Credit lines have recently become a major discussion point in the private equity industry as they become larger and larger, are outstanding for longer periods and are rather unrelated to the cash management around deal closings, for which they were originally introduced by private equity, private debt and infrastructure funds. The discussions centered around concerns by LPs that credit lines are misused, fueled by the current low-interest environment, to show inflated IRRs.
What is the impact of a credit line on the two most prominent performance measures, the net total value to paid in and internal rates of return? Which funds are the ones that profit the most from the use of a credit line? What is the impact of the credit lines on the carry for a fund manager? After all, one would assume that a small change in the IRR could have a large impact on the fund manager if it helps it overcome the hurdle. But how likely is this to happen? And how large is the impact actually?
Data and methodology
The analysis is based on all buyout funds from Preqin with vintages from 1990 to 2007 with quarterly cashflow data. Our sample consists of 491 funds. For funds that are not fully liquidated, we treat the remaining NAV as a final cashflow.
For each fund in the sample, we calculate the carry assuming an 8 percent hurdle, a 100 percent catch-up and a whole-fund waterfall. For our analysis, each fund is equipped with a credit line that finances each capital call in the first four years for four quarters. The interest rate on the loans is 3 percent.
The cashflows from and to the LPs are therefore charged in such a way that they put in their money later but have to bear the additional interests on the credit lines. In addition, the carry is recalculated. With the updated cashflow stream we can calculate the TVPI and IRR net to investors as well as the carry as a percentage of the fund size for the fund manager.
Impact on fully realized funds: not large for the majority of funds
Our analysis supports previous findings that the mean IRR can be improved substantially with the use of a credit line, for our sample by 4 percentage points. Second, the mean difference is considerably larger than the median difference of 1 percentage point. Third, for around 25 percent of the funds, the IRR is reduced by the use of a credit line.
How is the credit line improved IRR correlated with the original IRR? Funds with bad underlying performance hurt their IRRs with the use of a credit line and only very good performing funds can increase their IRR performance significantly.
For most funds though, a credit line will only have a minor impact on their IRR. These results should reduce concerns that managers are able to substantially inflate their IRRs with the use of a credit line: it is possible to do so, but only for managers with funds that already have a strong performance.
The TVPI is lowered for all cases with the use of a credit line as investors have to fund not only the delayed capital calls, but also the additional interest charged by the credit line provider. The impact, however, is relatively minor and around 0.03x both in the mean and median case with not much deviation in the tails.
Finally, we look at the carry (as a percentage of fund size), which is slightly reduced in the median case, while it is increased in the mean case. The decrease is below 1 percentage point even in the fifth percentile, while there is no change in the carry in the 75th percentile case and large increases over 4 percentage points in the 95th percentile.
The two charts on carry show on the one hand the carry without and with a credit line, and on the other hand the difference in the carry between the two in relation to the IRR without a credit line. For all funds well above the hurdle, the carry is only slightly reduced as some payments have to be made to the credit line provider. This disadvantage is more than offset in cases in which a fund’s IRR is around the hurdle.
In 14 percent of the observations, a fund increases its carry payment by using a credit line as it boosts the IRR, which in turn helps them to reach or exceed the hurdle. The increase is also economically significant and can be in some cases close to 10 percentage points as it is the fund manager who exclusively profits from exceeding the hurdle due to the catch-up.
We also know from our previous analysis that the mean difference is slightly positive, so the overall carry payment in our sample, ignoring different fund sizes, would have been increased if every manager used a credit line. As managers do not know a priori how their funds will perform, the bottom line is that the use of a credit line is beneficial to them: they marginally reduce their carry in cases where they are already well into carry for the chance of increasing their carry substantially in cases where their carry is otherwise very small or even zero.
Watch out for the impact on interim performance when analyzing funds
Next, we focus on the impact of a credit line on the interim fund performance. While the previous results showed that for most funds the use of a credit line does not change the fund performance in a major way for the full lifetime of a fund, the impact on the interim fund performance could be much more pronounced. This is due to the fact that over the fund’s lifetime, the credit line has to be paid back.
Hence, a credit line only impacts the timing of the cashflows between the fund and the investors, but not the amount (with the exception of the small reduction due to the interest expenses that have to be paid to the credit line provider). However, as long as a credit line is still outstanding, it reduces the cashflows by the investors and has a similar effect as leverage by scaling gains and losses in relation to the investor’s invested capital. This is particularly important for investors as investment decisions for successor funds are usually made while the current fund is still in its investment period.
In the following, we only focus on funds with vintage years between 2010 to 2014 as the interim impact on the fund performance of a credit line is dependent on the valuations of the unrealized investments. As mark-to-market valuation has only been adapted in the industry in recent years, focusing on old vintages could lead to misleading results.
This updated sample consists of 212 buyout funds. We calculate the TVPI and IRR after 16 quarters without and with the use of the credit line. In case of the latter, the reported NAV is adjusted for the outstanding credit line. We furthermore calculate the carry accrual and adjust for it.
There are two striking differences to the results for the full lifetime. First, the impact on the TVPI is now mostly positive, in around 25 percent of the cases even more than 0.1x. The impact on the IRR is even more pronounced and close to 10 percentage points in the median case. Second, the range of outcomes becomes much wider, so the interim IRR and TVPI are much more sensitive to the use of a credit line compared to the final IRR and TVPI.
Big short-term, but small long-term impact
To summarize our findings: credit lines improve the IRR by 4 percentage points on average, but this is driven by very well-performing funds. For most of the funds, the improvement, if any, is much smaller and only around 1 percentage point in the median case.
As the TVPI is reduced by a credit line, it is questionable that fund managers use them to pretty up their long-term performance statistics. There are two other reasons for their use: change in carried interest and enhancement of interim performance statistics.
We show that carry payments of well-performing funds are slightly reduced, but this is more than offset by funds with IRRs around the hurdle that are able to make it into carry or increase the carry, which is 14 percent of funds in our sample. With regards to interim fund performance, funds with early mark-ups in their valuation can increase the TVPI statistic substantially in case of an outstanding credit line.
The takeaways for investors are the following: for fully realized funds, they do not have to worry too much about inflated performance statistics due to credit lines; however, they should be careful for younger funds during their primary due diligence or when investing into funds on the secondary market. Hence, investors should make sure to normalize performance across different funds to remove the impact of credit line use.
Christoph Jäckel (email@example.com) is a director of Montana Capital Partners (mcp). mcp is a Swiss asset manager focused on attractive niches of the private equity secondary market globally. The firm has raised four funds so far, each closed at the hard-cap, and currently has €1.5 billion in assets under management. mcp provides liquidity solutions from straight sales to more innovative structures such as non-traditional secondaries (co-investments and fund-of-funds) and structured transactions. In addition to its secondary activities, mcp offers high-quality advisory services for investments and risk management.