Subscription credit: Fine lines

“When they are used properly and efficiently and there is proper disclosure on them, what we find is that many LPs can see the value of having them in place. When they start to become too aggressive or are used incorrectly, they don’t like them as much. Understanding the framework of how they should be used in the context of the market is a useful tool to have,” Alicia Gregory, head of private equity at Future Fund, told a seminar hosted by the Australian Investment Council.

Credit lines taken out against undrawn capital commitments from LPs have attracted a lot of attention given their proliferation in recent years. This financing can be used to make new investments – allowing GPs to act on opportunities swiftly – and cover ongoing costs so the capital call is delayed, or several smaller calls are consolidated into one. It also pushes out when the IRR clock starts on an investment, which eases the j-curve effect and can boost returns.

A rush of capital calls in the first quarter was linked to subscription lines, the implication being that managers were paying down existing facilities so they would have the ability to borrow if need be as well as maxing out lines in case lenders didn’t renew them or reduced capacity.

An Institutional Limited Partners Association (ILPA) survey found that capital calls increased during the fortnight ended March 26 as the economic impact of COVID-19 intensified, with nearly two-thirds of respondents expressing concern about exceeding their policy target for private equity. There was a degree of uncertainty as to what the capital was being used for. Just under half of LPs had seen changes in capital calls that related to subscription lines or shifting market conditions driven by COVID-19.

“One thing that has been talked about for a number of years is, in the drawdown, have LPs really understood how much they have outstanding on lines of credit with their GPs and when the time comes to call them – potentially in a crisis – whether LPs have the liquidity to meet them. There was a rush in March to clear those lines as equity markets were falling. GPs wanted to be at the front of the queue getting LP liquidity if it was going to be tight,” said Gregory. “Obviously, equity markets and currencies bounced relatively quickly, so that performance didn’t get properly tested.”

ILPA’s best practice guidelines for subscription credit lines include recommendations that they do not exceed 15-25% of uncalled capital, a maximum of 180-days clean-down period, and quarterly disclosure of the size and total amount outstanding (with more detailed information shared on annual basis). There is also an expectation that GPs will be able to give more notice on capital calls and clearer indications of when they expect to make drawdowns in the medium term.

There are concerns about longer clean-down periods. Some GPs in fundraising mode are pushing for 12 months, arguing that it helps them make investments but avoid calling capital between the first and final close; others are aiming for up to two years. Additional issues – in a minority of cases – include borrowing against the net asset value of the fund rather than against uncalled capital and using credit lines to make distributions to LPs.

“The worrying category is when there is a sense that the structure or use of these facilities is being done for a scope beyond what it is intended. It is intended to smooth subscription. It is not intended to create an entirely synthetic profile of cash in and cash out,” said Suzanne Tavill, a partner at StepStone. “And we do see pressure from the banks in terms of wanting to attach as much as they can. When one starts to attach fund holdings, moving beyond the uncalled capital, it introduces a whole raft of risk concerns that we find ourselves pushing back on.”

There is a risk that GPs will game the system, using subscription credit lines to inflate performance in the early years of a fund life. This can make returns appear superior to those of peers – potentially pushing funds into the first quartile – and help GPs raise more capital in the subsequent vintage. To this end, ILPA recommends that LPs ask managers for performance data including and excluding the impact of the subscription line as well as the methodology used to calculate those returns.

LPs might try and game this system as well if they face liquidity pressure for a prolonged period. Gregory offered a hypothetical example of how a GP that pushes for a credit line of 12 months might find the additional flexibility to be a curse, not a blessing. If the first investment from a fund turns out to be a dud within 12 months, LPs might decline to honor the capital call once it is made, having concluded that defaulting on their fund commitments is preferable to paying up.

“If you adopt a gaming approach it’s going to be a short game because that reputational impact will spread around and it will become difficult for you to enter other funds,” said Tavill. “The issue is then what would they do if they are under pressure? Secondaries and listed assets were used heavily as source of capital during the global financial crisis. People would try and find capital from wherever they could before damaging a relationship they had worked hard to get into in the first place.”

At the same time, LPs should pay attention to the identity – and creditworthiness – of their peers. Banks will underwrite against up to 90% of callable capital held by rated institutions and 65% for unrated institutions. Other investors, such as those that have previously defaulted on capital calls, are excluded. While there are restrictions on how much credit can be extended against an individual LP, a line might effectively be secured against one or two high-rated investors for the benefit of all.

“Understanding who else is around the table is really important today because if I’m the triple-A sovereign and everyone else has no creditworthiness whatsoever, that runs some risk for us. There is more focus today on who else is in the fund,” Gregory said. “There might have to be pauses on first closes if they are very small and the bulk of the money is going to be in a final close later on because we might not know who else is coming in.”

Alternative credit line structures are less sensitive to exclusion criteria. The flat advance rate model includes all investors but limits the size of the credit line relative to overall commitments – an advance rate of 50% would cap the line at $200 million against $400 million in callable capital – while the coverage ratio model requires that uncalled commitments cover total outstanding loans under the credit line at an agreed ratio at all times.

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• Topics
• Australasia
• Financing
• GPs
• LPs
• Australia
• Australian Investment Council (AIC)
• Future Fund
• Stepstone
• subscription credit lines