From Barron's "Wall Street's Best Minds" column:
Howard Marks on a Novel Form of Fund Financing
In my 2016 year-end review, which went only to clients, I included a discussion of the use of subscription lines by closed-end funds in areas such as private equity, real estate, distressed debt and private credit. It’s my impression that their use has become fairly pervasive in recent years, and in response to clients’ requests and market trends, Oaktree has utilized subscription lines in some of its newer funds.
That year-end note prompted some interesting and spirited discussion of lines and their merit and effect. Thus I decided to write this memo on the topic for general circulation.
How Do Subscription Lines Work?As I wrote in the year-end review, subscription lines are bank loans extended to funds that enable them to use borrowed money, rather than LP capital, to make early investments or pay fees and expenses. While there is no universal description, I believe it’s safe to say in general that subscription lines:• are limited as a percentage of the LPs’ capital commitments.(Commitments from the most creditworthy LPs earn a 90% advance rate, and commitments from lesser credits earn lower advance rates or, in some cases, zero),• are secured by the LPs’ capital commitments, and• generally must be repaid in the early or middle part of the fund’s life (unless extended), although terms are beginning to lengthen.
The key element is that a subscription line can substitute for LP capital, but it can’t be used to allow the fund to invest more than its committed capital. That is, a $100 million fund with a subscription line might be able to buy $50 million of assets without calling LP capital, but it still can’t invest more than $100 million in total (other than by recycling proceeds from liquidated investments). The bottom line is that essentially all subscription line financing does is defer the calling of LP capital.
So the starting point for this discussion is the fact that these lines lever LP capital but do not lever funds in the sense of allowing funds to invest more than their committed capital. Fund-level debt that allows funds to invest more than their committed capital is different from subscription lines and not my subject here.
What Are the Effects?
Since a subscription line doesn’t lever a fund, its use doesn’t increase the total dollar profits that the fund will earn from investments over its lifetime (assuming the GP makes the same investments that it would have made if the fund didn’t have a line).
Also, the use of a subscription line – obviously – doesn’t alter the fund’s committed or invested capital. Thus, assuming all LP capital eventually is drawn, the fund’s ratio of distributions to LP capital – either the multiple of committed capital (MOCC) or the multiple of invested capital (MOC) – isn’t improved by the use of a line.
So much for what isn’t changed. The question, then, is “what is?” First the positives:
• The original purpose of subscription lines was (a) to enable GPs to make investments and pay fund fees and expenses without frequent capital calls and (b) to prevent opportunistic funds that don’t sit on large amounts of cash from missing out on attractive investments requiring quick funding.More recently, however, their use has grown for the additional reasons discussed below.• With calls for LP capital postponed, the reported Internal Rate of Return or IRR in the early years – the dollar-weighted return on LP capital – will increase substantially (assuming the early profits exceed the interest and expenses on the line).• The use of borrowed money can reduce or even eliminate the deleterious impact on early returns of the so-called “J-curve.” The J-curve results from (a) the fact that in a fund’s early years, management fees are usually charged on total committed capital, while a relatively small percentage of the capital has been put to work, and (b) the tendency of private investments to take a while to show results.
• Over the course of a fund’s life, LP capital will typically be called for investments or to repay the borrowings under the subscription line. This will cause the ratio of subscription line capital employed to LP capital to decline. As a result, the fund’s IRR will retreat from its elevated early level and move down toward what it would have been if the fund hadn’t employed a subscription line. However, all other things being equal, the fund’s lifetime IRR will remain higher than it otherwise would have been, since the impact of using the line will taper off but not reverse....MUCH MORE
...Impact on Fund Performance Metrics
The most important question in assessing fund performance is clear: Did the GP do a good job? It’s a simple question, but answering it is anything but. In particular, if a fund that used a subscription line shows a high IRR, does that confirm that the GP did a good job?
Since a fund’s total dollar profits and multiple of capital aren’t improved by the use of a subscription line, the increase in IRR, while pleasant, might be thought of as illusory. Remember, as I wrote in a 2006 memo with the same title, you can’t eat IRR.
My basic point in that memo was that what really matters is how much money an LP makes as a result of having committed to a fund. It’s that simple.
But the deeper message was that, while valuable, neither IRR nor MOCC nor MOC – nor any other single metric – is sufficient to tell us whether the GP did a good job. There are many elements that must be taken into account, and if you hold all the others equal, one metric might be sufficient to answer the question. But the others rarely are equal. For example:
• A high IRR certainly is desirable. But that’s what a fund can show if the GP makes only one investment, with a small fraction of the fund’s committed capital, and that investment produces a substantial profit.For example, if a $100 million fund invests $1 million in something and sells it a month later for $2 million, that doubling will annualize to an IRR of roughly 400,000%.And if that’s the only investment the GP makes, that’ll be the fund’s IRR, too.But it certainly doesn’t mean the GP did a good job – I doubt the LP who committed $10 million to the fund will be happy with $10.1 million back in the end.
...MUCH MORETo understand what an IRR really says about fund performance, you have to know what percentage of the capital was called and how long the GP held onto it. In short, LPs want to see their committed capital become fully invested and remain invested at solid rates of return for a long time. That’s the formula for a big gain. A high return earned on a small amount of capital for a brief period doesn’t help in that regard. High annualized IRRs on investments of less than a year can be especially misleading.....