More Criticism of Private Equity Leverage on Leverage Via Subscription Line Financing

Chris Flood of the Financial Times wrote today about a worrisome issue we’d first noticed in 2014 and flagged last year, that of the use of so-called subscription lines of credit by private equity funds. As we explained:

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 equity 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.

Limited partnership agreements have always allowed for borrowing at the fund level, but the original intent was that it would be used only on a very exceptional basis, for instance, if the GP was consummating a deal and some part of the financing fell through (say a creditor rescinded a funding commitment).

Rather than hit up the limited partners for more money, which would presumably then be taken out via a conventional lender, the general partners would borrow at the fund level.

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.

Earlier this year, none other that Howard Marks of Oaktree Capital devoted an entire newsletter to the risks of subscription credit lines. He raised additional concerns, including that they could be gamed to increase carry fee payments to general partners, and that they would make the use of IRR, which is currently the widespread basis for measuring returns of funds during their life, meaningless.

The hook for the Financial Times story is that the normally toothless Institutional Limited Partners Association came out last month with surprisingly firm warnings about the growth of this practice. Note that we wrote about the ILPA

The fact that Bain, Oaktree, and now ILPA are sounding alarms strongly suggests that quite a few influential general partners aren’t keen about this development and see it as having the potential to do more harm than good. The fact that Flood has other industry incumbents largely echoing ILPA’s position suggests that there is a significant contingent that would like to tamp down on this “innovation”.

The irony is that Howard Marks’ newsletter suggested that limited partners were if anything more eager than general partners to see this gimmick deployed. Why? Goosing fund returns will often boost compensation since most limited partner have bonuses based at least in part on fund performance. And there is near-universal pressure to show better results, even if the current apparently-higher returns come at the expense of properly-reported eventual results.

The ILPA approach for curtailing this practice is clever: require returns to be reported with and without the effect of subscription credit lines.

From the Financial Times:

Tighter rules are required to stop private equity managers from artificially inflating claims about their performance, according to the largest association representing investors in buyout funds….

This little-discussed technique, known as subscription-line financing, helps private equity managers earn performance fees because one of their funds’ key assessment metrics, the internal rate of return, is based on the date an investor’s cash is put to work.

“This sleight of hand artificially raises the fund’s apparent performance but it does nothing to increase the actual returns earned by investors,” says Jennifer Choi, managing director of industry affairs at ILPA…

The association is calling for returns data to be reported from the time a private equity manager starts to use the bank loan, rather than the later date when a client’s capital is called into action.

The effect of this change would be to lower reported returns and to make it less likely that a private equity manager would be able to claim the industry’s standard 20 per cent performance fee.

ILPA wants to curtail how long the lines can be used. This is important because even though the subscription lines are sold as being used only on a limited basis early in the life of the fund to defer capital calls, the agreements are written so broadly as to allow for them to be drawn down at any time. Again from the pink paper:

ILPA wants stricter curbs to be imposed on the size of subscription-line financing loans agreed by private equity managers and a time limit of 180 days on the use of these lending facilities, which are frequently extended to a year or more.

One source to the Financial Times article told a flagrant lie:

He [Tim Powers, managing partner at Haynes and Boone]says these facilities proved their worth in the aftermath of the financial crisis by averting the need for investors to sell assets at knockdown prices in order to meet their existing promises to provide capital to private equity managers.

First, subscription credit lines weren’t in use then. If you Google “subscription line of credit” + “private equity” or “subscription credit line” + “private equity” prior to December 31, 2010, you get three hits each, with nearly all of them from law firms (the second version of the search gives some false positives in that it serves up old posts which do not contain the word “subscription”, but Google is finding the template for that site which inserts newer article links, like “The Positives and Negatives of A Subscription Credit Line” from this year. Even more important, subscription lines of credit would increase, not reduce, the risk of forced liquidation of the interest of a limited partner who was unable to meet a capital call. As we wrote:

CalPERS dumped stock at near-bottom levels of the crisis as a result of private equity and real estate imposing unexpected liquidity demands.

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.

Howard Marks though this risk was so high that he worried about multiple limited partners defaulting, leading to serious damage to banks and funds:

Most of these would be the result of negative developments in the financial markets or the larger world.

Since the use of subscription lines results in there being fewer but larger capital calls, the magnitude of potential defaults by LPs is increased, along with the potential consequences.

 Suppose the fund makes $5 million of investments against an LP’s $10 million commitment – borrowing $5 million on the line – and there’s a financial crisis (or the investments simply turn out to be big losers) and those investments decline in value to $2 million. And suppose the line comes due, the fund calls $5 million from the LP with which to repay it, and the LP – perhaps receiving simultaneous capital calls from a number of similarly affected managers – concludes it’s in its best interest (or its fiduciary duty) to NOT put up $5 million to secure investments now worth $2 million. Instead, it defaults on the capital call, depriving the fund of capital, potentially limiting the fund’s ability to repay the line and/or make further investments, and thereby possibly harming the remaining LPs….

 Some funds (although none of Oaktree’s) rely on subscription lines that are due on demand, rather than at the end of a stated term. What would be the effect if a large number of those lines were pulled simultaneously during a financial crisis? Or what if regulators required banks to call in their lines, even those that aren’t callable or whose terms haven’t expired?…

Market meltdowns and financial crises can increase the probability that banks will recall lines and decrease the probability that all LPs will meet the calls….

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…In the extreme, if defaults on lines are widespread, could lines become a source of significant risk to banks?

While we are glad to see many important players having a sense of urgency about curtailing this practice, the same can’t be said for CalPERS. As we pointed out in a May post, a former board member and private equity expert Michael Flaherman alerted CalPERS to this risk in December and again in May. What did CalPERS do?

It turns out Chief Investment Officer Ted ELiopoulos gave false reassurances to the board:

It turns out CalPERS did prepare a document which it presented privately to the board. However, Flaherman was correct when he said, “…it is especially concerning when the chair instructs the staff to bring back a report about hidden risks in your portfolio and they do not do it.”

That “report,” which we’ve embedded at the end of this post, does not discuss risk anywhere. And that shows yet again how CalPERS keeps its board in the dark. Instead, it discusses CalPERS’ procedures, as if to imply a mere staff review makes everything safe.

Since the board doesn’t appear up to it, the press, CalPERS beneficiaries and California taxpayers need to call for a major housecleaning at CalPERS. Investment professionals who repeatedly deny that risk matters, as Elopooulos has done by swearing undying fealty to private equity even as it is forecast to produce too little return to justify its extra risk, need to be turfed out.