For the last couple of years, we’ve been monitoring a troubling development in private equity, the use of “subscription line financing”. This innocuous-sounding term is for a credit line, offered by a bank, to allow general partners to borrow at the level of the investment fund. This is in addition to the considerable borrowing that already occurs in private equity, at the portfolio company level, where 70% of the purchase price typically comes from lenders.
This practice, which even major players like Bain Capital decry as dangerous, appears to have gone mainstream. As we’ll explain, these credit lines make already-exaggerated returns in private equity look more attractive than they are, not merely through the raw application of leverage but by changing how investment cash flows are reported. And they greatly increase the risk of investing in private equity during financial shocks. That risk obviates out one of the supposed advantages of private equity, that private equity appears to do well in bear markets, when in fact private equity partners are merely providing rosy portfolio values. The more general partners use these subscription lines of credit, the more private equity will amplify investor risks rather than reduce them.
Background: How Subscription Lines of Credit Work
The Bank of Montreal created subscription financing and it was always intended as a way to improve investors’ reported returns at the expense of the economics of the investment.
Early in the life of a specific private equity fund, investors will report negative returns. This will occur in the first year or two, after the investor has incurred management fees and had some initial capital calls. Unless the general partner has an aggressive, fast strategy for monetizing the investment (say the now out-of-favor “dividend recap” in which the GP loads the acquired company with lots of debt and pays investors a large special dividend), for at least the initial year after making an acquisition, the GP is likely to report the value of the portfolio company as par value, meaning the acquisition price. So when you include the management fees and the cost of closing the deal, the limited partners’ reported returns will be negative. This pattern is called the “J curve”.
Despite the impact on the level of individual fund, this J curve effect has been seen as more of an annoyance than a serious problem, since private equity investors are committing new monies to private equity every year and reaping returns over time from mature funds. It’s been bruited about much more in venture capital than in private equity generally, since in VC, the fund makes multiple financings before an exit, so the J curve is deeper on the downside and longer in duration.
By contrast, in private equity, the overall returns have been seen as good enough that the perceived negative impact of the J curve washed out over time. And let us not forget that private equity return are generally overstated, by virtue of the use of the internal rate of return as the prevailing method for presenting results (as opposed to more accurate measures, such as PME, or “public market equivalent”) and that GPs are widely acknowledged to under-report declines in value in bad markets.
But now that private equity returns are flagging, investors are willing to turn a blind eye to any gimmick that improves results. Here is where the subscription lines of credit come in.
Limited partnership agreements have always allowed for borrowing at the fund level, but the original intent was that it would be used only on a very exceptional basis, for instance, if the GP was consummating a deal and some part of the financing fell through (say a creditor rescinded a funding commitment).
Rather than hit up the limited partners for more money, which would presumably then be taken out via a conventional lender, the general partners would borrow at the fund level.
Subscription line financing makes it possible for general partners to borrow at the fund level on a routine basis, as opposed to its previous status as an unusual event. The bank provides a credit line with that borrowing secured not by the assets of any portfolio companies, but by the unused capital commitments of the limited partners. In other words, while these borrowings were expected to be rare and repaid by other means, from the lender’s perspective, legally they are advances against the limited partners’ capital commitments.
While we’d only seen limited information about these credit facilities in the last two years, a new article from Pensions & Investments reveals that they are becoming popular. Even more troubling is that this news is buried in the second half of a story titled, Private equity managers not budging on carried interest. From the article:
Most of the speakers on that panel — including moderator Sam Green, private equity investment officer at the Oregon Investment Council, Tigard, which runs the $68 billion Oregon Public Employees Retirement Fund — were sanguine about a relatively new development in which private equity general partners are taking out lines of credit to leverage their funds.
“There’s some controversy, but I am largely in favor if they (general partners) use credit lines properly,” said Paul R. Yett, managing director of alternative investment money manager Hamilton Lane, who spoke on that panel.
