Buyout Investor Group Advises Curbing Credit Line Excesses

(Bloomberg) -- For at least two years private equity firms have seized on a technique to artificially juice investment results. Now the main trade group for those firms’ investors says it’s time to curb excesses.

The Institutional Limited Partners Association issued guidelines Tuesday that take aim at buyout firms’ accelerating use of short-term bank loans, known as subscription credit lines, to defer -- often for months or even years -- putting money to work from the funds they manage in completed acquisitions. Investors in buyout funds traditionally have had to pony up when deals closed, but delaying that inflates a key benchmark for the firms with little benefit for clients.

The Washington-based group representing more than 400 pension plans, endowments and other leading buyout-fund investors said fund managers should take steps to increase transparency and be prevented from using the technique to pad fees.

The funds have been using the short-term loans to boost their so-called internal rate of return, or IRR, their main yardstick of annual performance. Shrinking the time that investors’ money is actually deployed lifts a fund’s IRR, which is a big selling point for firms trying to woo fresh money.

The pay-later strategy can jack up the IRR of a deal or of a fund by 20 percent or more, studies show. The longer the delay, the greater the effect on IRR.

‘Pressing Need’

Investors’ understanding of the strategy’s use hasn’t kept pace with its proliferation, Jennifer Choi, ILPA’s managing director of industry affairs, said in a phone interview. Prominent firms have taken out subscription credit lines for their newest funds -- lines enabling them to take out loans against 20 percent or more of the funds’ total undrawn equity commitments at a given time. Yet most buyout sponsors don’t tell investors when they take out loans, leaving them in the dark about their use.

There’s a “pressing need” to standardize reporting and practices with respect to subscription credit lines, Choi said.

“Their use has expanded over a short time,” she said. “Their prevalence, the maturities, the length of time the lines are being left open -- all that has changed in the last couple of years.”

Recommended Limits

The ILPA advises investors to ask fund managers to quantify the effect of subscription lines on their funds’ IRRs. It also recommends that investors:

  • Require fund managers to provide quarterly updates on active loans, how long the loans have been outstanding and how they’ve been used.
  • Pressure managers to accept reasonable loan limits, such as capping borrowing at 15 to 25 percent of a fund’s undrawn capital and repaying loans within 180 days.
  • Make sure partnership agreements prevent managers from manipulating the IRR to push poor-performing funds above the so-called hurdle rate -- typically 8 percent -- that triggers incentive-fee payments to managers. Agreements should specify that IRRs used to calculate whether a fund meets the threshold should assume that investors’ money is deployed when the loan is drawn, not when fund money is finally tapped.

Because the loans are secured by investors’ undrawn commitments to funds, partnership agreements should also spell out the risks investors face if a fund defaults and lenders seek to recall the line, the ILPA advises.

Choi emphasized that behavioral change is needed.

“To the extent managers have been toying with the idea of extending these lines out beyond a year, we would like that practice to stop,” Choi said. “We would also like to see them be more upfront" about whether their advertised returns depend on subscription credit lines, she said.