31st July 2017
The Institutional Limited Partners Association (“ILPA”) recently released guidance regarding how a Private Equity General Partner (“GP”) uses a fund’s credit line facility, collateralized by Investor/Limited Partner (“LP”) subscription commitments. ILPA’s role is to connect LPs, in an effort to advance the interests of the LP community, as a whole. As such, guidance such as this, presumably is issued with the assumption that this is best for LPs.
We, respectfully, disagree with ILPA’s stance and believe this guidance is not entirely in the best interest of the greater LP community.
To be clear, we do believe certain parts of the guidance have merit, including many of the provisions pertaining to additional disclosure. However, we would like to address just a couple of the key aspects that we believe are flawed. Particularly, the portions of the guidance pertaining to ILPA’s very specific limits on how credit lines should be used, as well as recommendations regarding how the credit line should affect performance metrics (such as IRR) and the preferred return hurdle:
• Revised IRR – Many LPs are in fact quite supportive of the free use of credit lines, because it allows GPs to increase investors’ performance metrics, including IRR, by calling capital later in the fund life cycle and returning it sooner. In addition, with LP capital tied up in the fund for shorter periods of time, it allows LPs to put that capital to work elsewhere. Many employees of LPs (such as those working for pension funds or endowments) are compensated based on IRR metrics and/or appropriate cash management. ILPA is suggesting producing an IRR that includes the use of the credit line, effectively creating two IRRs, which could certainly be misleading in many circumstances.
• Limiting Free Use – LPs typically do not want numerous capital calls in any given year. The free use of credit lines allows GPs to call capital far less frequently. Other than the administrative burden LPs face when capital is called often, the risk of sending sensitive information and/or cash to the wrong recipient increases with each capital call as well. ILPA wants to limit the free use of credit lines in various ways, such as limiting a draw on a credit line to 180 days.
• Revised Preferred Return – ILPA has suggested the calculation of the preferred return hurdle (within the waterfall calculation) should be based on the drawdown dates of the credit facility, rather than the traditional approach which coincides with the dates capital is called from investors. This type of change is unnecessarily punitive to GPs. Also, for the LPs who are in favor of using credit lines, they understand that this approach would likely result in many GPs eliminating the usage of credit lines all together, which as noted above, would have an adverse effect.
We believe, proper disclosure should always be provided by the GP, beginning with the fundraise process and continuing throughout the life of the fund. With that in mind, LPs are intelligent enough to make decisions about committing capital to funds and are proactive enough to engage the GP in appropriate conversations regarding the use of credit lines.
ILPA is over-stepping with this recent credit line guidance. Incidentally, we believe ILPA has similarly over-stepped with the standardized partner’s capital statement format they have designed and promoted over the last few years, as it is both confusing to LPs and requires GPs to provide unnecessary data points…but perhaps that’s a topic we can cover at a later date.
If you would like to discuss this topic in greater detail, please do not hesitate to get in touch.
Written by fund administration experts with Langham Hall.
ILPA’s full publication, “Subscription Lines of Credit and Alignment of Interests” can be found here.