A subscription credit line is a loan taken out by a private fund, secured against investors' committed capital, generally without recourse to the fund's underlying investments. Subscription financing allows managers to fund expenditure at short notice, with the loans eventually repaid by drawdowns from the investors.
Historically, private equity GPs have used them for short-term bridge financing, which was typically repaid in 30 to 90 days. But in the last five years the use of such facilities has surged. According to one oft-cited estimate, there is around $400 billion in outstanding subscription lines globally.
Advantages for funds
Subscription lines are a good way to manage the fund's cash flow. The GP can draw on the facility to clear outgoings as and when they arise and then periodically 'clean down' the facility with regular capital calls (e.g., once every six months). This reduces the frequency of capital calls, thereby trimming the administrative burden on GPs and LPs alike. If capital calls become more predictable, LPs are better able to plan ahead. They also retain control of money that would have been drawn down from them in the absence of a credit line.
The subscription line also gives the GP more freedom to structure, time and quickly close acquisitions. Instead of having to prepare and circulate drawdown notices to investors and then wait up to 10 business days (the typical capital call period) for the money to arrive while hoping that there are no late payers, the GP can simply draw on the facility at comparatively short notice.
Popular with lenders
Lenders tend to view subscription financing as a relatively safe bet, because of:
- the creditworthiness of the fund's investor base (most of whom will be investment-grade institutions);
- the size of actual loan advances (often capped at 20-25% of uncalled capital);
- the relatively quick turnaround (facilities are typically cleaned down every three, six or 12 months); and
- the severe consequences for an investor which defaults on a capital call (including the potential forfeiture of its contributed capital and interest in the fund's assets).
Consequently, interest rates on subscription lines currently sit a few hundred basis points below rates on other forms of commercial lending. Banks' apparent confidence in the robustness of fund finance as a business line is arguably backed by the relative rarity of default: the only big one so far is the Abraaj Group in 2018.
In the last few years, we have seen borrowing provisions in fund LPAs gradually become less restrictive compared to predecessor funds, particularly for mega-funds. Maximum repayment durations are being stretched (from 90 days to 180 or even 360), and the permitted purposes for subscription lines now often expressly include making investments and paying fees, expenses and fund liabilities generally.
In principle, an LPA with sufficiently liberal borrowing provisions could enable the GP to finance investments entirely by way of subscription facilities, roll the loans over until divestment, and then distribute net proceeds to the LPs, all without having to make any capital calls. However, practical examples of this 'no calls needed' scenario remain uncommon. One can conceive of special circumstances – for instance, if exit proceeds are temporarily blocked in a foreign jurisdiction while awaiting governmental clearance for repatriation or the completion of a tax audit – when a GP may opt to finance distributions on credit rather than 'pass' the delay on to its own investors.
Impact on IRR
The use of credit in lieu of capital generally boosts net IRR, because it delays capital calls and thus shortens the GP's hold period for investors' money. This booster effect makes it easier for the GP to achieve an IRR-based hurdle rate, which in turn may accelerate the accrual and pay-out of carry, which then increases the risk of clawback if the fund underperforms later in its life.
IRR is a popular metric to compare fund performance. All other things being equal, the higher the reported IRR, the better the manager's quartile ranking in league tables, even though the actual cash distributions to investors won't have increased with the IRR.
Not all LPs find credit-enhanced IRRs problematic; indeed, many strive to maximise IRR in their own portfolios. The booster effect of credit should partially fade over time as the GP makes the capital calls that it had delayed and distributions from portfolio company exits are fed into the IRR calculation. The booster effect is also minimised if the hurdle is based on a money multiple (e.g., Multiple of Committed Capital or Multiple of Invested Capital), rather than on IRR, assuming (in the case of MOIC) that the fund ultimately calls all capital prior to exits.
While most investors have generally been willing to go along with the trend toward greater use of subscription lines, concerns remain. For instance:
- The costs of obtaining and servicing the subscription line (interest, bank charges, etc.) are invariably classed as fund expenses, thus payable by LPs. While subscription financing is cheap today, it may not always be, if and when interest rates return to their historical averages.
- Subscription facilities are secured on uncalled capital. This makes the composition and financial strength of the investor base vitally important to the lender, so it often seeks veto rights over the transfer of investors' interests. If an important LP wishes to exit the fund (e.g., via a secondaries transaction), it may find its transfer blocked or conditioned by the GP on the grounds that it endangers the subscription line.
- Long-duration credit may enable capital calls to be postponed to such an extent that an institutional investor could find itself underweight in its strategic allocation to private equity.
After a long consultation process, the Institutional Limited Partners Association (ILPA), a major trade body for LPs, published a note on subscription facility practices in 2017. Among other things, it recommended that:
- Reasonable thresholds should be agreed to ensure the prudent use of credit, such as maximum percentages of undrawn capital (e.g., 15-25%) and maximum term on outstanding debt (no more than 180 days).
- LPs should ensure that they have enough information to scrutinise the impact of subscription lines on funds' performance, and to compare a fund's levered and unlevered IRRs.
- Subscription lines should not be used to fund distributions from divestments.
- Preferred return should accrue from the day when the subscription facility is drawn, rather than the date of the capital call to repay the facility.
The last of these is perhaps the most contentious, because the 'pref' has historically only been earned on cash from the point of contribution to the point of repayment. But, from an LP's perspective, preferred return is compensation for the period during which its money is 'at risk'. The use of a subscription facility postpones the LP's contribution of capital, but the facility is secured against uncalled commitments, so it can be argued that an LP's risk actually arises at the point when the facility is drawn down, not when its capital is called to repay the facility.
Is it leverage?
Subscription lending of the type discussed in this article is a short- to medium-term substitute for LP capital, but cannot be used to increase the fund's investable capital – that remains capped at total investor commitments (plus recycling distributable proceeds, to the extent permitted by the fund LPA). As such, a subscription line does not magnify returns on invested capital from the underlying investments, which makes it quite different to asset-backed lending in an LBO. The fund has used leverage, but it is not necessarily levered in a conventional sense.
The leverage question has regulatory implications in the UK/Europe, because a manager of leveraged funds is required to obtain full-scope permission under AIFMD once it has total AUM (i.e., committed capital of all the funds that it manages) of €100m, whereas for unleveraged funds the AUM threshold is €500m.
Helpfully, ESMA issued regulatory guidance in August 2018 confirming that borrowing arrangements won't be considered leverage if they are "temporary" and "fully covered by contractual capital commitments from investors". GPs should still take care, though: the longer the duration of a subscription facility, and the less frequently it is cleaned down, the more it starts to look like it is not "temporary" – which would qualify it as leverage under AIFMD.
When it comes to subscription financing, the regulatory focus so far, on both sides of the Atlantic, is mainly on transparency – ensuring that funds calculate and report performance to their investors accurately, fairly and comprehensively. But memories of the 2008-9 financial crisis are still fresh. Bigger, longer-term facilities are a relatively recent marvel; they haven't been tested in times of serious economic dislocation. The steady, quiet expansion of subscription facilities, even if not used to lever funds, is something that systemic regulators may want to keep on their radar.
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