The returns-boosting power of subscription lines of credit have GPs pursuing them “in droves, like a Black Friday shopping mob”, according to investment consultant Cambridge Associates.
In an article advising limited partners on how to properly assess the skills of fund managers they commit to in light of the use of subscription credit lines, head of global private investments research Andrea Auerbach lays out how, through drawing on such a line to both make investments and prematurely pay out distributions, a fund manager can lift returns by 300 basis points or more.
“By using commitment facilities to make investments and repaying the line at least six months later, we estimate that GPs could boost a fund’s net fund IRR by an average of 200 basis points (with a wide variation around that average),” Auerbach writes.
“Using commitment facilities to prepay a distribution ahead of a known exit event (that’s correct, they are now using them to pull exits forward) can further improve the net fund IRR by an estimated 100 bps or more.”
Such is the allure of this bump in IRR that Auerbach predicts even a rise in interest rates won’t be enough to put managers off.
“The siren song of easily increasing IRRs by using a currently inexpensive financial solution is just too great for a competitive GP to ignore,” she writes.
“But investing isn’t going to get easier; without actual talent and capability, the IRR ‘head start’ provided to a manager by a commitment facility will eventually be eroded and exposed.”
Greater transparency at the fund level is needed to help investors clearly assess fund performance. For their part, LPs “need to evolve their approach to assessing performance, with the goal of determining if their GPs are delivering on what they were originally hired for: to make good (preferably great) investments in line with their stated strategy.”
Auerbach advises LPs to ask managers to provide fund net IRRs as if no commitment facility were used to better understand how use of the subscription line has altered LP returns.
She also advises consistently reviewing individual investment-level performance (gross IRR, gross multiple, operating metrics) as of the dates the investments were made and held by the fund, not adjusted for when LP capital was used.
“Data like these allow for a more holistic review of performance and reveal more of the manager’s true capabilities, which are ultimately what we are all seeking to understand.”
The use of subscription credit lines, first conceived in the 1980s for use by private equity real estate funds, has ballooned in the last few years thanks to inexpensive credit and an insatiable desire on the part of managers to be top quartile in an increasingly competitive fundraising landscape.
One estimate cited by advocacy group The Fund Finance Association puts the value of committed subscription credit facilities held by financial institutions at about $400 billion.