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The great sub line debate

Even with more transparency and understanding, the proper use of subscription credit facilities is still a point of contention.

This article is sponsored by Blue Wolf Capital Partners, Saw Mill Capital, Citi Private Bank  and Alter Domus.

How long is too long? That is a question often asked of subscription credit lines. The industry is yet to iron out how long these facilities should remain outstanding. Durations are typically around 90 days, but general and limited partners alike have pushed for longer, while other groups, including the Institutional Limited Partners Association, have been trying – often unsuccessfully – to keep them short.

In an audience poll conducted at sister publication Private Equity International’s CFOs and COOs Forum at the start of 2019, 42 percent said the average length of loans drawn on their credit line was around three months, and a quarter said they were averaging more than six months. In a separate poll, 31 percent replied they had “generally extended” the duration of the loans over the course of the last year.

Timothy Ruxton

Managing director of business development and relationship management at Alter Domus

Ruxton focuses on private market funds including private equity, credit and securitizations. He also works with the Alter Domus European clients on securitizations and other credit opportunities including administrative agency, loan administration, loan trade closing and data analytics. Previously, he managed the CLO administration, compliance and analytics teams at Cortland, which Alter Domus acquired in 2017.

Michael Robin

Managing director and global head of financial sponsors at Citi Private Bank

Robin is the global head of financial sponsors at Citi Private Group in New York and started the bank’s subscription line business 20 years ago. He oversees credit products tailored to private equity funds, related management companies and their sponsor groups. Prior to joining Citigroup in 1995, Robin held various posts at NatWest Bank, Fleet Bank and Barclays Bank in mid-market lending.

Blinn Cirella

Chief financial officer at
Saw Mill Capital

Cirella is CFO at Saw Mill Capital, which was founded in 1997 and invests in lower mid-market companies, currently out of its 2015-vintage $340 million second fund. She manages the financial administration of the firm and its back office, including LP reporting, accounting and audit and tax preparation. She previously served as director of Bisys Private Equity Services, controller at Commonfund Capital and director of finance and administration at Orien Venture.

Joshua Cherry-Seto

Chief financial officer at Blue Wolf Capital Partners

Cherry-Seto is CFO and CCO at Blue Wolf Capital Partners, a mid-market buyout firm focusing most often on healthcare, forest and building products, energy services and industrial and engineering services. The firm manages more than $1.3 billion in assets. Cherry-Seto served as a portfolio and finance manager at Grove International Partners before joining Blue Wolf in 2013.

“In private equity, there’s definitely a move towards longer duration,” Joshua Cherry-Seto, chief financial officer at Blue Wolf Capital in New York, tells Private Funds CFO. “Ours historically has been 90 days. At their core, these lines are supposed to be bridging a capital call, so it’s a little funny to talk about them being two- to three-year facilities.”

Cherry-Seto notes that with a glut of capital coming from the pension market, there is pressure for borrowing to be short term to avoid generating debt-financed income. In short: the presence of acquisition debt can reclassify gains as unrelated business taxable income, which would flow through to the tax-exempt investor as taxable. LP interpretations of what classifies as short term “vary between 30 days and a year,” he notes.

“Certainly, there has been a move to bridging throughout the fundraising period, as true ups are painful and any distributions would be more than one year after the end of the fundraising period, eliminating the debt financed income concerns.”

Cherry-Seto adds that Blue Wolf proposed extending that tenure to 12 months in its latest fundraise, as operationally three months is still short, but the goal at the firm remains focused on using the lines strictly to bridge capital calls.

“I would agree that the longer borrowing terms are where the market is moving to, but I also continue to see many managers pay off their lines as soon as called capital comes in,” says Timothy Ruxton, managing director at Alter Domus. “Capital call lines are typically used for short-term bridges to the capital calls, while other subscription facilities are often utilized by longer-established managers for working capital, expenses and even acquisition. The timeframe for repayment can be upwards of 12 months and available to use for multiple years.”

Michael Robin, managing director and global head of financial sponsors at Citi Private Bank, has seen size and duration grow in line with the market. “As funds have become larger with considerable capital being raised in this asset class, the facilities have grown commensurately,” he says. “Managers are finding more applications for the product and utilizations have been outstanding for longer periods.”

Robin, who tends to transact with medium and larger size funds, explains that Citi doesn’t require an advance to be repaid prior to maturity, with the exception of funds in some emerging markets.

“Therefore, if we extend a three-year commitment, technically funds could borrow under the line and repay three years later,” he says. “In our portfolio, which consists of roughly 400 funds, if an LPA does limit the tenor of an advance, the most common limiter is 12 months, followed by six months, while three or nine months are the outliers. A very significant proportion, I’d say close to half of the funds, have no restrictions at all. We see some of the major buyout funds saying they’re going to borrow under their line to fund acquisitions for a year and not call capital in the interim.”

UBTI may be the main restraint on long-outstanding facilities for funds that have tax-exempt investors such as foundations and public pension plans. Vehicles with an investor base consisting of more family offices and high-net-worth individuals don’t have this issue.

