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Editor’s Letter: No break on the pref in capital-call subscription lines

Capital-call subscription lines is one of the most talked about issues in the industry this year. This is because many firms have now adopted the practice, ostensibly to smooth the capital-call process, with the peripheral effect of juicing a fund’s IRR and, as some LPs have described it to me, artificially getting a manager closer to the preferred return.

I heard recently that some LPs are telling GPs they’ll calculate IRR only when capital is drawn from the credit facility, not when it is drawn from LPs — which could be months or even a year or more after a deal is sealed. This negates the artificial effect of clearing the pref hurdle simply by holding deal financing in a credit facility and drawing from LPs later. In other words, GPs are not getting a break on the pref, as one source described it.

This comports with guidelines published by the Institutional Limited Partners Association in June. It’s all a negotiation, and LPs generally have to be happy with getting one or two points in fund negotiation in a list of 30 or 40 points of concern.

Perhaps the biggest point LPs are looking for is full disclosure in the LPA of how a manager will use capital-call bridge facilities. This is so LPs better understand how a manager plans to use these things, but it’s also good protection for GPs for future SEC exams, to make sure they are fully disclosing a practice that has a direct impact on fund performance.

Here’s a last, funny thing: So much noise and activity have surrounded this practice, and the reality is the use of capital-call sub lines will likely fade out after (or … I guess … if) interest rates rise to the point that such credit facilities become too expensive to use.

An anonymous reader felt compelled to write in after I mentioned capital-call sub lines in a recent morning Wire. Here’s that interesting perspective:

“The irony of Subscription lines of credit is that they diminish the GP’s ability to earn carried interest. Preferred Returns are “notional”, line of credit interest expense is a fixed cost with money leaving the system. When a Fund performs above the pref, the GP gets a full 20 percent of the profits due to the GP catch-up mechanic in the waterfall. Line of credit interest expense is paid to the bank and is not subject to the GP catch-up mechanic. Heavy use of a subscription line is a form of surrender by a GP, as they waive the white flag and accept they don’t have the ability to generate carried interest. Deal IRRs will be improved, but the interest expense will serve to widen the gap between gross and net IRRs. The average GP hasn’t even figured this out yet, just another chapter in the ‘everyone is doing it’ play book.”

Private Equity Editor Chris Witkowsky reflects at home. Photo by Wendy Witkowsky