ILPA Questions, Suggests Guidance on, Subscription Lines

An industry group representing institutions that invest in private equity funds has questions about how funds use subscription lines or other forms of leverage in their fund structures. The Institutional Limited Partners Association is in the process of formulating guidelines to ensure funds become more transparent about their actual use of subscription lines — credit facilities traditionally offered by banks to provide short-term liquidity to funds in advance of the funds’ calling on investors to fund capital calls. While funds typically disclose in their offering documents their ability to borrow and pledge the unfunded capital of investors to secure such borrowings, the ILPA is concerned about overuse or undisclosed use of these lines, which may result in increased risk to the industry.

Subscription lines were originally developed to allow funds to move quickly when an investment opportunity arises and to allow funds to better administer their capital call process. Some funds have used subscription lines on a longer-term basis to provide leverage in their acquisitions. This use has the effect of increasing the funds’ internal rate of return, or IRR, by having the investors’ capital remain uncalled while the borrowing to fund the acquisition is outstanding. Since IRR is measured by the return on the investors’ capital, the shorter the period that capital is outstanding, the higher the IRR. In fact, if an asset financed through a subscription line is sold before capital is called to repay the loan, the IRR for that asset is infinite. Although the IRR may be higher, the bottom-line return to the investors hasn’t really changed. Nevertheless, IRR is a significant measuring tool to judge a fund’s performance, so the higher it is, the better the fund’s performance appears.

The utility of subscription facilities to the private equity industry is well-documented, and most investors will look at the prudent use of financing as a benefit to the fund. As limited partners look to evaluate fund performance, however, the move to more transparency in all areas, not just borrowing, will increase. The ILPA’s guidelines are expected to call for disclosure of the amount of credit facilities, the percentage of fund investments funded by these lines of credit and the costs associated with the facilities.