Private Equity Should Ease Up on the Performance Enhancers

(Bloomberg Gadfly) -- Private equity firms, arguably the masters of financial engineering, put billions to work on behalf of their investors while of course clipping some of the profit for their efforts. By all accounts, transparency about how they go about doing this has improved in recent years, but it still could be better.

On Tuesday, a group representing pension plans, endowments and other investors in the industry raised concerns about private equity's use of so-called subscription credit lines and their effect on how and when firms can pay themselves. To recap, these lines are a type of borrowing that firms have been increasingly turning to that conveniently boost a key performance measure known as an internal rate of return. Because these interim loans effectively shorten the overall duration that such capital is deployed (they're meant to act as a placeholder until investors deliver their capital), funds can more quickly hit the pre-agreed return hurdles above which firms begin earning lucrative performance fees known as carried interest.

As I've written, the practice is perfectly legal: Firms using such loans (some stretching as long as two years) are obeying the letter of the law. But to the extent that this financing allows them to compensate themselves earlier, it's no wonder the investor organization, the Institutional Limited Partners Association, has some thoughts on the issue. It's calling for increased transparency, such as quarterly updates regarding the length and purpose of the credit lines' use, as well as capping their duration to 180 days, limiting their size and including the start date of borrowings in the calculation of IRRs.

Firms aren't under any pressure to adopt the recommendations because the ILPA isn't a regulator -- and indeed past efforts by the group to increase disclosure have met with mixed results. But these suggestions are are all valid and firms should consider following these guidelines, if only to build goodwill with investors.

While it's true that in the current fundraising environment, private equity firms hold the cards, the tide will eventually turn. They won't be able to dictate terms forever. Apollo Global Management LLC, Blackstone Group LP, KKR & Co. and Oaktree Capital Group LLC -- among the publicly traded firms using subscription credit lines -- can set the standard by leading the way. 

If they're not willing to forego the practice entirely for fear it will put them at a disadvantage, one potential solution is that firms give investors a choice. It's the least they can do.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Gillian Tan is a Bloomberg Gadfly columnist covering deals and private equity. She previously was a reporter for the Wall Street Journal. She is a qualified chartered accountant.

Stay Updated With Stock Market News on BloombergQuint