Money for nothing(1)

When someone describes something as “free money,” one gets nervous.

And yet, that is how a limited partner recently described the provision by lenders of increasingly long-term subscription credit lines to general partners. These facilities, which allow general partners to make acquisitions and delay calling capital from LPs often for up to a year, are now common.

For a lender, the amount loaned (often a fifth of the fund’s value); the creditworthiness of the limited partners; and the repayment term (usually a year) make the risk of such a loan defaulting “minute,” the same LP tells me.
From a GP perspective, the use of these facilities seems like a no-brainer. With benchmarking so widely used as part of the fund selection process, being able to say you are top quartile can mean the difference between a ‘yes’ or ‘no’ from an investment committee. If use of a credit facility can make that difference, you would be crazy to pass it up.

But what should LPs think? The Institutional Limited Partners Association is currently gathering the opinions of members on the use of subscription credit lines at fund level. One person with knowledge of the process said the association is getting mixed responses.

Some are vehemently against it, as they see it as a way of boosting the IRR to get the manager over the hurdle rate more quickly. Others see it as an efficient use of capital: why have your money in an asset that won’t perform for at least a year when it could be earning a return?

The most difficult question is: where the real risk is being introduced? Such facilities have been in place in some form for many years, but typically just to allow GPs to deploy cash quickly in deals and to call only the exact amount needed from LPs. The longer-term facilities are a relatively recent phenomenon spurred on by the availability of cheap credit. They haven’t been tested in times of serious economic stress.

Having discussed the risks with several investors, two scenarios stand out.

One involves a potential roadblock to secondaries transactions. Credit is secured against a fund’s LP base and its ability to honor capital calls. The lender may identify one or two large, stable investors against which to lend. Should one of those want to exit the fund via a secondaries sale, they may find their transfer vetoed by the general partner on the basis it will scupper the credit facility. A general counsel at a fund of funds says he is now seeing these clauses in LPAs.

Another scenario involves changing the fund’s risk profile in the eyes of the regulator. In Europe, for example, under the Alternative Investment Fund Managers Directive, a manager of a fund that uses leverage at the fund level is subject to a greater regulatory burden than one that is unlevered. In the US, there is no directly equivalent rule, but as law firm Dechert noted in an article in January, the Securities and Exchange Commission looks likely to examine these facilities in more detail.

The ultimate ‘regulation’ of the use of credit facilities, however, will be the LPs themselves. In December, for example, the San Bernardino County Employees’ Retirement Association said it would rescind a commitment to an Alcentra-managed credit fund based on its credit facility.

For the most part, however, it seems LPs are happy to go along for the ride.