By: Robert J. Raymond, Partner at Cleary Gottlieb, and David W.S. Yudin, Senior Attorney at Cleary Gottlieb
The views reflected in this article are those of the authors, and do not necessarily reflect the views of the American Investment Council.
This past June, the Institutional Limited Partner’s Association (“ILPA”) released guidance and best practices on subscription lines for private equity funds. Subscription lines have become more prevalent in recent years, so it is not surprising that ILPA chose to weigh in. Many of ILPA’s recommendations, however, are overbroad and misguided, and if adopted, we believe would impede the use of these facilities to the detriment of LPs.
A subscription line is a credit line obtained by the fund that is secured by LP commitments, in order to fund investments or pay fund-level expenses before ultimately calling capital from LPs. It is important to distinguish these subscription lines from fund level borrowings designed to increase the size of a fund’s investments. This is a critical distinction that mitigates many of the risks typically associated with leverage. Nevertheless, ILPA lists “liquidity risks” as one of its primary concerns. In a leveraged hedge fund, for example, if the fund’s investments do poorly, there is a risk that the fund won’t have enough assets to repay its loans. That is not the case in these situations, where the subscription lines are simply funded by LP capital already committed to the funds. In essence there is very little liquidity risk in the case of a subscription line.
Similarly, ILPA places a great deal of emphasis on the “negative impact on alignment of interests.” It argues that subscription lines increase a fund’s IRR, which could be misleading, and enable the GP to be paid carry earlier than if no subscription line was utilized.
While it is true that the use of subscription lines could increase a fund’s IRRs, in our experience, any such increase would generally not be material over the life of the fund because capital will eventually be called from LPs and the IRR is principally driven by returns. Moreover, subscription line borrowing would not have any effect on other commonly used performance metrics such as Multiple of Money. Private Equity LPs are sophisticated investors and would typically review all relevant performance metrics before making an investment decision. Moreover, we believe that the concern that the use of subscription lines accelerates the payment of carry is over-stated. Most private equity funds hold assets significantly longer than the few months that the subscription line is outstanding and the overall result on returns is typically immaterial. Ultimately, both LPs and GPs benefit from the use of subscription lines in terms of more streamlined administration – calling capital can be done less frequently and after there is a critical amount to be called instead of in a piecemeal fashion.
Nevertheless, in connection with its alignment of interests concern, ILPA makes its most extreme recommendation: that a fund’s preferred return run from when the capital is drawn from the subscription line instead of when it is drawn from an LP. This dramatic change would only serve to increase the cost to the GP of using subscription lines in a manner that would likely make their use prohibitive. The preferred return is meant to guarantee investors a return on dollars they put into the fund, it should not be turned into an arbitrary mechanism for addressing an immaterial issue, especially since in our view the use of subscription lines benefits the LPs as much as the GPs and over the life of a fund does not meaningfully accelerate the receipt of carry to the GP.
While a comprehensive analysis of all of ILPA’s conclusions is beyond the scope of this article, there are several other instances of misplaced concerns. For example, ILPA asserts that “the terms of the subscription facility may grant the lender excessive discretion over fund management decisions or assignment.” We do not believe that subscription facilities provide lenders any discretion over fund management at all, just the right to call capital from LPs when there is an event of default — and this right is in any event subject to the limitations in the LPA.
We believe that ILPA has exaggerated these and other concerns, resulting in far reaching recommendations that are at best unnecessary and at worst could restrict the use subscription lines by GPs. Ironically this would hurt LPs who tend to favor the use of credit facilities. On matters, such as these it is important for the LPs and GPs to engage, and we are not opposed to enhanced disclosure requirements that could facilitate a transparent dialogue so long as they are reasonable and do not unduly increase costs. To that end, some of ILPAs recommendations are helpful. At the same time, we believe it is important to keep in mind in these discussions that subscription lines benefit both LPs and GPs, and are a relatively conservative and simple form of leverage that need not be discouraged.
Cleary Gottlieb Steen & Hamilton LLP is an AIC Tier 1 Associate Member