Blinn Cirella, CFO at Saw Mill Capital, says: “It’s my understanding and experience that the more current LPAs allow for borrowing to be held out in accordance with the limitations on indebtedness outlined in the LPA unless there is a chance the borrowing will trigger UBTI. In that case, the borrowing is limited to no longer than 90 days. We have done about four deals in our new fund and have used the credit line to purchase each deal. As we become more comfortable with using the credit line and fully understanding the UBTI ‘triggers,’ we have held the line out past 90 days in some cases. It still makes me a little nervous, as the rules surrounding UBTI are complicated, so I always double-check with our tax advisor to be sure. But UBTI is really the thing that limits the length of time you hold the loan out.”

Typically, most of the language in the LPA has to do with allowing a credit facility and the ability for the GP to pledge uncalled commitments, says Ruxton.

“We’re starting to see the language evolve to clearly require the LP to fund a capital call, regardless of whether it is for management fees, expenses or repayment of a facility,” he says. “Very few problems have been had, but sometimes we forget the lessons of the past where things that are not supposed to go wrong sometimes do. Specifically, I’m seeing more language about what happens if an LP doesn’t fund and the obligation of the other LPs to fund that amount. This can affect the use of a subscription line while disagreement is being resolved.”

Cirella notes investors are starting to make side-letter requests for performance reporting with and without a line of credit, adding that this could start to come up in due diligence questionnaires. The experts around the table agree this is an emerging practice not entirely welcomed by GPs.

“The other place you’re going to start to see it show up is when you’re raising a new fund,” she says.

“The newer due diligence questionnaire will probably ask you to provide your returns with and without a credit line. That will be confusing because you have to make a bunch of assumptions. I know that with the next fundraise, I’m going to have to figure this out.”

An example of such an assumption would be the estimated cost to the GP of holding LP cash in advance of a transaction, instead of bridging the capital call, and whether the price of an asset would have been different because the GP could close the deal faster thanks to a line.

“LPs are starting to poke at it,” concurs Cherry-Seto. “They’re starting to ask what their returns would have looked like. Speed to close and ability to close all cash are becoming more important in this competitive environment. Without a line we would need to call capital in advance and leave cash on the balance sheet. We would at least a few times call large amounts of capital for investments that do not consummate. It is not such a simple exercise and I don’t think, if calculated honestly, the results would be favorable.”

Ruston adds: “Transparency is very important for investors, and they are demanding disclosure of the use of a credit facility. Regarding the disclosure of levered versus unlevered returns, that topic rests with the LP community and their ongoing conversations with PE sponsors. We prefer to not venture into the hypothetical possibilities of what could have occurred.”

Am I big enough to borrow?

“It’s hard to run a fund without a line,” Cirella notes early in the discussion, adding that Saw Mill had a line from JPMorgan for its first fund, but the bank exited the mid-market halfway through the fund because of regulatory restrictions, leaving them without a facility. “That was painful, so when we raised Fund II, I was so excited to be able to get to use a credit line,” she says.

Hamilton Lane estimated last year that about 90 percent of the private equity market uses lines of credit, compared with 60 percent about 10 years ago. But for first-time managers, obtaining a subscription line is a much more difficult task than for funds that have been established for longer.

“We work with a lot of managers that maybe don’t have an established track record yet,” Ruxton says. “In general, first-time managers have a harder time attracting institutional capital and therefore are more inclined to have non-institutional relationships committing funds. This can make it more difficult to secure a facility initially until a track record is established, since the only collateral securing that facility would be the uncalled commitments.”

But these first-timers who start with a smaller debut fund typically quickly raise a second vehicle, often larger, allowing them to obtain a line with mid-market providers. As their fund size grows with the third and fourth generations, they can borrow from the large banks.

A sustainable market?

With investors and GPs mindful of a market downturn and the potential for interest rate hikes, it remains to be seen how GPs’ use of subscription lines of credit will play out.

Current rates for such lines are still low, with spreads ranging from LIBOR plus 145 basis points to LIBOR plus 160 basis points or higher for mid-market funds, according to market sources, down from about 300 basis points over LIBOR on the heels of the global financial crisis.

If interest rates rise only slightly, it won’t have much of an impact on fund finance in private equity. If, however, they increase to the point of approaching a fund’s hurdle rate, fund managers may reconsider their cost. But that is not yet in the cards.

“I think that spread is always going to be attractive,” says Cherry-Seto. “In a market where the rates in general are higher, I don’t know if there will be as much as a dip in utilization.”

Committed or not?

Uncommitted subscription lines of credit – when banks don’t reserve capital for the line but simply agree to lend to GPs – have gained popularity in the private markets.

“The market has moved to uncommitted lines because there’s a lot of comfort that when asked, the capital will be available and banks don’t need to charge unused fees as they don’t have to reserve capital,” says Cherry-Seto.

With drawbacks and advantages attached to both committed and uncommitted lines, the industry has found comfort in the combination of both. “Often we provide a hybrid solution, where part of the facility is committed and part uncommitted. This structure gives the fund client the assurance that the committed portion will be there when they need it, and the uncommitted portion, with minimal fees, would be used episodically when they need to flex up,” says Robin.

“Even though the hybrid facility has fixed cost fees associated with the committed portion, the uncommitted portion has minimal fixed costs because we don’t have to reserve capital for the uncommitted line unless it is being utilized. By offering a hybrid structure, we give the client what they need in terms both of a commitment, usually three years, sometimes four years, and then an uncommitted piece that continues to be renewed either annually or every two years. If they need the flex up, it’s basically a one-day approval process.”