By Julia Keppe
London - the buzzing financial hub of the U.K. Over this past summer, it was difficult to evade the many headlines and substantial coverage in the morning papers or the street-level newsstands relating to subscription line facilities. These are lines of credit provided to funds in order to allow them to obtain funds quickly (e.g. if they spot an investment opportunity and need to move fast).
Such facilities are typically secured against the right to call capital from investors and are popular with general partners of funds (“GPs”). However, recent articles suggest that they are a negative for investors. Howard Marks, the Oaktree Capital Management (“Oaktree”) co-chairman, in his summer 2017 memo entitled “Lines in the Sand” went further and discussed potential systemic risk.
Most investors are probably not so concerned by this, but there are downsides to the use of such facilities:
The case for subscription line facilities
For the GP, quicker access to capital, reducing administrative burden and avoiding utilising true-up mechanics.
These facilities have evolved, with the facility size (as a proportion of unpaid commitments) increasing and they now include alternative products (e.g. a separate overdraft, or provide access to letters of credit, add-on facilities and alternative currencies). Increasingly, hedging is permitted and co-borrowers can be added - thus providing flexibility.
For investors, it is efficient if the fund invests via a facility initially as capital can be deployed elsewhere (however, debt costs may exceed the return from such deployment). A facility may mean funds make distributions to investors earlier than they would otherwise return capital.
The case against
A popular criticism on these facilities relates to manipulation of a fund’s internal rate of return (“IRR”). IRR assesses return in respect to time and is calculated from first investor drawdown, which can be delayed by use of a facility. However, to meaningfully affect IRR, debt must be in place for the medium to long term, which is not always possible due to tax (e.g. Unrelated Business Taxable Income) or regulatory issues (e.g. the Alternative Investment Fund Managers Directive). And, let's not underestimate that investors are very much aware of this issue. Conversely, the risk to GPs is negative IRR is magnified in an underperforming fund.
The secondaries market and GPs can refuse to allow transfers if it decreases their borrowing base. This risk can be mitigated by investors via side letters and/or timely discussions with the GP.
If there were to be a downward economic shift, this could be exacerbated if banks demand repayment and investors default on capital calls. GPs will then sell liquid assets (shares and bonds) to meet these demands, leading to further instability and the facility potentially becoming a significant risk to banks. However, such facilities are over-collateralised and issues have been resolved promptly. It is unclear if this will hold during any financial crisis.
Overall, investors are broadly supportive of the use of credit facilities but going forward we can expect the following to come to the surface:
Increased activism: Investors expect to have more information and a say in the process, including focusing on the terms of the Limited Partnership Agreement (the fund’s governing document) and quantum of debt. GPs must engage in this process as financing terms can impact fundraising; an Alcentra fund investor withdrew its commitment based on concerns over the credit facility.
The California Public Employees' Retirement System (a very large institutional investor) recently undertook a review of their leverage policy. They subsequently published (July 2017) the results in a document entitled “Use of Leverage in Strategic Asset Allocation” which, among other things, addresses the risks and benefits of using leverage and their internal governance requirements. Oaktree is developing internal guidelines “to mitigate the risks of subscription lines while preserving the benefits”. Others may follow.
Different metrics: An additional metric to measure performance can be used e.g. multiple on invested capital. No single metric is perfect but used alongside IRR, a more balanced picture of performance is provided.
Interest rates: The increase in subscription facilities occurred in a low interest rate environment. As rates increase in the US, and potentially the UK, cheap credit may become less available. Though significant rises are probably needed (maybe 200 basis points) before it becomes prohibitively expensive.
Alternative sources: GPs may use other financing structures, e.g. preferred equity or preferred priority distribution. These arose to avoid borrowing restrictions but also provide increased transparency.
Market feedback: The Securities and Exchange Commission in the US is looking into the use of fund facilities, including investor disclosure and communications. The Institutional Limited Partners Association published its influential guidance for investors on 27 June and the SEC is understood to be interested in these results.
A major immediate shift in the use of these facilities is unlikely. The bigger picture is that investors’ focus on these facilities is increasing and GPs will need to respond. Unfortunately, their real test and impact is likely to come during an economic crisis.