- Use of capital call subscription lines has steadily grown
- Help smooth back-office processes
- Bank rates creditworthiness of LPs in funds
1.) How has the market for capital-market calls for subscription lines evolved?
I have been familiar with subscription financings, sometimes referred to as capital-call financings, since the late 1970s. Then, most financings were for real estate joint ventures or single-investor funds with the investor commitment provided by insurance companies or pensions. The commitments were bankable, providing developer partners with working capital, letters of credit and other transitional expenses. There were buyout funds that were coming into their own in the early 1980s, but many of them were borrowing working capital from either the investment banks growing private equity platforms or from the investors on a short-term basis. The fund sizes and number of investors committing to private equity strategies was a small universe compared to today. Investors came to realize taking the risk of other investors was not a comfort zone of any particular institutional investor. No matter how small the fund, the sponsor always put in place a banking account for operations.
2.) What is the purpose of such credit lines for a GP?
Consider that it was not until 1999 when businesses were created to track private equity capital commitments through public filings and reported the market to be approximately $534 billion. Today the PE market — all strategies including funds and other committed capital structures — is likely approximately $7 trillion. You can imagine [that] what goes on in a sponsor’s back office day to day between working-capital and other financial needs can be very complicated. Sponsors need the services [that] lines provide to support their operations. When it comes to our client base, I would say that investors are typically appreciative that a subscription line is in place.
There are buyout funds buying big companies and others buying small companies. Some acquisitions require regulatory approvals and sponsors need to be ready to close within 24 to 48 hours of such approval. Other acquisitions have closing dates prior to acquisition financings being finalized. The lines provide a bridge in between capital calls as well as being an aggregation facility for permitted expenses in between capital calls. The lines are a cash-management tool.
Alternatives are predicted to be $22 trillion by 2020, with half of the AUM in private equity strategies. Try to imagine the back-office operations and needs.
3.) How do you address the LP concerns about the growing use of subscription lines of credit and the potential for creating systemic risk?
We’ve been spending a great deal of time with ILPA and members of the Fund Finance Association, of which we are a founding member. I believe ILPA’s guidelines and the FFA response to the guidelines is emphasizing that there’s not one size fits all, that each strategy has different needs when it comes to how often capital will be called from the investors, whether that be six months or up to one year.
I do see, based on our client base, that details about subscription lines [are] much more transparent than many of the early articles acknowledged. In all of the funds, there is an LPA that investors and sponsors agree to abide by. The LPA defines not only how the lines can be utilized, yet also defines the expenses that the investors have agreed can be fund expenses.
We’ve gone through a more or less long period of time with minimal corrections. I do not believe a correction is necessarily bad to balance everything. But for the time being, I see pricing remaining steady. Coming through the last crisis and being involved in this product for as long as I can remember, when I think about systemic risk, I do not think the next crisis will be a liquidity issue like the last crisis.
4.) Some believe there will be a point when interest rates will rise, making these lines of credit prohibitively expensive, and firms will stop using them. Do you anticipate this activity dropping off?
I do not anticipate the need for lines to drop off based on the increasing amounts being allocated to committed capital structures and bank lines needed to ensure smooth operations.
5.) How do you determine reliability of the LPs in a fund to meet their capital calls? How do you determine pricing?
We look at the types of investors and their individual creditworthiness as well as the overall mix of investors and the individual concentrations of each within the fund. One investor could comprise a large concentration of the fund. We would look at the concentration risk. This affects the amount of credit we provide to such a commitment. It doesn’t necessarily affect the cost. You asked how we look at underfunded state pensions compared to a healthy pension commitment. We would apply a lesser advance rate or possibly no advance rate to such a commitment. We have built our own data around every investor commitment in all loans we provide. We apply a rating to each of the investors; some are publicly rated and others we need to implicitly rate. We review important investors as well as sponsors we lend to annually. We keep up with all changes.
Pricing varies based on the types/mix of investors, clarity in the partnership agreement/LPA, the size of the line and anticipated usage of the lines. We’re looking at all those factors.
Dee Dee Sklar is vice chairwoman of subscription finance at Wells Fargo Securities.
Photo of Dee Dee Sklar courtesy of Wells Fargo