Private equity fund managers’ use of subscription credit lines leads to a misalignment of GP-LP interest by distorting fund performance, according to a recent report by advisor TorreyCove Capital Partners.
In its research report released in September titled “Subscription Credit Lines: Impact on GPs and LPs”, TorreyCove discussed the effects of the use of credit facilities, which has surged recently amid a low-interest rate environment. These credit lines provide GPs with a convenient source of capital, using LP equity commitments as collateral and source of repayment.
Overall, TorreyCove finds the effects of using credit lines are “neutral at best” for LPs, but more likely negative.
“Traditional credit lines can be convenient in case a GP has to move quickly to try and close a deal and doesn’t want to wait and make a capital call,” TorreyCove senior vice president Tom Bernhardt told Private Equity International. “But if GPs are going to start using them for longer periods of time, which is what we’re starting to see, that can be problematic. While the higher-stated IRR is a clear benefit, LPs need to consider whether higher ‘paper’ returns are really enough to balance the costs and downsides of using credit lines in this way.”
The overall use by GPs of these debt facilities not only distorts a fund performance, but also makes comparisons between funds more difficult, TorreyCove said.
GPs are drawn to use these credit lines to artificially boost the net internal rate of return, according to TorreyCove. Rather than drawing capital from LPs to make investments, GPs can use these credit lines to artificially shorten the investment holding period that is included in the IRR calculation.
In one hypothetical scenario, TorreyCove found that if a $100 million fund making a $100 million investment with a standard 2 percent management fee rate has a net IRR of 10.56 percent generated at the end of the sixth year of the fund, returns would jump to a 13.93 percent net IRR in the same time frame with a credit line.
And while fund managers wouldn’t jump to higher performance quartiles from using debt, it could put “a significant number of them within striking distance of the next quartile”, TorreyCove wrote in the report.
For example, using debt from credit lines wouldn’t be enough to push GPs from the lower quartile to the median quartile, or from the median quartile to the upper quartile. But it could be enough of a performance booster for about a third of GPs in each quartile to approach the next one, based purely on their use of a credit line.
Credit facilities could also help GPs reach their hurdle rate faster, allowing them to begin sharing profits from the fund’s investments with LPs in the form of carried interest more quickly as well. According to TorreyCove, a GP who uses debt from a credit line could increase returns by 137 basis points to push the fund to be “in the carry”.
In another hypothetical scenario, TorreyCove assumed that a $100 million fund with a standard 2 percent management fee making a single investment of $100 million had a 6.63 percent net IRR after six years on an investment made in year one with capital called from LPs. But if it used a credit line instead, and only called capital from LPs during the third year, it would lead to an 8 percent IRR, or 1.37 percent higher than the IRR without a credit line.
Even though interest on debt cuts into the carried interest earned by GPs, most would probably find the chance of receiving carry earlier more attractive, according to TorreyCove. Similarly, GPs would take advantage of low interest rates to draw from credit lines to cover management fees, including operational expenses and salaries, reimbursing themselves once returns start flowing in by taking a cut from distributions.
The deferred capital calls may allow LPs to invest their money elsewhere for the time being, but given the low-yield environment, their ability to invest cash elsewhere is not much better, according to TorreyCove. Even if the environment turns to produce higher returns, at that point, the cost of debt would be higher for debt sources like these credit lines, offsetting any increase in yield.
Furthermore, adding debt from credit facilities increases risk to “an unacceptable” level, considering portfolio companies usually already are levered, TorreyCove said. The private equity advisor distinguishes credit lines from “true leverage” because since the credit line draws from LP commitments as a form of repayment, it acts as an equity deferral for some time, without mitigating risk for the fund’s pool of capital.