In recent years, private equity firms have seen an increased use of fund subscription lines.
Subscription lines are short-term, revolving credit facilities offered by banks to help private equity funds (i.e. PE funds) bridge temporary financing needs. You can think of subscription lines like credit cards for PE funds. You might also hear them referred to as capital call facilities.
Please note: For the sake of simplicity, we will use industry jargon and refer to PE funds as General Partners or GPs and investors as Limited Partners or LPs.
What are fund subscription lines?
Historically, PE firms use subscription lines as a fund finance solution to bridge the financing time gap between when a PE fund makes an investment vs. when a PE fund calls capital from its investors.
This type of financing facility is usually secured against the LP commitments into the fund. One quick clarification, subscription lines are different from corporate leverage facilities. The latter is used to provide funding for operating companies and the facilities are secured against the assets of the operating companies.
Are subscription lines widely accepted?
In the past, investors frowned upon prolific use of subscription lines, because it can be viewed as a form of financial engineering to boost internal rate of return (i.e. IRR). Investors can question the motives behind GPs using subscription lines when GPs can just draw down on investor capital to fund an investment. After all, using subscription lines costs extra for the GP.
In the early 2010s, roughly 40-50 percent of funds globally were using fund finance.
By 2018, more than 90 percent of funds are using these types of facilities. PE firms’ increased demand of alternative short-term capital and investors’ increased acceptance viewing this practice as the norm have led to the growth of PE fund finance solutions.
Now, there is a wider appreciation from investors preferring to receive fewer but chunkier capital calls from GPs vs. frequent but small capital calls. Why? Responding to each capital call has real costs to LPs as well. These can range from opportunity costs and time to process capital calls to actual administrative costs such as wiring fees for each check.
How do PE funds use fund finance?
If a GP uses any type of fund finance solutions, the first question an LP should ask is “why”. Why is there a need for PE funds to use fund finance solutions, despite having access to investor capital via capital calls? We encourage LPs to ask every GP using any type of fund finance. It is critical to understand the underlying motives, how a GP is incentivized and benefits by the choice of using fund finance, whether it is an interest alignment with LPs.
The example mentioned earlier addresses the GP’s need to bridge financing time gap. Again, this the time between when an LP’s capital call hits the GP’s bank and when the GP can write a check to make an investment.
Today, fund finance can offer financing solutions for various stages throughout a PE fund’s life cycle.
Fund finance can provide the GP with immediate access to capital, especially if the GP is still fundraising and has not secured enough capital or completed a close to be in position to call investor capital, but needs to write a check to secure an investment.
Fund finance can provide the GP with some flexibility on the date when they make capital calls from LPs. With a subscription line, a GP can consolidate few smaller capital calls into a chunkier one per quarter, thereby managing capital drawdown pace and also saving some administrative hassle for LPs.
Fund finance can provide a GP some control of timing capital drawdowns, which impacts the fund’s overall IRR. GPs often like to delay the first few capital calls of a fund in order to smooth out the resulting IRR and mitigate the negative J-curve impact, as the earliest cash flows have the biggest impact.
Fund finance can also provide the GP extra capital to preserve net asset value at the end of a fund’s life when LPs’ committed capital has been completely called.
How did fund finance evolve into a credit strategy itself?
Given the nature of fund finance solutions being typically more lucrative for lenders (i.e. higher interest costs than bank debt) and shorter term (i.e. maturity usually less than 12 months) than similar bank loans, more and more banks have entered the market to provide fund finance solutions.
The function of fund finance solutions has evolved to become more versatile than the traditional use simply as subscription lines of credit. Today, there are credit GPs who will raise credit funds specifically to provide fund finance solutions for other PE funds.
These credit GPs have an edge compared to traditional banks because of the credit GPs’ ability to understand their private equity GP peers better, underwrite under faster timelines and offer more sophisticated funding structures. Texas-based Crestline and London-based 17Capital are prime examples of this growing pool of niche credit GPs.
As the need for customized or innovative solutions increases, some traditional banks’ plain vanilla subscription line solutions may not fit the needs of certain GPs anymore. Naturally, more and more credit funds have entered the fund finance market as lenders to offer increasingly sophisticated structures.