Many private equity firms have yet again started to review their IRR calculations and disclosures since it emerged the Securities and Exchange Commission had subpoenaed Apollo Global Management for additional information on its calculation methodology in December.
While IRRs have long been used by investors to measure a private equity firm’s performance and draw comparisons between firms, to date there has not been a standard industry-wide calculation and reporting methodology. The inclusion or exclusion from fund IRR calculations of the following can have a material impact:
Reinvestment of capital (ie, recycling of distributable proceeds)
Capital sourced from subscription lines of credit or other lending facilities to make long-term
The performance of capital accounts of the fund sponsor and/or its affiliates.
Insufficient disclosure could implicate the broad anti-fraud provisions of the Investment Advisers Act, under which investment advisors have a fiduciary duty to avoid misleading their investors. Violations can trigger enforcement action, as has been demonstrated by various SEC actions against private equity firms over recent years.
Subscription credit lines
Historically, private equity firms have used subscription lines of credit as bridge loans to quickly close time-sensitive deals without having to wait to receive capital called from investors. Such loans have traditionally been repaid within a few weeks upon receipt of investor commitments. Several reports indicate a recent uptick in the use of subscription lines for longer-term borrowing early in a fund’s lifecycle to make acquisitions.
Longer-term borrowing creates potential for a firm to boost its reported IRR early in a fund’s life and receive carried interest before the firm would otherwise have been entitled to do so. Regulators and certain investors are concerned that this could impede the ability of investors to meaningfully compare the performance of fund managers who use subscription lines with those who do not. The impact of this practice on a private equity fund’s IRR calculations should be adequately disclosed to current and prospective investors.
The SEC has started scrutinizing these practices during its examination of private equity firms. To date, it has focused on whether a firm has adequately disclosed the impact of subscription credit lines on a fund’s reported IRR, the other risks and/or conflicts of interest associated with such practices, and the accompanying costs.
As with any other practice that impacts a fund’s reported IRR, private equity firms should carefully review and, where necessary, enhance the disclosures they provide to current and/or prospective investors relating to the use of subscription lines to ensure that the impact of such subscription lines on fund performance reporting and related risks and conflicts are adequately disclosed.