Some managers use lines of credit instead of calling investor capital, thereby easing limited partners’ capital call burden, Mr. Yett said.
“I expect general partners to be good managers of their funds … and subscription line (lines of credit) rates are very attractive right now,” he added.
John Connaughton, co-managing partner and head of global private equity at Bain Capital, who spoke on the same panel, said leveraging portfolio companies and then leveraging equity on top of that “could be like the boiling frog.”
“It’s not a good idea,” he said.
Look at how topsy-turvy the panelist comments are. The party that ought to be most positive about this trend, namely a general partner, is the one sounding alarms. By contrast, Hamilton Lane, which acts both as a pension consultant and runs funds of funds, is hunky-dory. Bizarrely, the rationale is that the general partners will be “good managers of their funds.” As we’ll show shortly, general partners are indeed concerned about their funds…which has nothing to do with the liquidity management issues of their investors.
Hamilton Lane’s cheery take means at a minimum, it sees these credit lines as popular among its clients and does not want to rock the boat, and at the worst is promoting this development. More attractive-looking private equity investments means more allocations to private equity, which is all to the benefit of Hamilton Lane.
Former CalPERS Investment Committee chairman and private equity executive Michael Flaherman was also alarmed about the rise in this practice. As he said:
This leverage-on-leverage stuff is a disturbing development in private equity.
What is particularly troubling about this issue is that it’s a classic form of hidden risk, where the private equity staff looks smart because they get marginally better returns, until some big upset in financial markets when the credit lines all get called at once and investors suffer another liquidity crisis and a big loss on their PE portfolio. However, at that moment, everyone will be hurting in the institutional world, and the staff will claim, “Who could have predicted this?”
Private equity investors are setting themselves up to the Landesbanken* of the next financial crisis.
How Subscription Lines of Credit Juice Private Equity’s Reported Returns
So how do these lines of credit make private equity returns look better at a time when the industry leaders have warned that the glory days are over and to expect more modest results?
Turning early year J-curve negative into super-positive-looking results. Without seeing the interaction between the subscription line use and capital calls, it’s too speculative to estimate how great the impact of these subscription lines might be. However, at a high level, it’s not hard to see that it would be significant. Private equity limited partners could have the fund borrow the entire amount of their early-year deals, while allowing them to report their borrowed equity investment as the reported value. Thus in that scenario, the amount of “investment” would be at most their hard-dollar payment of management fees and annual fund level expenses, such as the fund audit.** So if you assume that the general partner spends 1/5 of a limited partner’s $500 million commitment amount at the start of year 1, levers it up with equity at 30% and debt at 70%, carries the investment at cost, and the management fee of 2% of the commitment amount is paid fully (as in no shifting onto the portfolio company via fee offsets), you have an “investment” of only $10 million (the management fees; we’ve kept the fund expenses out because they aren’t all that large) with a portfolio value of $100 million. An apparent ten-bagger out of the gate! And the impact on IRR is going be be even prettier because the management fees are paid quarterly, plus the computation of IRR exaggerates gains reported early in the life of the fund. Needless to say, the subscription lines are alchemy that turn the limited partners’ actual economic exposure of being on the hook for the equity component of these investments from an outlay before returns are realized into an apparent out of the box huge gain.
Increasing overall fund leverage. Even though some general partners have been telling limited partners (or even getting fund amendments to be more explicit) about using subscription lines and presenting the intended use as only to counter the J curve effect, that is not how the subscription line financings are structured. They allow for broad borrowing against limited partner capital commitments, and we are told that a careful reading of fund amendments allows for that use.
This practice allows limited partners to achieve vastly higher levels of overall leverage. Again, using the example above, if a fund has borrowed what would have been the entire limited partner equity contribution, the leverage is infinite. Using a less aggressive assumption, that by year two, half of the equity component has come from capital calls and half from the subscription line, the equity is a mere 15% as opposed to the more typical 30%. The result is a substantial increase in reported returns at the expense of a much greater risk of lose. And let us not forget that private equity deals regularly end in bankruptcies or restructurings.
