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Private Equity

Rising credit lines sounding alarms for LPs

Many see trouble ahead for firms using strategy to grab extra return

Andrea Auerbach called the increasing practice a ‘zombie outbreak.’

Private equity managers' increasing use of credit lines is capturing the attention of consultants and limited partners around the globe, as concerns mount over the potentially risky trend.

The rising interest rate environment is also adding to the concern.

The use of credit lines, subscription line financing or commitment facilities — the many terms for a practice that sees a manager borrow from a bank to make investments, which are secured against capital commitments — dates to the 1980s. And it traditionally has been a benign practice: Sources said private equity managers would typically borrow in the short-term to bridge financing gaps in deals or to manage the number of capital calls they make to LPs.

But now, managers are increasingly using credit lines to bolster their internal rates of return. Using credit lines allows managers to defer calling on investors for capital, meaning the period of time capital is held appears shorter and amplifies investment returns. Source estimates on the impact ranges from about 200 basis points to more than 300 basis points, depending on the duration and interest rate associated with the loans.

Some managers also now are using credit lines for exits, with general partners drawing on commitment facilities to pay themselves earlier, return LP money earlier and then using the proceeds from portfolio sales to repay the ​ borrowed money. That can add 100 basis points to returns.

"I would say it is spreading rapidly, like a zombie outbreak," said Andrea Auerbach, a managing director and head of global private investment research at Cambridge Associates LLC in Menlo Park, Calif.

"This is the No. 1 conversation at the water coolers. It is being rapidly adopted by private investment fund managers," and while the practice has been around for a while, "the intention and use was much more benign ... to clean up capital calls. It's been a fast arms race and, as managers have started to avail themselves to this fund level engineering, everyone has cottoned onto it."

Taken to 'the extreme'

That's one of the concerns for consultants.

"LPs should be concerned because it's a growing trend," said Andrew Brown, head of private equity manager research at Willis Towers Watson PLC in London. He said he has heard from managers borrowing for longer time periods and taking bigger loans. These managers "have to compete and get benchmarked, so it is an arms race and it's an arms race to the bottom."

It's that trend of increased borrowing and duration, in an effort to keep up with peers and compete effectively, that worries Mr. Brown, "and what it could potentially look like. It started off as short-term borrowing to manage cash flows ... but now it has been taken to the extreme," he said.

There are benefits to using subscription lines, sources said.

"The good part of these facilities is that they optically boost an IRR measure," Mr. Brown said. "There are people who are, through the food chain, getting compensated on that measure, so it is a good result for them."

And multiple capital calls are a "burden" on investors, so a general partner managing that can help. "And I think if things are going well (an LP) can say actually, from an efficiency use of capital (point of view), wouldn't it be great if we could invest in a number of different managers and different funds, and almost overcommit, because they might not need the capital because things are going well," Mr. Brown added.

Agreeing with Mr. Brown was David Fann, New York-based president and CEO of private equity consulting firm TorreyCove Capital Partners LLC. "This approach works great in good times. Everyone wins: LPs benefit from convenience and 'better' investment returns. GPs show 'better' returns and have a higher probability of earning their performance fee."

But, said Victor Quiroga, New York-based founding partner at private equity advisory firm Triago, "the temptation is to overuse them, and that's where the industry has to be careful."

Rising rates

While borrowing always carries risks, the increased durations and values intensifies things. As does the rising interest rate environment.

"The obvious risks relate to interest rate changes and LP default on capital commitments," Mr. Fann said. "This approach works great in a low interest environment. If interest rates increase, the return benefits diminish."

Added Mr. Brown: "If interest rates increase to such degree that managers don't want to use these facilities, this might all go away. (The use of credit lines) has an interest rate clock ticking on it — there will be a point where it makes that return target harder to achieve."

From the limited partners' points of view, interest rate rises could see them call time on their managers using credit lines. "LPs would like to know how high rates have to get for these lines to become less attractive to GPs," said Jennifer Choi, managing director at the Institutional Limited Partners Association in Washington. "At some point, rates may rise to where these lines may offer a more attractive cost of capital relative to the hurdle rate for the GP, but no longer at a palatable cost to the LPs," she said.

The ILPA published recommendations last year on subscription line financing, "the culmination of conversations happening within our membership for some time. Subscription line financing is not new, nor is bridging finance, so what has changed? In today's low interest-rate environment, we have seen a significant increase in the number of managers using (it) and at the same time the use of proceeds has expanded," Ms. Choi said.

At the extreme regarding risks is the chance of an LP default on a call. The use of credit lines "pre-supposes that all LPs will make good on the capital calls. During times of crisis, some LPs may default. There's also the possibility LPs may default if they see some bad investments made under the subscription line borrowings and decide to walk away from the fund — that hasn't occurred yet to our knowledge but it could theoretically," Mr. Fann said.

Cambridge's Ms. Auerbach said that "should a deal tank badly within a couple of months, LPs may be asked to pay it down. That is probably not a fun moment for the GP or LPs having to put money into what is essentially a hole in the ground."

And while the concern over LP defaults is "far-fetched," it is still a risk, she said. "This is a disaster scenario, but my concern is that these disaster scenarios have not been fully explored. (Should) we meet that moment ... these commitment facilities may not behave in a benign fashion," she said.

That means GPs should be thoughtful in the use and deployment of subscription line financing, Ms. Auerbach added. "There are some real elements of this that could sour at the worst possible moment."