“Howard Marks Seems to Read Naked Capitalism” on Private Equity Fund-Level Borrowing That Juice Reported Returns While Increasing Risks

A reader pinged us yesterday to tell us that “one of the major sooth-sayers of finance,” Howard Marks, the co-founder of Oaktree Capital, had published a newsletter on private equity subscription line financing that closely paralleled a post we ran last August.

The motivation for Marks’ article, derived from a year-end review sent to clients, is to explain why Oaktree is studying how to change, which in context means constrain, its use of subscription credit lines. As we indicated last year, this risky practice had become popular.

As you’ll see, there is a lot of two-handed economist in Marks’ post. He puts a positive spin on the supposed benefit of this approach, which is to artificially goose reported returns and undermine one of the supposed main purposes of private equity, to put capital to work over a longer period of time. Recall that private equity isn’t even as long term as it seems: even though the expected life of a fund is ten years, the committed amount is deployed only for an average of five years, according to Oxford professor Ludovic Phalippou. The money sits with the investors and is called over the typical five year investment period, then is returned as investments are exited, again over a period of years.

Mind you, both limited partners and general partners are strongly motivated to improve reported returns, even via gimmicks like this. So Marks dignifies these not-healthy desires (after all, the client is never wrong!) while doling out his medicine.

Here is an overview from our post last year of how these credit lines work:

For the last couple of years, we’ve been monitoring a troubling development in private equity, the use of “subscription line financing”. This innocuous-sounding term is for a credit line, offered by a bank, to allow general partners to borrow at the level of the investment fund. This is in addition to the considerable borrowing that already occurs in private equity, at the portfolio company level, where 70% of the purchase price typically comes from lenders.

This practice, which even major players like Bain Capital decry as dangerous, appears to have gone mainstream. As we’ll explain, these credit lines make already-exaggerated returns in private equity look more attractive than they are, not merely through the raw application of leverage but by changing how investment cash flows are reported. And they greatly increase the risk of investing in private during financial shocks. That risk obviates out one of the supposed advantages of private equity, that private equity appears to do well in bear markets, when in fact private equity partners are merely providing rosy portfolio values. The more general partners use these subscription lines of credit, the more private equity will amplify investor risks rather than reduce them…

Early in the life of a specific private equity fund, investors will report negative returns. This will occur in the first year or two, after the investor has incurred management fees and had some initial capital calls. Unless the general partner has an aggressive, fast strategy for monetizing the investment (say the now out-of-favor “dividend recap” in which the GP loads the acquired company with lots of debt and pays investors a large special dividend), for at least the initial year after making an acquisition, the GP is likely to report the value of the portfolio company as par value, meaning the acquisition price. So when you include the management fees and the cost of closing the deal, the limited partners’ reported returns will be negative. This pattern is called the “J curve”.

Despite the impact on the level of individual fund, this J curve effect has been seen as more of an annoyance than a serious problem, since private equity investors are committing new monies to private equity every year and reaping returns over time from mature funds. It’s been bruited about much more in venture capital than in private equity generally, since in VC, the fund makes multiple financings before an exit, so the J curve is deeper on the downside and longer in duration.

By contrast, in private equity, the overall returns have been seen as good enough that the perceived negative impact of the J curve washed out over time. And let us not forget that private equity return are generally overstated, by virtue of the use of the internal rate of return as the prevailing method for presenting results (as opposed to more accurate measures, such as PME, or “public market equivalent”) and that GPs are widely acknowledged to under-report declines in value in bad markets.

But now that private equity returns are flagging, investors are willing to turn a blind eye to any gimmick that improves results. Here is where the subscription lines of credit come in…

Subscription line financing makes it possible for general partners to borrow at the fund level on a routine basis, as opposed to its previous status as an unusual event. The bank provides a credit line with that borrowing secured not by the assets of any portfolio companies, but by the unused capital commitments of the limited partners. In other words, while these borrowings were expected to be rare and repaid by other means, from the lender’s perspective, legally they are advances against the limited partners’ capital commitments.

