Private equity’s dirty finance secret

Tighter rules are required to stop private equity managers from artificially inflating claims about their performance, according to the largest association representing investors in buyout funds.

The Washington-based Institutional Limited Partners Association (ILPA) last month appealed for private equity managers to come clean about financial engineering techniques that are increasingly used to flatter returns and trigger lucrative performance bonuses.

Private equity funds are attracting record-breaking inflows from investors drawn by the promise that managers of buyout funds will deliver higher returns than those on offer from publicly traded equity and bond markets.

Preqin, the data provider, estimates that private equity managers raised around $194bn in the first half of 2017, running ahead of the record annual total of $338bn gathered in 2007.

Money promised by investors is increasingly being used by private equity managers as security for bank loans that are then used to pay for deals in place of a client’s capital.

This little-discussed technique, known as subscription-line financing, helps private equity managers earn performance fees because one of their funds’ key assessment metrics, the internal rate of return, is based on the date an investor’s cash is put to work.

“This sleight of hand artificially raises the fund’s apparent performance but it does nothing to increase the actual returns earned by investors,” says Jennifer Choi, managing director of industry affairs at ILPA.

ILPA’s criticisms echo recent comments by Howard Marks, co-founder of Oaktree Capital, the $100bn US alternative investment manager.

“A fund that used a subscription line and came in with a high IRR [internal rate of return] may not have done as good a job, or made its investors as much money as one that didn’t use a line,” says Mr Marks.

The association is calling for returns data to be reported from the time a private equity manager starts to use the bank loan, rather than the later date when a client’s capital is called into action.

The effect of this change would be to lower reported returns and to make it less likely that a private equity manager would be able to claim the industry’s standard 20 per cent performance fee.

ILPA wants stricter curbs to be imposed on the size of subscription-line financing loans agreed by private equity managers and a time limit of 180 days on the use of these lending facilities, which are frequently extended to a year or more.

It also wants private equity managers to provide quarterly updates on these loans as well as details of how the facilities influence fund performance.

“We want to ensure that investors have access to the necessary information regarding private equity managers’ use of subscription lines of credit and how these facilities affect the alignment of interests between the two parties,” says Ms Choi.

The association is concerned that the use of subscription lines could ensnare investors in unforeseen legal problems or leave them nursing unexpected tax bills.

One factor driving growth in subscription-line financing is that the standard 8 per cent return hurdle that has to be met to trigger performance payments has become more challenging in the low-rate environment.

But the cost of servicing these bank loans can run into millions of pounds and reduce final returns for investors. It should be made clear that any fees and interest on the bank loans are paid by the fund’s investors, according to ILPA.

“The burden placed on investors to secure the subscription credit line should be made clear,” says Ms Choi, adding that the use of these loans was “surging”.

Maurice Gordon, head of private equity at Guardian Life, the New York-based mutual insurance group, says banks have become “pretty aggressive” in tempting newer private equity managers with subscription lines, offering larger loans for longer periods stretching up to two years.

He says disclosure and reporting requirements should be strengthened so that investors have a clearer understanding of the impact of subscription lines on the performance of a fund.

“There can be meaningful differences in fund returns depending on whether a subscription line was used or not,” says Mr Gordon.

Iain Leigh, global head of private equity for APG, the €451bn Dutch pension provider, says investors should be concerned about the additional risks that the use of subscription lines has introduced.

“We are seeing a number of private equity managers pushing the boundaries of the duration of borrowings and the amount of leverage used,” says Mr Leigh, adding that this is causing distortions in performance.

“Investors should support the suggestion that private equity funds should also disclose their returns excluding the effect of subscription lines to ensure a level playing field,” he says.

However, many institutional investors support the use of subscription-line financing as a tool to help them manage cash flows.

But some public pension fund managers are also paid performance bonuses based on the internal rate of return of their portfolios of private equity investments, a clear conflict of interest that makes them less likely to criticise the use of subscription lines.

The value of outstanding subscription-line loans are about $400bn, according to Tim Powers, managing partner at Haynes and Boone, the US law firm. A veteran of the fund financing market, Mr Powers dismisses any suggestion that investors are being short-changed by private equity managers through their use of subscription lines.

“Private equity investors are pretty sophisticated. They understand the trade-off between the costs of the loan and the benefits they receive,” says Mr Powers, adding that investors can already impose limits on the use of subscription lines by private equity managers.

He says these facilities proved their worth in the aftermath of the financial crisis by averting the need for investors to sell assets at knockdown prices in order to meet their existing promises to provide capital to private equity managers.

“Subscription lines are win, win, win for lenders, private equity managers and their investors,” says Mr Powers.