommended due diligence questions. Broadly, the Guide encourages increased dialogue, both before subscription lines are put in place and afterwards, by way of investor reporting.
Whilst the Guide focuses on private equity funds, it is likely to be of use to stakeholders in other closed-ended private funds, including private debt funds.
Use of Subscription Lines
Subscription lines have long been a feature in the private fund context (particularly for short-term bridging purposes and to smooth the capital call process) but, over recent years, there has been a move to expand their use to allow for longer-term borrowing. Subscription lines were traditionally only lent against the covenant strength of, and secured against, the uncalled commitments of investors. However, more recently, as managers have sought greater flexibility in the use of subscription lines (particularly in the case of private debt funds), they have been advanced not only against uncalled capital commitments but also against the net asset value of the underlying portfolio assets and portfolio investment cash flows. For certain longer term financing, a hybrid of these products is increasingly being considered, with lenders looking for recourse from both undrawn commitments and underlying portfolio assets. In each case, such facilities allow a manager to manage deal execution as well as, in certain cases, enhancing returns and maximising the use of a fund’s available capital. Their use is generally charged as an expense of the fund (and is therefore ultimately borne by investors).
While the traditional use of subscription lines can be beneficial to investors (helping them manage cash flow and administrative burden), they can prove controversial. The debate has focused particularly on the impact on the internal rate of return (“IRR”) of the fund (making performance look more impressive relative to managers not using such facilities) and to carried interest3. In addition, to the extent a fund is reliant upon a subscription line, it is (and its investors are) further exposed to the actions of a lender withdrawing the subscription line due to a breach of the subscription line documentation with the perceived risk increased in the case of more complex hybrid subscription lines.
Practical Changes for Managers
Managers should expect an increased focus from investors on this issue, who will likely have regard to the terms and recommendations of the Guide.
The key practical changes managers should expect are set out below:
- Reporting. The Guide includes specific information that ILPA recommends should be included in quarterly reports, including: (i) the balance and percentage of outstanding called capital (to provide a sense of the relative use of subscription lines by the fund); (ii) the current use of proceeds from subscription lines; (iii) the terms of and costs to the fund of such subscription lines; and (iv) the net IRR with and without the use of such subscription lines. On a similar note, the Guide also suggests certain disclosure obligations be included in the fund’s constitutional documentation (which are discussed under “Fund Documentation” below) and that investors sitting on advisory committees add the use of subscription lines as a discussion item to meeting agendas.
- Subscription Line Policy. The Guide encourages managers to develop a policy on subscription lines and to include this as part of the due diligence information available to investors4. Managers should therefore be prepared to be asked for this.
- Using Subscription Lines to Cover Fund Distributions. The Guide discourages managers from using subscription lines to cover fund distributions in anticipation of (but prior to) a portfolio company exit. This provision seems most applicable to private equity funds but could conceivably be applied in respect of a private debt fund (i.e., where a significant debt investment is disposed of). This appears to be a similar concept to the ‘asset stripping’ rules set out in the E.U. alternative investment fund managers directive.
- Standard Questions. The Guide includes a list of suggested due diligence questions. Some of these points require detailed and/or potentially sensitive information to be considered and disclosed, such as the recourse a lender has to uncalled commitments upon an event of default and the cost to renew the subscription line. Again, managers should aim to prepare answers to these questions to ensure the smooth running of investor negotiations.
The Guide includes a number of recommendations that are likely to affect fund constitutional terms where a subscription line is used. Managers should be aware that certain points are more likely to be raised in a negotiation with investors now that they have been consolidated into the Guide.
In particular, in light of the recommendations, investors are likely to focus on the calculation of the preferred return payable in respect of a fund. Whilst this is currently generally calculated purely by reference to drawn commitments, ILPA suggest this should also take into account when a subscription line is drawn.
The Guide also suggests that the parameters of the use of a subscription line (including maximum limits on items such as the percentage of uncalled capital subject to subscription line exposure) should be clearly defined in the fund’s constitutional documentation. As documentation develops in response to this, managers will need to engage with their service providers at an early stage of planning a fund to define how they intend to use subscription lines.
ILPA also indicate that the requirement to disclose certain issues in relation to the use of subscription lines is clearly set out in the fund’s constitutional documentation, including specific information on the assets used to service the subscription line, information on applicable loan covenants and any terms of the line that may introduce additional risks.
ILPA advise that subscription lines should only be secured by investor commitments to the fund (and not the invested assets of the fund or the underlying assets of investors). The Guide also states that cross-collateralisation of subscription lines should be avoided.
Whilst the Guide is not binding, it is likely to shape how fund documentation and subscription lines are structured in the future as the recommendations are likely to be persuasive in negotiations. Managers should be aware of the contents of the Guide when arranging subscription lines and be prepared to discuss their proposed use with investors in some detail, particularly where more complex hybrid subscription lines are being considered.