Subscription lines of credit, which GPs use to fund LP capital calls for a period of time, are putting pressure on investors even as they serve an important purpose during a time of constrained liquidity, sources told Buyouts.
Sources aren’t expecting anything as drastic as an LP not being able to fund a capital call from an expiring sub line. But the situation could quickly turn ugly for those who are juggling commitments across multiple subscription lines with an unclear view of how much they owe.
Institutional Limited Partners Association warned against just this sort of situation in 2020 when it called for better reporting from GPs about an LP’s exposure on sub lines. The nightmare scenario would be when the bill comes due from numerous sub lines during a time of constrained liquidity, with an LP not clear on exactly how much they owe.
A dearth of liquidity is much on LPs’ minds these days as distributions slow to a trickle in the sluggish M&A environment. Pressure is coming from GPs calling capital for new deals, and, on top of that, LPs are paying off expiring sub lines that were tapped for deals earlier this year. This in addition to LPs continuing to commit to new funds, even as they battle overweight exposure to the asset class.
For some LPs, capital call loans are revealing both why they are useful and why some organizations like ILPA flagged their widespread use as posing something of a systemic threat in a downturn.
“We’re increasingly asking managers to provide both sets of data, show us the net returns and cash flows as if you had not used a sub line and ones where you did,” a family office LP said in a past interview. “Everyone is using sub lines a little differently – some people are still not using them, that’s probably the exception to the rule. Some are keeping them longer, some shorter. It does skew results.”
So far, sources who spoke to Buyouts have not seen a decline in GP or LP appetite to use capital call loans. In fact, subscription line of credit activity rose double digits in the second quarter, according to Silicon Valley Bank’s global fund banking outlook report for the third quarter.
“Funds across all strategies continue to use these credit lines, suggesting resilient activity across the industry,” the report said. “While the second half of 2022 may show weaker investment activity if GPs do slow deal pace, activity so far this year remains healthy, even if it’s at a lower level than in 2021.”
“I don’t think we’ve seen a curb in demand from GPs in the funds and LPs in terms of wanting to use [sub lines] even in today’s interest rate environment,” said Michael Timms, an investment director at 17Capital. “If anything, the issue we’ve been hearing about is on the supply side, with the banks being capital constrained.
“The market to put a sub line in place is not as liquid as the demand side, in terms of managers still out there raising larger pools of capital. We’ll be interested to see longer term if interest rates stay elevated whether the managers will choose to use sub lines in the same frequency and capacity they have in the last 10 years.”
Some banks, however, have been weighing the business against other pressures in the market dislocation. Citi, for one, planned to slash its exposure to the sub line business, according to a September article in the Financial Times. Still, sources stressed that other institutions are eager to get into the business, especially if opportunities arise as other players bail out.
Pricing and other pressures
Sub lines are used by GPs to fund LPs’ portion of a deal price, to be able to fund the deal in a timely manner without having to pressure LPs to pony up. They are secured by a fund’s uncalled commitments and because LP defaults are rare, they are considered a safe form of credit.
This is known as “smoothing” the capital call process. The use of this credit also has the effect of boosting the IRR on a deal, because LPs don’t actually fund the transaction at inception. Rather, their contributions come at some pre-defined time period, whether 30 or 90 days after a deal closes, though some sub lines extend for six months to a year or more.
The price on sub line credit is expected to rise in the higher rate environment but not at the rate of asset-level financing, according to Samantha Hutchinson, a partner with Cadwalader, Wickersham & Taft. “The subscription line market has proven itself to be a reliable source of liquidity during good times and bad,” she said.
The length that sub lines stay active is a sticking point for some LPs, who simply want to see this type of debt used to ease the capital call process, and not for engineering returns.
“Our preference is to deal with managers that might keep lines out for 30 to 90 days,” according to Trevor Williams, managing director and portfolio manager of Penn Mutual Asset Management.
“The short term nature of the loans, and the benefits that accrue to LPs by just not having to make a ton of capital calls, even at current rates, it’s still a rather attractive position because administratively, we’re not as burdened,” Williams said.
The length of the credit lines will change if conditions continue to deteriorate, sources said.
Several sources said they’d seen very few LP defaults on sub lines. “[I’ve] been in this market for over two decades, I’ve seen how these products fare over multiple cycles, how they performed over the Great Financial Crisis, the noise around liquidity as we worked through the covid era. Through all those cycles what we have seen is sub-line performance continuing to be resilient and very few LP defaults,” Hutchinson said.
Sub lines present even less risk today than a decade ago because the secondaries market has expanded and has become a routine tool for LPs to manage their portfolios. Unlike during the GFC, today if an LP needs to exit a fund and transfer ongoing commitment obligations, they have a developed and sophisticated marketplace in which to sell, Hutchinson said.
In 2017 guidance, ILPA recommended the lines don’t stay active longer than 180 days.
ILPA in 2020 recommended more reporting and transparency about how GPs are using the lines and what an LP’s exposures are, including levered and unlevered returns.
“When LPs do not have a clear understanding of how much capital will be called and when, they may struggle to balance their liquid and illiquid assets in order to ensure sufficient liquidity to meet the demands of future capital calls,” according to ILPA’s 2020 subscription line recommendations for more transparency around the use of the credit.
“This challenge becomes more pronounced when LPs are meeting capital calls by selling more liquid securities at a meaningful discount. During times of market turmoil that lead to higher than anticipated capital calls or uncertainty surrounding the anticipated volume of future capital calls – such as the current environment with covid-19 – this issue is further exacerbated,” ILPA said.