LPs increasingly wary of subscription lines as usage abounds

Private equity firms’ growing reliance on capital-call facilities is leading to significant changes to how limited partners assess fund performance, according to LPs speaking at SuperReturn US West in San Francisco on Feb. 13.

“Over the last three years, this has become dramatic. And it’s had a dramatic effect on the industry,” Guardian Life Insurance Managing Director Maurice Gordon said at the conference. “Look, if one fund is doing it, everyone else feels like they need to do it, too, to feel like they’re being judged accordingly.”

Subscription lines, sometimes known as capital-call facilities, enable general partners to borrow against their LPs’ commitments to their funds. GPs can use these facilities to finance their deals without calling capital, hastening their ability to invest while keeping LPs from having to sign off on multiple capital calls.

But while GPs initially used subscription lines to smoothen their investment processes, some are waiting months or years to call capital from their LPs.

Waiting longer to call LP capital to pay down a subscription line increases an investment’s internal rate of return. While some GPs wait only a few weeks or months to call capital, Silicon Valley Bank Managing Director Wibke Pendse said she’s seen facilities with very long durations. Those give GPs incentive to wait longer to call capital from their fund investors.

“There, you see quite a spectrum. All the way from 90 days to unlimited — as long as the fund is around,” she said, adding that most fall between three months and two years.

Widespread use of these facilities has led Guardian to ask more questions about the terms and duration of its GPs’ subscription lines, Gordon said.

Stuart Blair, director of research for Canterbury Consulting, said he’s encouraged some of his LP clients to push back on the use of the facilities if it seems they’re being used to game an increase in a vehicle’s IRR.

According to Pendse, some LPs are using side letters to keep their committed capital from being used as bank collateral for the subscription line.

Last year, the Institutional Limited Partners Association released a documentoutlining suggested terms for subscription lines, which included limiting the duration of the facilities to 180 days and specifying how GPs should disclose their use to LPs.

ILPA Managing Director Emily Mendell, who was also at the conference, said the organization is currently fielding feedback on the subscription-line guidelines and may make small changes to their recommendations in the near future.

It’s not as if there are no safeguards on capital-call facilities, however.

Banks often require GPs to make a certain number of capital calls per year before issuing the subscription line of credit, Pendse said. Some GPs might not receive the subscription line until LPs respond to the first capital call. Both provide the lender some sense of security that LPs are willing and able to pony up when the GP asks.

“At the end of the day … the subscription lender is looking at the underlying LPs,” she said. “We’re lending against the creditworthiness of the LPs.”

Action Item: ILPA’s suggested guidelines for subscription lines: http://bit.ly/2sV8MDv