Why LPs will start calling the shots on subscription lines

The question is 'when' not 'if', with Cambridge Associates' Andrea Auerbach pointing out GPs have been flocking to these facilities 'in droves, like a Black Friday shopping mob'.

A portfolio company requires capital fast. You don’t know exactly how much or if it will need more next month. What’s your immediate recourse? Turn to your bank and draw from the subscription line of credit. Something that was conceived three decades ago to help real estate developers close their deals has now become a ubiquitous – and cheap – fund financing feature for private equity firms.

In a recent roundtable discussion hosted by sister publication pfm, we brought together insiders with decades of experience in this field to discuss the state and future of fund finance. When it comes to transparency, general partners say they’re willing to work with limited partners to understand the guidelines on subscription lines set by the Institutional Limited Partners Association. The guidelines are open to interpretation and the Fund Finance Association last year criticised ILPA for its ‘one-size-fits-all’ approach in applying the same standards without considering differences such as fund size.

The use of subscription lines has evolved over time and the next big change will likely be who dictates the format and usage of the facility. Noah Becker, chief financial officer of LLR Partners, a lower mid-market private equity firm from Philadelphia, says soon it will be LPs that influence the use of lines as they start to understand how they work.

“In three to five years, the LPs are going to start to have a more cohesive position on ‘I want you to use it. I don’t want you to use it. I want you to use it heavily,’” he says.

That’s arguably already happening. One infrastructure GP commented it only ever used subscription lines for the shortest-term possible, given how many LPs had reacted negatively to any hint of long-term subscription line usage.

GPs should not expect this to be plain sailing. In a recent note, Andrea Auerbach of Cambridge Associates – an influential figure among limited partners – wrote in pretty unflattering terms about the “siren song of easily increasing internal rates of return” and how managers had been flocking to these facilities “in droves, like a Black Friday shopping mob.” Auerbach stopped short of calling on GPs to curtail the practice, but did warn that the IRR “headstart” credit lines generate would eventually be “eroded and exposed.”

Right now sub lines are a great and relatively inexpensive tool for private equity firms and they will continue to use them to suit their needs – be it to help boost internal rates of return or deal with tax-related issues. And with lending rates at what one chief financial officer says are hundreds of basis points below commercial lending rates, banks are keeping the spigot open.

Dominic Diongson is the editor of pfm. Write to him: dominic.d@peimedia.com