Fund Finance Focus: Everything in moderation

When Howard Marks, co-chairman of Oaktree Capital Management, issued a memo in April exploring the use of subscription credit lines by private fund managers, limited partners paid attention. 

In mid-May, a former board member of the California Public Employees' Retirement System, Michael Flaherman, also raised the issue. He told its investment board meeting it prompted “significant concerns of systemic risk” for the private equity portfolio. 

The limited partners that Private Equity International spoke to are less concerned with “systemic” risk, but can see pros and cons for the financing method.

Aoifinn Devitt is chief investment officer at The Chicago Policeman's Annuity and Benefits Fund, which is beginning to encounter these facilities more often, having recently increased its target private debt allocation from 2 to 8 percent.

She is broadly in favour of subscription credit lines, appreciating the benefits of GPs being able to react more swiftly to investment opportunities as well as what she considers to be a more suitable rate of draw-down. 

“I think, in general, it's a great capability for managers to have to make investments in their own timeframe,” she says. “If there's an opportunity set that is rich, I would prefer the manager to take advantage of it.” 

She adds: “We are cashflow-negative here as a fund. So we don't have a lot of cash sitting on the sideline at any one time. Sometimes having a less aggressive schedule can suit us well from a cashflow perspective.”

Devitt says the proposed use of a subscription line has neither persuaded nor dissuaded CPABF from making a commitment and that its discussions with GPs tend to focus on the quantum of leverage being used rather than the use of the facility per se.

Jeremy Golding, founder and managing director of Munich-based fund of funds manager Golding Capital Partners, says he is seeing subscription lines used extensively in both private equity and private debt funds, even by those at the small- to mid-cap end of the market.

“Some GPs may be more cautious than others, but these days nearly everyone will use such a facility if they can. It's a good tool; financing is cheap and it's a sensible way to leverage if used in moderation.”

In common with Devitt, Golding highlights cash management as a plus, arguing that fewer but more sizeable capital calls make life easier. He also points to improved IRRs and reduction of the J-curve as compelling reasons for using subscription lines.

But there's no such thing as a free lunch. “Any financing still has to be paid for regardless of how low interest rates are, so you end up with a trade-off between higher IRRs at the outset and lower multiples over the long term.”

Golding also has reservations about the way in which the true performance of a fund may be obscured. “Comparing like with like becomes more difficult. A manager may have delivered a 200 basis points better return than expected, but was that through smart deal selection or simply down to the use of leverage? 

“You can no longer take the top-line number at face value. Ultimately, you have to do more due diligence to understand where the return has come from and try to work out what the true numbers would have been in the absence of financial engineering.” 

Indeed, this issue has become so challenging that some LPs are now inclined to discard IRR as a standard measure of performance.

“We are… focusing more on investment multiple, both the unlevered and levered equity multiples in addition to the distributions to paid-in capital,” says Anthony Breault, senior real estate investment officer at the Oregon State Treasury. “With greater use of subscription lines in the levered strategies, it is becoming less relevant to use IRR as a metric to determine performance.”
Time critical

Another bone of contention is the tenor of the subscription line, which can vary greatly from a month to – in at least one case – numerous years. The longer the subscription line is in place, the greater the possibility that an LP commitment does not get fully drawn down.

“There is one concrete example I am aware of where more than the raised fund volume was deployed by the fund while only 65 percent was called from investors,” one European institutional investor confides. “For sure, that is not what investors are looking for.”

“For investors which are not able to run an over-commitment strategy and/or are facing negative interest rates, it would be better to have the committed capital at work in the LP investments than the use of subscription lines,” says Peter Schwanitz, managing director and European co-head at Portfolio Advisors, the investment advisory and portfolio management firm. “However, notwithstanding LPs' desire to put capital to work, subscription lines in today's low interest rate environment should enhance LPs' net IRRs.”

Another potential issue is how LPs extract themselves from funds they no longer wish to be in. Experts advise investors which may want to do secondaries deals to examine the small print of proposed fund financing facilities with care given that, under certain circumstances, they could face difficulties in transferring stakes.

“LPs will tend to have side letters with certain rights and some will ask for information about fund financing. But are they so familiar with fund finance that they know the facility agreement may put restrictions on secondaries transactions?” asks Kate Ashton, a partner in the London office of law firm Debevoise & Plimpton.

Ashton, who has been a regular advisor to private equity fund of funds manager HarbourVest Partners on secondaries acquisitions, points out that facilities are generally secured against a set percentage of commitments made by the so-called “borrower base” of the fund, which normally comprises the most creditworthy LPs. 

If numerous LPs within the borrower base want to exit the fund at the same time, it could result in the facility not being sufficiently secured. “The borrowing base is normally much higher than the amount lent,” says Ashton. “But if the borrowing base starts to get close to the amount borrowed under the facility, a transfer by an LP could ultimately lead the borrower to end up in a default scenario.”

But can the provider of the facility prevent such a transfer? Until recently the answer would probably have been no, but things may now be changing – with providers of subscription lines increasingly looking to take control of the issue.

“The bank may ask for an express covenant restricting LP transfers (above an agreed transfer threshold) without its consent. It's not in all or even most agreements, but it's in some,” says Tom Smith, a partner and colleague of Ashton at Debevoise & Plimpton. 

Unless LPs successfully push back against such covenants, they may discover that strategic flexibility and improved IRRs may come at a price for the fund's investors. 

Additional reporting by Andrew Hedlund, Evelyn Lee and David Brooke.