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Getting to grips with sub lines

The growing use of subscription credit lines deserves level-headed analysis.

At the California Public Employees’ Retirement System’s investment board meeting this week, a former board member raised the issue of subscription credit lines for the second time.

Michael Flaherman, a visiting scholar at the University of California Berkeley, told the meeting he brought up the issue in December 2015 and was promised a report on it. Subscription credit lines, he said, “[raise] significant concerns of systemic risk” for the private equity portfolio. The report never came.

“It is especially concerning when the chair instructs the staff to bring back a report about hidden risks in your portfolio and they do not do it, and then you have somebody like Howard Marks pointing out the hidden risks serve to bump up people’s compensation,” he said.

Marks, he added, should come in and give the pension fund a presentation on credit lines.

In a memo last month, Oaktree Capital Management’s Marks warned the use of subscription lines of credit by private equity funds could, in a worst-case scenario, add substantial risk for general partners and their investors. Marks highlighted risks ranging from tax implications to the ‘doomsday’ scenario of limited partners defaulting on fund commitments.

The use of fund financing has become one of the most talked-about issues in the private funds universe in the last year, and there are no simple answers. As Silverfleet Capital managing partner Neil MacDougall told one of our reporters recently, “you ask 10 people a question, you get 10 different points of view”.

Marks is not alone in his cautious approach. No doubt stoked by headlines referencing ‘financing tricks’ and ‘more debt’, not everyone is entirely comfortable with the extra risk these facilities can introduce and their distorting effect on IRRs.

But to brand all credit facilities as ‘tricks’ employed by GPs purely to beef up returns is, at best, unhelpful. For starters, not all LPs are suspicious – in fact, many embrace GPs’ use of this tool. “It’s a great capability for managers to have to make investments in their own timeframe,” says Aoifinn Devitt, chief investment officer at The Chicago Policeman’s Annuity and Benefits Fund. “If there’s an opportunity set that is rich, I would prefer the manager to take advantage of it.”

There are, however, questions to be answered. In particular, there is a very real trade-off between the gain in IRR that a delayed capital call can bring and the reduction in money multiple ultimately returned to LPs. After all these loans, while cheap, are not free.

What’s more, as one LP tells us, the use of these lines means IRR is becoming less relevant as a metric to determine performance.

As developments at CalPERS this week attest, there is more to be done to understand the advantages and risks of the prolonged use of credit facilities at fund level. Starting in our June issue, PEI is embarking on a detailed examination of their use.

We invite you to join us as we explore this issue from every angle, from regulators’ questions to lenders’ views to secondaries complications. Our series opens with views from fund managers and limited partners across alternative asset classes, as well as a look at the concerns catching the Securities and Exchange Commission’s eye.

An issue as complex and nuanced as this deserves in-depth and level-headed analysis. Over the next few months, with our colleagues at sister publications Private Funds Management, Infrastructure Investor, Private Equity Real Estate and Private Debt Investor, we will bring our readers just that.

Look out for the first instalment of our Fund Finance Focus in the June edition of PEI. Keen to share your thoughts on this issue? Drop Toby Mitchenall a line at toby.m@peimedia.com