Marks confirms our description and adds some details, for instance, that the magnitude of advance permitted against the committed capital depends on the creditworthiness of the limited partners.¹

Oaktree Capital uses subscription lines of credit, so it isn’t surprising to see Marks tout how flattering they are to reported returns (emphasis original):

• With calls for LP capital postponed, the reported Internal Rate of Return or IRR in the early years – the dollar-weighted return on LP capital – will increase substantially (assuming the early profits exceed the interest and expenses on the line). 
• The use of borrowed money can reduce or even eliminate the deleterious impact on early returns of the so-called “J-curve.”The J-curve results from (a) the fact that in a fund’s early years, management fees are usually charged on total committed capital, while a relatively small percentage of the capital has been put to work, and (b) the tendency of private investments to take a while to show results.  
• Over the course of a fund’s life, LP capital will typically be called for investments or to repay the borrowings under the subscription line. This will cause the ratio of subscription line capital employed to LP capital to decline. As a result, the fund’s IRR will retreat from its elevated early level and move down toward what it would have been if the fund hadn’t employed a subscription line. However, all other things being equal, the fund’s lifetime IRR will remain higher than it otherwise would have been, since the impact of using the line will taper off but not reverse.

It’s revealing, and in not a good way, to see Marks defend higher IRRs as desirable, when we’ve stressed repeatedly that IRR is widely acknowledged in business schools and financial economics to be a poor performance metric by making mediocre investments look good. He only discusses the impact of this device on IRR and other flawed performance measures like multiple of capital and multiple of committed capital. Nowhere does he even mention the existence of the gold standard of “public market equivalent”.

However, he does come around to a reasonable conclusion, that this heavy-handed gaming may eventually backfire. But how long will eventually take? Again, from his post, emphasis original:

What if the typical race to the bottom happens at the banks, making financing available on ever-easier terms?  What if we reach a point where GPs are able to obtain lines equal in size to the vast majority of their LPs’ commitments and keep the borrowings outstanding for most of the funds’ life?  In that case, there will be little need for a GP to draw LP capital, and even low returns on investments could give rise to ultra-high IRRs at the fund level.  The bottom line on all this is that the use of subscription lines sheds considerable doubt on the significance of IRR.  And when IRR becomes suspect, anyone wanting to evaluate fund results has no choice but to put greater emphasis on the multiple of capital.

And in the middle of a paragraph, Marks discussed another major reason some general partners may be so keen to adopt this approach:

The preferred return that must be earned before the GP receives incentive fees is calculated based on how much LP capital has been called and for how long it has remained outstanding.  Thus the use of a subscription line in lieu of LP capital shrinks the dollar preferred return hurdle.  Lowering the hurdle can increase the GP’s probability of collecting incentive fees and cause the payment of incentive fees to the GP to begin sooner, although it will have no effect on the amount of incentive fees ultimately paid by a fund that would easily have cleared the percentage hurdle rate if it hadn’t used a line.  (At the same time, however, the interest and expenses paid on the line will reduce the fund’s lifetime net dollar gains, and thus the eventual amount of incentive fees received by the GP.  The interaction of these effects can be complex.)

This is an issue that we didn’t flag and is much more problematic than Marks indicates. The red flag is “that would easily have cleared the percentage hurdle rate”. As regular readers may recall, for private equity funds in the US, incentive fees, also known as carry fees, are paid on a company by company basis as they are sold. Both the mechanics of how IRR is calculated, as well as the desire of fund managers to launch a new fund 4ish years after closing their last big fund means they try to realize profits early. That often means the best deals are sold early and the dogs are unloaded later.

The danger of that is that losses on the later company sales mean that too much was paid out in carry fees. While the contracts governing the deals, the limited partnership agreements, have “clawback” terms that supposedly cure this defect, in practice, clawbacks are virtually never paid. Thus the subscription credit lines make this problem even more acute.

Marks flags another possible big problem in passing:

Some LPs seek to avoid so-called Unrelated Business Taxable Income (“UBTI”).Without getting into further details, suffice it to say the use of subscription lines increases the risk of UBTI to these LPs.

