FUND FINANCE SPECIAL: Potentially short changed

In last month’s issue, PEI Media’s publications, including PERE, opened the lid on the debate brewing around the impact a subscription credit line can have on fund level performance. It is generally accepted that delaying capital calls will boost internal rates of return and that the cost of such a facility – even in a low interest rate environment – will have a dampening effect on the money multiple that ends up in the pocket of the investor.

Private equity advisor TorreyCove Capital Partners attempts to model what that effect would look like in practice in its report Subscription Credit Lines: Impact on GPs and LPs.

The report presents two scenarios: a ‘traditional’ equity-only investment, in which a $100 million fund is deployed in a single $100 million transaction in year one, and a $100 million fund in which a credit line is used and capital is not drawn down from investors for the first two years of the fund’s life.

The second scenario assumes 100 percent debt financing of fund assets for two years, which is extreme. None of the GPs we have spoken with say they would leave a facility outstanding for more than 365 days.

The scenarios are then placed into two hypothetical situations: one in which the funds perform well and the other in which they underperform.

Assuming the funds perform well – realizing $200 million at the end of year six – the credit line offers an IRR boost of 300 basis points, while the multiple on invested capital (MOIC) was negatively affected by 0.12 turns.

The effect of the credit line is amplified if the funds make a loss. Here we see a negative impact of almost 700bps on IRR and 0.03x MOIC.

What is more, the use of a credit line can be enough to push a fund ‘into the carry’ – even when the return on the underlying assets is not sufficient to achieve the preferred return.

In a third hypothetical situation, TorreyCove assumed a $100 million fund with a 2 percent management fee making a single investment of $100 million in year one using LPs’ capital had a net IRR of 6.63 percent after six years.

If the fund had used a credit line and only called capital from LPs during the third year, it would lead to an 8 percent IRR, venturing into typical industry-wide preferred return hurdle territory. This is despite the MOIC decreasing from 1.45x to 1.35x.

In the case of a successful investment, the attractiveness of credit facility usage from an LP’s perspective comes down to which performance metric they place the most value on: IRR or money multiple. In the case of an unsuccessful investment, the downside is more clear-cut.