Don’t Be Fooled by Inflated Private Equity Returns
Investor beware: the annual returns touted by your private equity fund managers can easily be inflated by a few hundred basis points.
Blame the proliferating use of subscription lines of credit. Years ago, fund managers with a transaction teed up would simply draw capital from backers to finance their equity investments. Immediately, the clock would start ticking on their internal rates return (IRR). Straightforward.
Today, by contrast, many fund managers first draw on low-interest credit lines provided by First Republic Bank, Silicon Valley Bank, Wells Fargo, and other big banks. Fund managers may not call capital from investors to replace these bridge loans for three months to a year. In some cases, the loans remain in place far longer.
“Our sense is that the use of these facilities has continued to grow and has continued to become more mainstream,” said Jennifer Choi, managing director-industry affairs at the Institutional Limited Partners Association, which has eyed the trend warily.
Indeed, a recent study by data provider Preqin found that 31% of vintage 2018 buyout funds use subscription lines of credit. That is up from 25% for vintage 2013 funds. But those figures may understate their popularity since some fund managers don’t disclose whether they use them. A source at one European pension manager said that every one of the last 30 to 40 buyout funds he’s backed over the last two years uses subscription lines of credit. His firm typically backs buyout funds of $1 billion or more in size.
Because the clock doesn’t begin on the IRR of deals until investor money is drawn, fund managers using subscription credit lines see their IRRs get an artificial boost. That’s so even as the absolute dollar returns that they produce for investors—and in turn for their beneficiaries—fall due to the interest payments.
“We’re just giving money to the banks for no good reason,” said the European pension source. “IRR isn’t a return. It’s just a comparison measure…No beneficiary can eat IRR. All the people who want cash-on-cash returns are losing out.”
The upshot for CIOs: They must be more vigilant than ever in evaluating individual fund performance to make sure they’re making apples-to-apples comparisons. They need to understand the inflationary impact of subscription credit lines on industry benchmarks. And they need to be aware of worst-case scenarios that could result in substantial losses in their private equity portfolios.
Swift-moving Trend
Subscription lines of credit have been around for years, but it’s only recently that they’ve become widespread—and controversial.
David Fann, president and CEO of TorreyCove Capital Partners, an advisor to pension funds, said that their original purpose was to reduce the number of capital calls for investors. It was “a huge benefit” for investors to get a single capital call every six months, say, rather than getting them every time a fund manager made an investment, Fann said.
But the cost of borrowing fell in the post-financial-crisis years, and banks, ever seeking ways to grow their loan portfolios, offered generous terms on subscription lines of credit. Private equity firms responded by keeping the bridge loans in place for longer periods.
Fann said he’s heard of credit lines that remain outstanding for as long as three years. “There are those [fund managers] that have expressly stated to their LPs that it’s not going to be a drug that they will abuse,” Fann added. “And then there are others that see it as a mechanism for IRR management.”
TorreyCove Capital has done research showing that the impact of subscription lines of credit on IRRs and investment multiples can be substantial. Consider a single $100 million private equity investment that is exited at a value of $200 million after six years (see chart).
Using a two-year subscription line of credit, the deal would produce an IRR of 13.93%—much higher than the 10.56% IRR that would be produced without it, according to the research. On the other hand, the investment multiple would be lower, 1.67x vs. 1.79x.
Oliver Gottschalg, an associate professor at HEC Paris, and founder and head of research at data analytics provider Peracs, said that the potential for this kind of IRR inflation has led to an “arms race” among buyout firms. Fund managers fear being pushed down the performance rankings by firms using subscription lines of credit more aggressively than they do. The thinking is that “if we don’t use them, we’ll be crowded out of the top quartile,” said Gottschalg.
For their part, institutional investors have conflicted feelings about the use of subscription lines. The bridge loans can be a tremendous help in cash flow management, especially for thinly staffed family offices and wealthy investors who would otherwise be swamped by capital calls. And then you have self-interest. Investment officers in charge of private equity portfolios can point to the higher IRR as evidence of their fund selection prowess. Their annual bonuses may even be tied to IRRs.
In fact, so many investors find subscription lines alluring that, in trying to put limits on them, the European pension manager source feels as though “we’re actually negotiating against ourselves.” He added: “I get more push back from LPs than I do from GPs these days.”
For investors, the downsides of subscription lines go beyond the difficulty of knowing how much of an IRR can be attributed to deal acumen and how much to the impact of bridge loans. Most buyout firms can only begin taking carried interest—typically 20% of profits—when they’ve cleared a hurdle rate of return for investors. The hurdle can be jumped earlier if subscription lines of credit are in place.
Gottschalg pointed to a worst-case scenario in which the value of the first investment made by a private equity firm drops by, say, 50% before the capital call is made. What if some investors decide to default on the capital call rather than immediately take a 50% loss? Remaining investors might be compelled to fund not just their own capital calls but those of defaulting investors. If they balk, the whole partnership could crumble.
Another doomsday scenario: a financial crisis or severe recession in which banks call in their subscription lines and demand immediate repayment. Family offices and other small investors that took advantage of the loans to commit more capital than they might otherwise could have trouble meeting a flurry of simultaneous capital calls.
There is no easy answer to how CIOs can protect themselves from subscription credit-line abuses. But ILPA recommends several steps that investors should take when negotiating limited partnership agreements. Among them:
- Make sure fund managers provide a reasonable limit on the time outstanding on the loan (such as 180 days and no more than 360 days);
- Place a cap on the amount of borrowing as a percent of commitments; also consider limiting the amount outstanding to a fixed percent of undrawn capital;
- Ask that fund managers in their financial statements show their IRRs with and without the impact of the subscription lines;
- Make sure the hurdle rate of return is linked to the performance of the fund as if no lines subscription lines of credit are in place.
Unfortunately, the balance of power is such in negotiations that popular fund managers won’t have to agree to these requests. And while they have less negotiating power, newer fund managers and those with less-than-stellar track records are the very ones who feel the most pressure to prop up their IRRs through the use of bridge loans.
So for now, you can expect the use of subscription lines of credit to grow even more pervasive in private equity. Indeed, sources for this article said they’ve heard of firms expanding their use of subscription lines of credit to accelerate distributions.
Rather than wait for a full exit, they borrow money to make a distribution to investors at the time, say, that the purchase agreement is signed. It’s hard to see how this kind of bridging benefits fund investors. But it does give a boost to the IRR.
Ready for the day when you get a distribution on a private equity deal within days of getting a capital call to finance it? With subscription lines of credit growing more popular, it just might happen.
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