Downside Risks to Limited Partners
How are limited partners like CalPERs, CalSTER, university endowments like Harvard and Yale, and other long-term investors put at risk by this accounting gimmickry and leverage on leverage?
Remember that these credit lines are secured by the commitments of the limited partners to the private equity fund. And those commitments have teeth. When a general partner makes a capital call, the limited partner is required to send the money pronto, typically in five or ten businesses days. The consequences of missing a capital call are draconian. A common penalty is for the assets of the defaulting limited partner to become the property of the fund and be reallocated among the remaining investors.
Limited partners take comfort from the fact that traditionally, general partners make capital calls only when times are good, as in when they can readily obtain financing. Even though it would have seemed to present a great opportunity for bottom-fishign, private equity firms did not buy companies at the panicked moments of the crisis because financial markets participants had all run to their bunkers.
Hoever, even with that general proviso, limited partners, and CalPERS in particular, got burned by private equity capital calls in the runup to the crisis. It’s widely known that CalPERS had contacted its private equity general partners and beseeched them not make capital calls because the giant pension fund was liquidity constrained. Industry sources say that the GPs weren’t moved by CalPERS’ pleadings. As the Wall Street Journal reported in late October 2008:
The nation’s largest public pension fund, known as Calpers, is unloading stocks in a falling market to make sure it has enough cash to meet its obligations.
The pressures come as the California Public Employees’ Retirement System has had to raise cash to fulfill commitments to private-equity firms and real-estate partners. The giant fund’s predicament is another sign of how the market selloff is tightening the screws on pension funds nationwide. Many other pension funds have similar partnerships and could also confront liquidity strains…
Typically, Calpers keeps less than 2% of its assets in cash, but the recent demands have forced it to raise that level…
Under normal conditions, pension funds count on some private-equity partners to distribute investment gains, while pensions owe some partners more capital. During the recent market selloff, however, distributions have dried up while capital calls continue. That’s created a mismatch and a cash strain.
Since the credit markets have tightened up and real estate and alternative investments aren’t very liquid, Calpers has been compelled to sell off stocks to raise large sums quickly. Those sales are turning paper losses into realized losses.
So CalPERS dumped stock at near-bottom levels of the crisis as a result of private equity and real estate imposing unexpected liquidity demands.
This risk would become more acute and the exposure larger the more general partners use subscription line financing. Why? One of the covenants is that the fund maintain a certain coverage level relative to aggregate EBITDA. EBITDA can fall sharply in a recession or financial shock. That would lead the bank to demand a credit line paydown, which in turn would lead the general partners to issue a capital call. Needless to say, this would also take place when securities values would be under stress generally, meaning if the limited partner ran through its liquidity buffers, it would, as CalPERS did, be forced to sell other investments to meet the cash demands on the private equity front.
Of course, funds like CalPERS could also hold more cash to insure against that need. But that’s perceived to be a real cost and would offset the perceived advantages of goosing reported returns. And as both behavioral economists and statistical experts like Nassim Nicholas Taleb have warned, investors tend to greatly underestimate the likelihood and amplitude of tail events. So it’s pretty much a given that even if limited partners recognize this need, they are unlikely to take sufficient precautions.
Leverage on leverage structures, particularly ones that have connections to the banking system, are very dangerous. The trusts of the 1920s, which were leveraged vehicles for investing in the stock market, evolved into trust of trusts and even trusts of trusts of trusts. It was common for retail investors in equities in the Roaring Twenties to have only a 10% to 30% investment in their positions. The Great Crash not only wiped out overgeared investors, it blew back to the banking system, directly via losses on margin calls where the liquidated stocks were sold at too low a price to cover the loan, and then through second-order effects: the economic damage, particularly to housing. Mortgages then were five year loans that were routinely refinanced. As investors were wiped out and as depositors lost their savings as banks failed, homeowners were either wiped out or had their saving greatly depleted So they would miss their mortgage payments or be unable to refinance when their loans matured. For instance, my maternal grandparents had deposits in three different banks, all of which failed. They lost their home and eventually got back three cents on the dollar of their deposits.
