How a private-equity tool could distort outcomes

Investors must properly understand how an emergent financing mechanism works to avoid getting misled

How a private-equity tool could distort outcomes

Those in the know about private equity have probably heard about subscription lines of credit. Essentially loans taken out by a private fund and secured against investors’ committed capital, they provide managers of such funds with a way to finance expenditures at short notice. Traditionally, they were typically repaid in 30 to 90 days, but today terms can last as long as five years.

These financial tools have gained significant traction, with some estimating that outstanding subscription lines amount to US$400 billion globally. But according to new research published by BlackRock and the Technical Institute of Munich, PE investors should be careful to understand how the use of such instruments affects a fund’s metrics.

“If not properly understood by investors, extended subscription lines could distort future fundraising outcomes,” the paper said.

As reported by Institutional Investor, the researchers examined 6,353 buyout deals across 700 different funds across 250 PE firms. Using the data, along with deal-level cash flow data from 1994 to 2017, they created a simulation of hypothetical subscription lines of credit across different vintage years, even before they came into common use.

From their calculations, they determined both final fund performance and fund rankings based on internal rates of return. They found that when subscription lines of credit were used for six months or less, the median net internal rate of return improved by 0.2%, while the mean net IRR improved by 0.47%. In addition, 10.4% of funds saw an improvement of at least one percentage point in their ranking.

But stretching the maturities of subscription lines of credit to two years resulted in a ranking improvement of at least one decile for 44.4% of all funds. Such bumps in ranking, the paper suggested, suggest that lines of credit provide an advantage for buyout funds, leading to their increased use.

The story doesn’t end there, however; in spite of their ability to improve performance, using subscription lines of credit can still be costly. “Due to the costs incurred by subscription lines, net multiples inevitably deteriorate for every fund that employs them,” the research showed.

The researchers examined PE fund metrics such as net fund multiples and public market equivalents, and found that they are “hardly influenced” by funds using subscription lines of credit. Such results, they said, underscores the importance of looking beyond internal rates of return when evaluating a fund.

“Our clients that we’ve spoken with about the research find it interesting, intuitive, and substantial,” Jeroen Cornel of BlackRock Private Equity Partners in Switzerland, one of the study’s authors, told Institutional Investor. “It is very important for LPs to have experience with best practices, to screen fund documentation, and to be very thorough in their due diligence.”


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