When someone describes something as “free money”, one immediately gets nervous.
And yet that is how a limited partner recently described the provision by lenders of increasingly long-term subscription credit lines to general partners. These facilities, which allow general partners to make acquisitions and delay calling capital from LPs often for up to a year, are now common.
From a lender's perspective: the amount lent (often around a fifth of the fund's total value), the credit worthiness of the limited partners and the repayment term, which is usually a year, make the risk of such a loan defaulting “minute”, the same LP tells me.
From a GP perspective, the use of such facilities seems like a no-brainer. With industry benchmarking so widely used as part of the fund selection process, being able to say you are top quartile can mean the difference between a 'yes' or 'no' from an investment committee or consultant. If the judicious use of a credit facility can make that difference, you would be mad to pass it up.
But what should LPs think? The Institutional Limited Partners Association is currently gathering the opinions of members on the use of subscription credit lines at the fund level. One person with knowledge of the process said the association is getting mixed responses from all types of investors. Some are vehemently against it as they see it only as a way of artificially boosting the IRR to get the manager over the hurdle rate more quickly. Others meanwhile see it as an efficient use of capital; why have your money shoved into an asset that won't perform for at least a year when it could be sitting somewhere else earning a return?
LPs like managers that can deliver high IRRs, but are less keen on anything that makes a historical IRR, which may be distorted by delayed capital calls, tricky to analyse. Some view a single predictable annual capital call as an aid to cash management. Others see it as a pain.
The most difficult question to answer is where the real risk is being introduced. Such facilities have been in place in some form for many years, but typically just to allow GPs to deploy cash quickly in acquisitions and to call only the exact amount needed from LPs. The longer-term facilities are a relatively recent phenomenon spurred on by the availability of cheap credit, with many firms only introducing them to their current generation of funds. They haven't been tested in times of serious economic stress.
Having discussed potential risks with a number of investors, two scenarios stand out.
One involves a potential roadblock to secondaries transactions. Credit is secured against a fund's LP base and its ability to honour capital calls. Not all LPs are created equal, so the lender may identify one or two large, stable investors against which to lend. Should one of those important organisations want to exit the fund via a secondaries sale, they may find their transfer vetoed by the general partner on the basis it will scupper the credit facility. A general counsel at a fund of funds tells me he is now seeing these clauses appearing in LPAs.
Another scenario involves changing the fund's risk profile in the eyes of the regulator and thus exposing it to greater oversight. In Europe, for example, under the Alternative Investment Fund Managers Directive, a manager of a fund that uses leverage at the fund level is subject to a greater regulatory burden than one that is unlevered. At what stage a credit facility becomes gearing has not yet been tested.
In the US, there is no directly equivalent rule, but as law firm Dechert noted in an article in January, the Securities and Exchange Commission looks likely to examine these facilities in more detail. The agency itself declined to comment at the time.
The ultimate “regulation”, however, of the use of credit facilities will be the LPs themselves. In December, for example, the San Bernardino County Employees' Retirement Association said it would rescind a commitment to an Alcentra-managed credit fund based on its credit facility.
In the main, however, it seems LPs are happy to go along for the ride.