In my 2016 year-end review, which went only to clients, I included a discussion of the use of subscription lines by closed-end funds in areas such as private equity, real estate, distressed debt and private credit. It’s my impression that their use has become fairly pervasive in recent years, and in response to clients’ requests and market trends, Oaktree has utilized subscription lines in some of its newer funds.
That year-end note prompted some interesting and spirited discussion of lines and their merit and effect. Thus I decided to write this memo on the topic for general circulation.
How Do Subscription Lines Work?
As I wrote in the year-end review, subscription lines are bank loans extended to funds that enable them to use borrowed money, rather than LP capital, to make early investments or pay fees and expenses. While there is no universal description, I believe it’s safe to say in general that subscription lines:
- are limited as a percentage of the LPs’ capital commitments.(Commitments from the most creditworthy LPs earn a 90% advance rate, and commitments from lesser credits earn lower advance rates or, in some cases, zero),
- are secured by the LPs’ capital commitments, and
- generally must be repaid in the early or middle part of the fund’s life (unless extended), although terms are beginning to lengthen.
The key element is that a subscription line can substitute for LP capital, but it can’t be used to allow the fund to invest more than its committed capital. That is, a $100 million fund with a subscription line might be able to buy $50 million of assets without calling LP capital, but it still can’t invest more than $100 million in total (other than by recycling proceeds from liquidated investments). The bottom line is that essentially all subscription line financing does is defer the calling of LP capital.
So the starting point for this discussion is the fact that these lines lever LP capital but do not lever funds in the sense of allowing funds to invest more than their committed capital. Fund-level debt that allows funds to invest more than their committed capital is different from subscription lines and not my subject here.
What Are the Effects?
Since a subscription line doesn’t lever a fund, its use doesn’t increase the total dollar profits that the fund will earn from investments over its lifetime (assuming the GP makes the same investments that it would have made if the fund didn’t have a line).
Also, the use of a subscription line – obviously – doesn’t alter the fund’s committed or invested capital. Thus, assuming all LP capital eventually is drawn, the fund’s ratio of distributions to LP capital – either the multiple of committed capital (MOCC) or the multiple of invested capital (MOC) – isn’t improved by the use of a line.
So much for what isn’t changed. The question, then, is “what is?” First the positives:
- The original purpose of subscription lines was (a) to enable GPs to make investments and pay fund fees and expenses without frequent capital calls and (b) to prevent opportunistic funds that don’t sit on large amounts of cash from missing out on attractive investments requiring quick funding.More recently, however, their use has grown for the additional reasons discussed below.
- With calls for LP capital postponed, the reported Internal Rate of Return or IRR in the early years – the dollar-weighted return on LP capital – will increase substantially (assuming the early profits exceed the interest and expenses on the line).
- The use of borrowed money can reduce or even eliminate the deleterious impact on early returns of the so-called “J-curve.”The J-curve results from (a) the fact that in a fund’s early years, management fees are usually charged on total committed capital, while a relatively small percentage of the capital has been put to work, and (b) the tendency of private investments to take a while to show results.
- Over the course of a fund’s life, LP capital will typically be called for investments or to repay the borrowings under the subscription line. This will cause the ratio of subscription line capital employed to LP capital to decline. As a result, the fund’s IRR will retreat from its elevated early level and move down toward what it would have been if the fund hadn’t employed a subscription line. However, all other things being equal, the fund’s lifetime IRR will remain higher than it otherwise would have been, since the impact of using the line will taper off but not reverse.
- Finally, any committed capital that hasn’t been called because of borrowing under the line will remain in the hands of the LPs.Thus any return the LPs earn on the uncalled capital in excess of their share of the fund’s subscription line costs will be additive to their results.
What about the negatives?
- If a fund finances investments by borrowing under a subscription line, interest and expenses will be paid that wouldn’t have been paid if LP capital had been called instead.The payment of these costs, even with interest rates below LIBOR+2%, is a permanent net negative for the fund: since the fund isn’t becoming levered, it won’t be offset by an increase in dollar profits (see above).Thus it eats into the fund’s dollar lifetime gains as well as its multiple of capital.
Some LPs may actually want to have their capital called and earn their preferred return. That will jibe with their expectations and preserve the historic hurdle for incentive fees. The preferred return that must be earned before the GP receives incentive fees is calculated based on how much LP capital has been called and for how long it has remained outstanding. Thus the use of a subscription line in lieu of LP capital shrinks the dollar preferred return hurdle. Lowering the hurdle can increase the GP’s probability of collecting incentive fees and cause the payment of incentive fees to the GP to begin sooner, although it will have no effect on the amount of incentive fees ultimately paid by a fund that would easily have cleared the percentage hurdle rate if it hadn’t used a line. (At the same time, however, the interest and expenses paid on the line will reduce the fund’s lifetime net dollar gains, and thus the eventual amount of incentive fees received by the GP. The interaction of these effects can be complex.)
- Less disciplined or less diligent GPs may be induced to lower the standards to which they subject investments because (a) their effective cost of capital seems so low and/or (b) they perceive an increased likelihood that the reported IRR will exceed the preferred return hurdle and thus a greater potential to earn incentive fees.
- Some LPs seek to avoid so-called Unrelated Business Taxable Income (“UBTI”).Without getting into further details, suffice it to say the use of subscription lines increases the risk of UBTI to these LPs.
- Since each LP’s commitment to the fund is an essential part of the bank’s collateral, the existence of a line could conceivably complicate