Apparently, one GP in market with a fund is offering a unique term: LPs can choose to commit under a structure in which the GP will use a subscription line of credit to delay calling capital. Or the LP can commit outside the commitment credit facility. Each of the options comes with a different fee/carry arrangement.
I’m not entirely clear how that would work, but it does highlight the idea that LPs are paying a lot more attention to the use of subscription lines of credit than ever before.
Sources have told me LPs are asking about use of such credit lines up front when they are considering backing a fund. They’re trying to bake into fund contracts how long commitments will stay in the credit lines and exactly how they will be used.
One GP recently said they did a hypothetical calculation on keeping a credit line open for a year (so not calling capital for a year), which boosted returns by 500 basis points. “We were shocked by the results,” the GP said, explaining that they have been encouraged by some of their LPs to make more use of subscription lines of credit.
“We’ve had bankers come to us pitching lines of up to four years,” the GP said.
Benchmarking: The use of such credit lines has made benchmarking increasingly tougher because it has not yet become standard for GPs to disclose levered and unlevered returns. If they are asked, firms will disclose returns without factoring in the use of credit lines, but right now it’s hard to parse that for benchmarking purposes.
“It’s definitely skewing the numbers, and when it gets baked into a [benchmarking] chart, it makes those useless,” the GP said. “It’s a huge difference and the industry will have to grapple with how to deal with it … maybe go back to gross IRRs and TVPIs and forget net IRR because it’s too variant right now.”
While GPs are leading the charge on the widespread use of subscription lines of credit, some LPs also push their GPs to use the lines (usually the ones who get bonuses based on IRR). “I had a big state pension prospect lecturing me that ‘you have to do this, you should do this, you’re irresponsible if you don’t.’ Some GPs feel caught in the middle on this.”
One thing no one seems to have seen yet is a clawback on a subscription line of credit.
This would occur because a GP achieves an 8 percent preferred return based on boosted performance from the credit facility, which falls back once the actual, real capital gets collected from the LP.
The industry standard 8 percent preferred return, by the way, also seems to have been rendered almost useless by widespread use of sub lines, Andrea Auerbach, global head of private equity research at Cambridge Associates, said during a recent talk in New York.
“The whole point is, ‘hey, you need to be able to return to me that 8 percent; we’re all in this together.’ That commitment facility obliterates the purpose of that,” Auerbach said. The question is, “how to get back to that stronger sense of alignment?”