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Editor’s Letter: Court Square puts sub lines in LPs’ court

LPs are a conservative bunch.

As much as they complain about the things they don’t like about GPs, they’re not big on change. And not much will prevent them from opening their wallets to the best performing managers.

This is the case with a lot of issues in the PE world — fee structures, for example, have not changed in 30 years. While some may argue that a 2 percent management fee and a 20 percent profit share is outdated, the structure remains in place.

Another major issue that has come up in recent years is capital call subscription lines of credit. A portion of the LP community has concerns about the widespread use of this type of credit, which allows GPs to fund deals well before actually collecting capital from LPs. The use of this credit can have the effect of boosting a fund’s internal rate of return because the GP hasn’t yet collected money from LPs. This can boost IRRs up to 300 basis points or more, which in some cases can put a fund over its 8 percent preferred return, which a GP has to hit to start collecting its share of profits.

Some LPs believe these credit lines are a way for GPs to artificially enhance performance to push a fund over its pref. This becomes especially important around the time a GP is ready to launch its next fund, when studies have shown prior fund performance gets a sudden boost, before falling back after fundraising has progressed for a time.

“The credit line abuse is getting outrageous. Most GPs wrap themselves in the flag of, ‘Well, we want to smooth capital calls for LPs, can’t risk losing a deal due to financing, blah blah blah,’” one LP told me email earlier this year. “In reality, they are simply stat-juking to the best of their ability. They know the first few deals in the fund have to be big winners because they’ll likely be right back in the market for the next vintage, showing those inflated returns.”

But many LPs love the use of sub lines to smooth the capital call process and because of the potential IRR boost, which looks good for their portfolios and ultimately their shot at a bonus.

In a way to seemingly address concerns about sub lines among LPs, Court Square Capital is offering an interesting choice in its fourth fund, which is targeting $3 billion. (See my story on page 6.)

Court Square is offering limited partners the option to opt out of capital call subscription lines of credit. It’s doing this by offering two structures on Fund IV — one that uses a capital call line of credit and one that does not.

My understanding is most LPs are choosing the structure that uses the subscription line of credit. That makes sense, because as much as LPs complain about practices they don’t like, they are also not likely to make waves, especially for GPs with whom they want relationships. So while Court Square’s fund structure is interesting, it’s not likely to become a trend among new funds.