In the crisis just past, leverage on leverage vehicles, namely derivatives and collateralized debt obligations whose assets were primarily credit default swaps, were what would have been a savings and loan level housing crisis into a global financial crisis
In the savings and loan crisis and the 2008 crash, the losses on private equity borrowings have gotten little attention. Yet the leveraged buyout bust hit a lot of lenders and investors severely. Similarly, in the 2008 crisis, banks and investment banks were stuck holding a lot of unsold collateralized loan obligation inventory (structured credit vehicles based on leveraged loans, meaning almost always acquisition lending for private equity investments). As we discussed at the time, they underreported losses by trading itty bitty amounts with friendly investors to establish inflated “market” prices that they used for accounting purposes.
However, the broader point it that even as large as private equity borrowing has been, it hasn’t been enough to even warrant much mention in crises past because it wan’t large enough in aggregate, most deals had had reasonable levels of equity and much of the borrowing, like junk bonds and CLOs, sat with investors who could sustain losses, as opposed to thinly-capitalized banks who sat at the heart of the payments system.
These subscription lines have the potential to amplify financial crises by amplifying shocks and sending them across markets. We wrote about that phenomenon regularly in the 2008 debacle, when you’d see a sudden plunge in a market that seemed to have nothing to do with the bad news of the day, like gold. It was clear that a large investors had been hit with a margin call and needed to sell something to raise the needed dough. The logical move was not to sell an investment that was showing losses, if possible, or if not, to liquidate one that was in relatively good shape and in a market that was not so roiled that the order could be executed.
And let us not forget that if some private equity limited partners could not meet initial subscription line capital call, the other limited partners might be on the hook, up to the limit of their unused commitment amount. And what would happen if that were to prove insufficient to meet the remaining amount due? Presumably, the fund would be liquidated. This isn’t as outlandish as it seems. Quite a few quant funds folded during the crisis due to liquidity demands. It similarly seemed inconceivable that AIG could fail due to a parent-company liquidity crunch until it happened.
It’s one thing for a CalPERS (and perhaps some of its similarly too-clever brethren) to have to dump a few hundred million worth of stocks at a bad time. It’s a self-inflicted wound that shows how they underestimated the true risks of private equity, but was mere surface wound. By contrast, if these subscription lines become widely used, and the patter from the Pensions & Investments article says that is starting to happen, they post a vastly larger risk to the limited partners and have the potential to amplify financial crises. And these risks are being incurred in the name of making returns look better than they are. This ought to be financial malpractice but too often that sort of snake oil it touted as innovation.
* Landesbanken were among the dumbest money in the crisis just past. They were the buyers of many rancid CDOs in their hunger for safe-looking assets that provided a modest pickup in yield over similarly-rated conventional bonds. Readers of The Big Short may recall that patient zero of dodgy CDOs, salesman Greg Lippmann of Deutsche Bank, told inquisitive parties that “Dusseldorf” was the on the other side of these trades. IKB, headquartered in Dusseldorf, was the result of a merger of a landesbank and an industrial bank, went head over heels into US subprime and was the first major German institution to suffer large subprime losses and need a bailout.
** Recall that general partner transaction fees are offset against management fees. However, even then, some funds set up the management fees as part of the “commitment amount” as opposed to a separate contractual obligation. The costs of consummating the transaction are typically treated as part of the initial investment and thus paid out of limited partner capital calls and acquisition-related borrowing. So the limited partners are presumably exposed only to management fees and annual fund-level expenses.