Understanding Risks & Aligning Interests
By Shay Caufield, Executive Vice President, PEF Services
The traditional funding mechanism for illiquid alternative asset funds includes the periodic drawdown of capital from investors. This amount is based on the predetermined amount of capital committed by the investor. The timing of these drawdowns is unique to the fund and coincides with the need to make an investment or pay the operating expenses of a fund. The typical lifecycle of these funds assumes an investment period (typically 4-5 years) where investments are made and a harvest period (typically 6-10 years) where investments are realized, with the ultimate goal of returning all capital plus profits to the investor.
ALTERNATIVES AND IMPACTS OF USING CREDIT LINES
An alternate mechanism for a fund to access capital is the use of subscription lines or bridge facilities which have typically been used by a fund to bridge the period between a deal closing and the calling of capital from investors. These have been a valuable operating tool, particularly in instances where capital has to be deployed quickly. They have typically been short-term financing used for 90 days or less and repaid with capital called from investors. The unfunded capital commitments serve as the collateral for these lines.
The use of these subscription lines has expanded recently, mainly due to low-interest rates and the availability of inexpensive capital. Additionally, there has been a shift to longer term borrowing under these facilities with prolonged periods in excess of 12 months. The practice is legal, operationally efficient and will benefit a manager’s track record, so what is the issue?
There is a perception that this practice is becoming more of a performance engineering technique; the intention being to artificially increase the IRR (Internal Rate of Return) by delaying the calling of capital from investors and correspondingly accelerate the preferred return hurdle and payment of carried interest to the General Partner. While there are operational benefits and valid reasons for using subscriptions lines, they have become an area of focus and concern for both investors and regulators.
In June 2017, the Institutional Limited Partners Association (ILPA) issued Subscription Lines of Credit and Alignment of Interest – Considerations and Best Practices for Limited and General Partners. The guidance highlights many of the impacts of the use of credit lines and provides useful recommendations with an emphasis on enhanced disclosure, as well as a sample questionnaire that can be used to facilitate an investor’s understanding of the intended use and operation of these lines.
Some of the highlighted issues of using subscription lines noted in the ILPA guidance include:
- Comparability of performance across funds
- Acceleration of the preferred return hurdle may trigger future clawback of carried interest
- Associated additional partnership expenses to the fund
- Tax considerations and potential UBTI (Unrelated Business Taxable Income) exposure
- Liquidity risk and cumulative exposure through these facilities
- Legal risks including covenants that may limit transfer rights, inhibiting GP approvals of secondary sales
ILPA believes there should be agreement between Limited Partners and General Partners for the reasonable use of such lines as well as enhanced transparency of their impact. The full ILPA guidance, including recommendations for Limited Partners and General Partners and the questionnaire can be found at: Subscription Lines of Credit and Alignment of Interest – Considerations and Best Practices for Limited and General Partners