A brouhaha has broken out regarding the use of subscription credit lines by fund managers in recent months. The Institutional Limited Partners Association waded into the debate last Tuesday when it issued a nine-point guidance to help ensure they are used appropriately.
The private equity investor trade body urged members to take responsibility for ensuring they are informed about a manager’s use of these lines, specifically regarding any impact they may have on performance. The association asked investors to dig deeper into the impact credit lines have on a firm’s track record, and to compare its levered and unlevered IRRs.
Some investors appear to be taking note already, taking a firmer role in negotiating subscription finance provisions within their limited partnership agreements. At the Fund Finance Association’s conference in Hong Kong this month, fund managers and fund formation lawyers discussed how investors are increasingly dictating the timeframes in which a subscription line should be repaid. In a hypothetical example explored at the event, should a repayment not happen within a predetermined timeframe, then an investor will have been deemed to have funded its capital contribution for the purpose of calculating the IRR.
The lobby group also called for fund managers to agree to “reasonable thresholds” for the use of credit lines, such as establishing the longest period for which subscription lines can be used and a maximum percentage of the uncalled capital that can be borrowed against. At the FFA event, participants said the length of subscription lines already had been trending downward with more flexible arrangements now having a six to 12-month timeframe. They also discussed how a best practice today is for lines to reflect between 15 and 25 percent of a fund’s uncalled capital.
ILPA also reflected on a more recently discussed concern: the use of these facilities when exiting investments, a practice which effectively involves managers drawing capital from these lines once an exit is determined and then repaying the lines once it completes. This practice again shortens a fund’s hold period and therefore further boosts its IRR, something ILPA points out should not be permitted to happen. Some of sister title PERE’s sources already have distanced themselves from that practice, one remarking that investors would be quick to question lines being used like that.
Whether malpractice exists to any meaningful extent or not, the noise surrounding subscription credit by fund managers has sharpened the industry’s focus on how they are used. Provisions are even being made for the worried. One source said investors that communicate their concern can be given parallel levered and unlevered fund reports, meaning they can use whichever numbers best suits their purpose.
So, while both investors and their managers are already alive to the issue of potential misuse and are doing something about it, an astute investor’s due diligence process is dynamic and always being fine-tuned. One real estate head at a US public pension plan said that his CIO circulated the ILPA report as a reminder that it should be asking all GPs about the use of subscription lines. The pension plan has also started periodic lunchtime briefing sessions to review best practices. Having the industry body give official guidance is helping bring fund managers towards a true best practice.