The Institutional Limited Partners Association (ILPA) recently released “Subscription Lines of Credit and Alignment of Interests,” a report designed to provide private equity fund limited partners (LPs) guidance regarding best practices, potential risks and other considerations related to the use of lines of credit by general partners (GPs) of private equity funds.

Short-term financing has been a common tool utilized by private equity fund managers in connection with transactions for their funds for some time, providing LPs with a mechanism to smooth cash flows between closing transactions and reducing the burden to respond to capital calls on a short time frame. For GPs, lines of credit offer multifaceted benefits, such as greater flexibility in executing deals and delivering the LPs with a higher internal rate of return (IRR) due to the ability to defer the drawdown of capital from them.

However, ILPA’s report indicated that the practice has been expanding in both prevalence and scope in recent years, fueled in part by low-interest rates. Within that environment, subscription lines have “evolved beyond a short-term bridging function, to serve as a broader tool used to manage the overall cash of the fund.” This increased use and longer borrowing duration prompted ILPA to issue this guidance.

Considerations

The ILPA report details several considerations for both LPs and GPs related to the utilization of a line of credit. For example, the use of a credit line may enable a GP to receive carried interest even though the unlevered IRR may not have been sufficient to do so. The concern from ILPA’s perspective is that this may result in a clawback issue later in the life of the fund.

Similarly, lines of credit may create additional expenses for a fund, potential unrelated business taxable income exposure for tax-exempt institutions and heightened cumulative institutional liquidity risk. ILPA states that LPs “have raised concerns about the ability for the lender to recall the line in the case of an Event of Default with the manager,” while a negative market event resulting in widespread calling of capital could create a scenario wherein individual LPs would be unable to respond.

Finally, the report describes the legal risks presented by the use of credit lines, including terms that may bestow upon the lender excessive discretion over fund management decisions or assignment, as well as the regulatory risks for managers in markets where added fund-level leverage is accompanied by greater regulatory requirements.

Recommendations

With these risks in mind, ILPA provided nine specific recommendations that it felt would allow GPs to more effectively exploit credit lines while also minimizing risks. Guided by the principle that “the use of lines of credit should accrue to the benefit of the LP,” the report recommends that “GPs and LPs must agree to clearer thresholds for the reasonable use of such lines, and LPs should be provided greater transparency related to their impact.”

Among its recommendations is that the carried interest waterfall provisions in partnership agreements should specify that the date used to calculate the GP’s preferred return hurdle aligns with the date when amounts are drawn down from the credit facility, rather than when capital is ultimately called from the LPs.

ILPA also recommended that GPs should enhance the disclosure in their quarterly reports to LPs to include such information as the balance and percentage of total outstanding uncalled capital; the number of days outstanding of each drawdown; the current use of the proceeds from such lines; net IRR with and without the use of the credit facility; terms of the line (e.g., upfront fees, undrawn fees); and costs to the fund, including interest and fees. ILPA advised that during due diligence, LPs ask prospective managers to provide the impact of credit facilities on their past reported performance.

One additional recommendation was that private equity fund partnership agreements should include provisions that address the reasonable thresholds for the use of subscription facilities; for example, a maximum of 15-25% of all uncalled capital and a maximum period of 180 days outstanding. These provisions should also clearly describe the burdens placed on the LPs whose commitments are used to secure the line.

The full list of recommendations is available through ILPA’s website. Clearly, credit lines can be useful to both GPs and LPs, and perhaps the ILPA report can serve as a document that will help to facilitate discussion among the GPs and LPs on this issue as the industry will seek to move toward a market approach on the use of credit lines. In the near term, GPs should be prepared to field questions from LPs regarding their intended use of credit lines, given that many LPs review guidance issued by ILPA in connection with their investment decisions.

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