In June 2017, the Institutional Limited Partners Association (ILPA) issued guidance in relation to the use of subscription lines (also referred to as subscription facilities or bridge facilities) by GPs of private funds – the term ‘GP’ refers to either general partner or manager as the context requires.
This guidance has been issued in response to what ILPA characterises as the increased use and scope of subscription lines by GPs. Traditionally used as a short-term bridging function, subscription lines are now often used as a cash management tool and the guidance has been issued in response to this shift. ILPA recognises the benefits of using subscription lines from the perspective of both GPs (who benefit from a shortened J-curve, enhanced IRR return and increased flexibility to execute deals) and LPs (subscription lines can reduce the administrative burden of having to respond to capital calls). However, ILPA identifies a number of concerns that have arisen in connection with this change:
- it is difficult to compare performance across funds because the use of subscription lines is not universal. The use of a subscription line tends to inflate the IRR (particularly early in the life of the fund) since deals can proceed without having to draw investor capital;
- this IRR inflation also means that GPs may be entitled to carried interest even where the unlevered IRR would not have met the hurdle. This could lead to claw back issues arising later in the life of the fund;
- there are expenses attributable to the use of these lines (e.g. an upfront fee and interest expenses) which will be borne by the fund;
- there is potential for unrelated business taxable income (UBTI) for tax-exempt institutions where the maturities of these lines have been extended to 1 year or more (traditionally these lines were cleared every 90 days to prevent against this exposure but increasingly they remain open for up to one year or more); and
- due to there not being a consistent standard of disclosure by GPs, LPs may not be fully aware of their cumulative exposure across different funds.
ILPA’s central point is that the use of subscription lines “should accrue to the benefit of the LP”. With this objective in mind, it makes a series of balanced recommendations that focus more on disclosure and transparency rather than prescriptive rules. Its recommendations include the following:
- waterfall provisions in partnership agreements should specify that the date used to calculate the GP’s preferred return hurdle aligns with when the subscription line is drawn, rather than when capital is ultimately called from the LPs;
- provisions in partnership agreements should specify reasonable thresholds for their use (e.g. a maximum percentage of all uncalled capital (ILPA recommends 15-25% – which is at the lower end of what we are seeing in the market), a maximum of 180 days outstanding and a maximum period of time for which such lines can be used);
- managers should disclose certain information to LPs as part of the quarterly reports in connection with the use of subscription lines (for example, the balance and percentage of total outstanding uncalled capital, the number of days outstanding of each drawdown, net IRR with and without the use of the subscription line);
- LPs sitting on Limited Partner Advisory Committees (LPACs) should consider adding a discussion item on the use of subscription lines to LPAC meeting agendas; and
- as part of their due diligence of a prospective manager, LPs should request that manager to provide information regarding the impact of subscription lines on track record (i.e. levered and unlevered IRRs as well as any tax impact).
In addition, ILPA also provides a set of recommended questions for LPs regarding the (on-going) use of subscription lines to be added to their due diligence questionnaires. This guidance (plus any updates that ILPA subsequently makes) will be incorporated into the revised ILPA Principles (version 3.0), expected to be released early 2018.
Opinions on the benefits and drawbacks on the use of subscription lines are varied (including among LPs). The drawbacks outlined by ILPA are real but there are some significant advantages, from the perspective of LPs, associated with the use of subscription lines. The ability for GPs to make investments without drawing investor capital is valued by many LPs (particularly public sector investors and fund of funds), as they can plan ahead for drawdowns rather than having to respond at the discretion of the GP. In addition, whilst there are indeed expenses associated with the use of subscription lines, these may often be less (on a per-LP basis) than the expenses that the LP would otherwise have to bear by having to break long-term commitments to source funds to respond to drawdown notices on 10 business days’ notice.
ILPA’s recommendations are balanced in recognition of the variety of opinions on the use of subscription lines. Nonetheless, we expect that the use of subscription lines will be an issue on the radar of many LPs. Consequently, we can expect to see more LPs raising questions on the use of subscription lines at the DDQ stage and discussing related issues at LPAC meetings. LPs may request that GPs grant side letter provisions or amend partnership agreements to provide for the disclosure of certain information relating to the use of subscription lines.
It is possible that one effect of the ILPA recommendations is that GPs may revert to ‘cleaning-down’ (a reduction of loan to zero) subscription lines every 3-6 months. However, given the lack of direct influence which LPs have on lenders, this is likely to be GP led rather than a lender requirement. It is worth noting that GPs may wish to increase the frequency of the clean-down for another reason. This is because the more frequently a subscription line is cleaned-down, the more likely that it will not count as leverage for AIFMD purposes. The general view in the UK market at least is that subscription lines do not count as leverage for AIFMD where they are secured against undrawn commitments and cleaned-down at the end of each quarter, because they are then “temporary” in nature (although this position is not fully settled). In the short-term, we do not expect that many GPs will volunteer to include all of the recommended partnership agreement provisions without significant pressure from large LPs. This may change when the updated ILPA Principles are released in 2018, although experience suggests that GPs may still resist some of those recommendations with significant economic impact.