July 13, 2017

ILPA Issues Guidance on “Subscription Lines of Credit and Alignment of Interests”

Subscription lines of credit, or capital call facilities – which are just two of the many names given to borrowing arrangements put in place by private fund managers at the fund level – have been in the market for many years and have recently become an important talking point.

This type of loan facility is usually put in place to ease administration when managers are calling for funds from investors. Instead of issuing a drawdown notice each time the fund needs capital, fund managers can draw on the facility from the bank as and when required and then issue one drawdown notice periodically to investors to pay off that previous period’s borrowings. With more and more managers using these facilities, and the length of time and amounts borrowed increasing, investors are beginning to ask more questions about the details of these arrangements and could soon begin to ask for changes in fund documentation to deal with their concerns.

On 27 June 2017, the Institutional Limited Partner Association (ILPA) issued a publication to its members which included nine points of guidance. ILPA also outlines some concerns that they have in relation to lines of credit, such as the difficulty in comparing the performance of funds that use these facilities and those that do not (as the use of a credit line can increase a fund’s IRR), the expenses incurred as a result of a credit line (both upfront costs and ongoing interest), how longer term facilities may cause UBTI issues for U.S. tax-exempt investors, and also the liquidity risk to investors if a market event triggered a large number of capital calls from managers to repay the outstanding facilities.

The guidance to investors includes several points on disclosure, such as quarterly reports detailing the terms of the credit line (most importantly fees), the balance and percentage of total outstanding capital, use of proceeds (capital call bridges, but also accelerated distributions) and the net IRR of the fund both with and without the use of the credit facility. This could have the effect of adding to the administrative burden of the fund manager and, as the main reason for credit lines existing is ease of administration, this in-depth reporting may negate some of the reasons for putting one in place. Most significantly though, ILPA recommends that the provisions of the limited partnership agreement should state that the preferred return begins to accrue as soon as amounts are drawn from the credit line, not when they are drawn from investors. This will mean that investors will receive not only the benefit of ease of administration, but it would also maximise the preferred return payable as it would start to accrue even before investors put their own money into the fund. The result being that instead of both investors and managers seeing a benefit from the use of credit lines, the pendulum would swing over fully to the investors.

In the context of alignment of interests, if both parties can enjoy the benefit of a subscription line facility, then that is potentially the best solution. Investors want to see their commitments being put to use and do not typically expect to fund investments 12 or 18 months after they have been made (once the subscription line can no longer be used for that investment). It can be argued that investors should get some credit for their commitments whilst a subscription line facility is drawn, after all, the facility would not be available if their commitments were not in place. At the same time, there is ultimately a clear distinction as the commitments have not been called. A compromise could be the preferred return accruing after an agreed period (if no drawdowns are made in that time).

The full guidelines can be accessed through ILPA’s website, and managers should prepare for investors enquiries in this area to increase. ILPA intends that this guidance will be included in the 2018 ILPA Principles, but it should be noted that these principles were initially designed to promote dialogue between fund managers and their investors, not to be a list of points that should be included in every fund document.