I will check with my tax mavens, both of whom are recognized experts and have written regularly about private equity. This would be a very big deal for tax exempt investors, namely public and private pension funds, endowments and foundations, that contribute the bulk of private equity commitments.

Marks given an interim summary of why this questionable practice has become common. Notice the commonality of interest of limited partners and general partners in goosing returns:

For LPs:

• the desire for high reported IRRs,
• better cash management, including fewer drawdowns, and
• the potential to use their capital more efficiently (i.e., to use undrawn capital to make investments that may add to overall profits)
  

For GPs:

• the expectation that higher IRRs will enhance their reputations and enable them to raise more money,
• the potential to lower the hurdle that must be cleared before incentive fees are received,
• the ability to enhance reported results in a low-return world or mask otherwise-low investment returns, and
• defensively, a way to be competitive with other GPs who raise IRRs through the use of lines

I dunno about you, but to me, the bennies look skewed in favor of the GPs. Not that that is unusual in private equity.

And Marks at the end flags the risk we did, of limited partners getting capital calls at the worst possible time, during a crisis, being increased thanks to subscription credit lines. We discussed how this happened at CalPERS in 2008 with no subscription credit lines, and how CalPERS had to dump investments at distressed prices to meet the capital calls. We pointed out how the subscription credit lines increased this risk:

This risk would become more acute and the exposure larger the more general partners use subscription line financing. Why? One of the covenants is that the fund maintain a certain coverage level relative to aggregate EBITDA. EBITDA can fall sharply in a recession or financial shock. That would lead the bank to demand a credit line paydown, which in turn would lead the general partners to issue a capital call. Needless to say, this would also take place when securities values would be under stress generally, meaning if the limited partner ran through its liquidity buffers, it would, as CalPERS did, be forced to sell other investments to meet the cash demands on the private equity front….

These subscription lines have the potential to amplify financial crises by amplifying shocks and sending them across markets. We wrote about that phenomenon regularly in the 2008 debacle, when you’d see a sudden plunge in a market that seemed to have nothing to do with the bad news of the day, like gold. It was clear that a large investors had been hit with a margin call and needed to sell something to raise the needed dough. The logical move was not to sell an investment that was showing losses, if possible, or if not, to liquidate one that was in relatively good shape and in a market that was not so roiled that the order could be executed….

And let us not forget that if some private equity limited partners could not meet initial subscription line capital call, the other limited partners might be on the hook, up to the limit of their unused commitment amount. And what would happen if that were to prove insufficient to meet the remaining amount due? Presumably, the fund would be liquidated.

Marks, as a general partner, is particularly concerned about having to unwind a fund:

If a fund has diversified commitment sources and just a couple of LPs default, the fund will probably manage just fine. But suppose many LPs default? In that circumstance it’s easy to imagine a fund being forced to sell assets during a market downturn to pay off its line and/or lacking the capital it thought it would have with which to take advantage of market opportunities. Both outcomes could be very negative for funds and LPs alike.

To put it mildly…

On the one hand, it’s instructive to see a major general partner in the process of restraining its use of subscription lines out of concern for the danger they could pose to its franchise and investors.

But why have the limited partners been asleep? Recall they are the ones with a fiduciary duty; the general partners have gotten waivers from the limited partners. Again, it’s another example of a pathology we’ve described repeatedly. Investors like CalPERS and CalSTRS have become so desperately attached to the idea that private equity can bail them out of their central-bank-induced low returns fix that they’ve become more loyal to private equity that the parties to whom they have a legal duty.

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¹ Marks also stresses that the use of subscription credit lines doesn’t allow the fund to invest more than its committed capital. While true, it obscures as key point. Some funds market themselves as being more virtuous by engaging in lower levels of borrowing at the portfolio company level than is typical for private equity funds. But the terms of the subscription credit lines don’t limit their use. A fund manager could just as well use them to increase overall leverage in addition to deferring capital calls. We know of funds that were marketed as low leverage that were early to make use of subscription credit lines.