The use of subscription credit lines was a defining debate among LPs and GPs in 2017. While it is nothing new for a fund to use a credit facility to finance acquisitions, concern began to mount about the length of time managers were leaving these facilities outstanding before calling capital from limited partners.
At the start of the year the discussion of credit facilities was already rolling. Headlines like ‘Financing ‘trick’ boosts lucrative private equity fees’, courtesy of the Financial Times the previous October, had piqued the interest of certain limited partners who had begun to ask more about the usage of these facilities.
PEI revealed early on in the year that the Institutional Limited Partners Association was formally gathering LP views on the topic with a view to publishing guidance on the topic. As the year rolled on, investors and managers voiced opinions that ranged from generally in favour to stridently against, with every shade of grey in between.
In March, San Bernardino County Employees’ Retirement Association, a California pension fund with more than $8 billion of assets under management, rescinded a commitment to a private credit fund managed by Alcentra over concerns about the leverage facility used in the fund.
Howard Marks, the chairman of Oaktree Capital Management, poured petrol onto this sparking debate when he chose to focus one of his widely read memos on the topic in April. Among the many aspects Marks explored, the most notable ones pointed to the unknown risks that may result from the practice.
His note would later prompt a former board member at the California Public Employees’ Retirement System, Michael Flaherman, to quiz the board about how much the pension understands the risks of credit facilities. “It’s striking that you have Howard Marks, who works for a private fund manager, discussing the risks that these credit lines can present to LPs, and you have an LP here who can conduct a similar analysis but doesn’t outline these risks,” he told PEI in May.
In July ILPA released a document offering a nine-point guide investors to help ensure credit facilities are used appropriately. In doing so, the association nudged the debate in the direction of creating ‘industry best practice’ (while also acknowledging that different fund types had differing credit facility requirements).
As the debate rumbled on, PEI was gathering views from all parts of the private equity ecosystem to get a better handle on how important an issue this was. What we found was an issue as divisive among limited partners as any we’ve covered during our 17 years of publishing. This is not because investors seem genuinely worried about the possibility of fund level leverage triggering the next financial crisis (they don’t), but because GPs who use long-dated lending facilities to postpone capital calls can make their performance look better than it otherwise would.
LPs who, like these managers, strive to maximise IRR tend to welcome the approach. Plus they may feel able to redeploy funds that would otherwise have been drawn to earn a return somewhere else.
But if you are an investor who focuses on the money multiple, and all you can do with your uncalled cash is park it in a zero-interest bank account (or worse still, your banker charges you a fee for holding it) while footing the extra cost of the facility – well, then you will be less inclined to applaud GPs for perfecting the art.