Subscription credit facilities or bridge loans are not new to the private equity market, but have certainly grown in popularity over the past decade. As defined by Preqin, subscription credit facilities are short-term loans provided to private equity firms to cover transactional costs—giving buyers more flexibility as to when they have to make capital calls and how they fund their portfolio companies.
“There are two distinct segments of the market. The traditional short-term subscription facility is truly bridging the capital calls for 30, 60, or 90 days. These are bridge facilities,” says Mark Kromkowski, a partner with McGuireWoods LLP and head of its investment fund group. Kromkowski represents both funds and lenders in connection with subscription credit facilities throughout the United States. “On the other side of the spectrum, some private investment firms are using them for two or three years or even longer. They are pushing the upper limits of semi-permanent leverage.”
It’s important to note that there are no requirements for GPs to submit information on subscription credit facility usage. However, anecdotal evidence demonstrates that there has been an increase in usage. According to Preqin, the number of private equity funds using subscription credit facilities has almost tripled since 2010. In the past decade, the proportion of funds using credit lines peaked at 53% for vintage 2016 funds.
“We are definitely seeing more use of these and similar credit facilities than we have ever before. After 2008 and 2009 there were very few defaults, so lenders feel comfortable extending these facilities to borrowers even in today’s market,” says Kromkowski.
Trevor Freeman, a managing director with Signature Bank, which offers subscription facilities to private equity firms, says subscription facilities give private equity firms another tool to work with. “You are seeing more private equity firms add this to their toolbox. Banks like the subscription facility product because you are lending against uncalled capital, and for the most part, the investors in private equity funds are highly rated or are strong from a total assets perspective. It’s a good credit risk for banks,” says Freeman.
Subscription credit facilities can also reduce the risk of the transaction falling through because the capital is covered by a single loan versus the private equity firm relying on multiple LPs to pull their capital together. Subscription facilities offer a quick solution when trying to get to close. According to Meghan Neenan, a managing director with Fitch Ratings, calling capital from LPs can delay certainty of close by 10 days or more, which is enough time for another buyer to seal the deal.
GPs also use subscription facilities to smooth out cash flows. “Private equity firms can also add portfolio companies as borrowers to the facilities and they can get the benefit of the private equity firm’s credit and borrow at a lower interest rate,” says Freeman. In addition, Private equity firms can use the credit lines in lieu of capital calls and there’s no real repercussion if the deal does not come to fruition.
All these are all good reasons, but perhaps one of the more common reasons for firms to delay the capital call is that it increases internal rate of return (IRR).
IRR is calculated based on the day private equity firms call the capital and then the day the capital is returned to LPs. If a private equity firm closes a deal without using LP money, it shortens the length of time the capital is outstanding, thus increasing IRR.
However, this maneuver isn’t a new one. LPs are hip to this strategy and some feel the usage of subscription facilities have made using IRR to value private equity firms less valid. “The use of credit lines makes it loud and clear that IRR is completely and absolutely IRRelevant,” wrote Ludovic Phalippou, a professor of financial economics at the Said Business School, in the Preqin report.
The Institutional Limited Partner Association (ILPA) has made some recommendations around usage of the product. ILPA recommends that private equity firms disclose on a quarterly basis:
- The amount on the subscription facility, as well as what percent of uncalled capital draws from the facility represent;
- The number of days outstanding of each drawdown;
- Net IRR with and without the use of the credit facility;
- Terms of the line; and
- Costs to the fund.
Though use of subscription facilities can make LPs skeptical, there is a benefit for the LPs as well. Subscription facilities certainly administrative burden, which is relevant for both LPs and GPs. “For the most part, LPs have embraced the convenience that these products provide. LPs do not have to constantly be funding capital calls. There is a balance between putting their capital to work and convenience. Subscription funds allow for the private investment firms to put money to work efficiently in the market at appropriate interest rates,” says Kromkowski.
Going forward, the use of subscription credit lines will likely continue to increase. Banks have always offered the product, and now more alternative debt providers have embraced it as another lending opportunity. “As more firms continue to get comfortable with it you will continue to see the product grow in popularity. It is getting more popular in the middle market every day,” says Freeman.