In this Ropes & Gray podcast, asset management partner Isabel Dische and finance partner Patricia Lynch dive into the use of capital call facilities by private investment funds. Specifically, they go into detail on some of the pros and cons for limited partners of such subscription facilities, recent ILPA guidelines relating to their use, the market response to the ILPA guidelines, and their predictions for the future of the market following the adoption of these ILPA guidelines.
Isabel Dische: Hello, and welcome to our podcast. My name is Isabel Dische, and I am a partner at Ropes & Gray in our asset management group. Joining me today is Patricia Lynch, a partner in our finance group, who regularly advises private investment funds on subscription facilities and also leads the firm’s U.S. securitization practice. In today’s podcast, we will be focusing on the use of capital call facilities by private investment funds. We will discuss some of the pros and cons of using subscription facilities, recent ILPA guidelines relating to their use, the market response to the ILPA guidelines, and our predictions for the evolution of the market following the adoption of the ILPA guidelines. Patricia, to start us off, could you provide us some background on why so many fund managers use subscription facilities?
Patricia Lynch: Sure, Isabel. Fund managers use subscription facilities for a number of reasons. First, these facilities can give funds flexibility to close investments on short notice without having to wait to receive proceeds of a capital call from investors. This flexibility helps to reduce execution risk and gives the fund a competitive advantage relative to other potential buyers who cannot close as quickly. In addition, it allows a fund to reduce the number of capital calls it makes to investors by allowing the fund to bridge expenses between calls. Investors generally prefer fewer capital calls, as this increases predictability and reduces the amount of cash they need to keep on hand in the event of an unexpected capital call.
Isabel Dische: Thanks, Patricia. Given this added flexibility, you would think investors would want funds to use subscription facilities, but we often receive some push back from investors on the terms related to their use. How have investors tried to address those concerns?
Patricia Lynch: While subscription facilities definitely have some advantages, some investors focus on potential drawbacks, and we often see negotiation between managers and investors to address some of these concerns. The concerns that investors raise generally fall into four categories: cost, effect on IRR, effects on specific investors and systemic risks.
The first category is pretty simple – while the interest rates on most subscription facilities have been relatively low in recent years, these facilities do come with incremental costs (in the form of interest rates, fees and legal expenses) that are borne by the funds. Unlike investment-level leverage, which has the potential to improve returns by increasing the amount of money that a fund can ultimately invest, subscription facilities merely postpone the timing of capital calls. This means that the use of a subscription facility will not generate additional profits to offset its costs.
The use of a subscription facility can also make it difficult for an investor to compare IRRs (internal rates of returns) across funds, as the number reported by the fund manager will vary depending on whether it is calculated based on the date of that an investment is made or the date of the capital call, which in certain cases may be significantly delayed if the fund has relied on a subscription facility to finance an investment. In theory, a fund manager could even try to artificially inflate returns by delaying a capital call, making it easier to meet the applicable preferred return.
In addition, certain investors may have specific reasons why they don’t like the use of a subscription facility. While some investors may like the flexibility of having fewer capital calls each year, others may want to put their capital to work more quickly, rather than waiting for pre-scheduled capital calls. Still others may object to restrictions on transfers of their partnership interests that may be required under the loan documents. And others don’t like what they perceive as intrusive diligence requests that banks may make in connection with their process of reviewing a fund for the purposes of the issuing alone.
Finally, on a macro level, there is a view among certain investors that an over-reliance on subscription facilities poses risks for the financial system as a whole. One concern is that, during a financial crisis, multiple subscription facilities from multiple funds could experience defaults and be called for repayment at once, meaning that investors would have to fund multiple capital calls on short notice. As we discussed earlier, one of the benefits of using subscription lines is less frequent, more predictable capital calls giving investors flexibility to hold fewer liquid assets on hand to meet unexpected capital calls. It may be difficult for these investors to meet multiple unexpected capital calls in this context. Other investors may refuse to make additional capital contributions to repay a loan if the underlying fund investment has declined in value (which of course, would be more likely during a financial crisis). This would make it more likely that the fund would then have to liquidate assets at fire sale prices in order to repay its debt.
Isabel Dische: Thanks, Patricia. It is not surprising that we commonly see investors negotiate provisions relating to the use of subscription facilities based on the concerns you’ve just articulated. How have investors tried to address those concerns?
Patricia Lynch: Sure. As is the case with many concerns that impact institutional investors, the Institutional Limited Partner Association, or ILPA, has issued guidelines for the use of subscription facilities. These guidelines include recommendations relating to, among other things, the calculation of the internal rate of return in connection with the use of a subscription facility, disclosure of the use of these facilities to investors, terms of the fund documents relating to the use of these facilities and the terms of the subscription facilities themselves.
Isabel Dische: Can you give us some examples of some of the ILPA recommendations that you think are most important to protecting investors investing in a fund using a subscription facility
Patricia Lynch: Some of the most important ILPA recommendations focus on transparency regarding the use of such facilities, so that investors can make educated decisions in determining whether to invest in a fund that uses a subscription facility. There’s an emphasis in particular on ensuring that the manager provides clear disclosure to investors regarding the role that the subscription facility plays in the calculation of IRR (including providing calculations of IRR both with and without giving effect to the use of the facility), as well as disclosure about costs associated with the use of the facility, the use of advances under the facility, and the amount of time that advances will generally remain outstanding.
Isabel Dische: While the recommendations would address some of the investor concerns you’ve discussed, I know that with other ILPA guidelines, in practice, there’s been some push back from fund managers and lenders. Can you give us a sense of how the market has responded to the publication of the ILPA guidelines?
Patricia Lynch: I think that’s right. While we’ve certainly seen more discussions between investors and fund managers regarding the use of subscription lines since the ILPA guidelines were published, we haven’t seen a wholesale adoption of every aspect of the guidelines. In practice, for instance, the terms of the credit facilities, themselves, have remained largely unchanged.
Isabel Dische: How do you think investors have gotten comfortable with this measured response after the publication of the guidelines?
Patricia Lynch: I think there are a couple of key reasons for that. First, some of the specific ILPA recommendations for subscription facilities suggested a misunderstanding about the way that these facilities actually work. For example, the guidelines recommended caps on borrowing that were so tight that they would have dramatically reduced funds’ ability to take advantage of a subscription facility. For this reason, we find that many of our investor clients prefer not to request all of the recommended restrictions. I think another reason for the response is that the interests of fund managers and investors with respect to the use of subscription facilities are not as opposed as reports in the financial press would sometimes indicate. Many investors like a fund to use subscription facilities for the benefits I mentioned previously. In addition, there are some investors that actually like the boost in reported IRR that use of a subscription facility can provide.
Isabel Dische: This makes sense, but there must have been some changes to market practice as a result of the ILPA guidelines.
Patricia Lynch: That’s right – I think there have been two major trends in negotiations between fund managers and investors recently in connection with subscription facilities. The first trend is greater disclosure. Fund managers are increasingly providing separate calculations of IRR (one reflecting the use of the subscription facilities and the other backing it out). There’s also more disclosure to investors about related costs and some of the material terms of the facilities like prepayment triggers.
The second major trend relates to limitations on the time that advances can remain outstanding under a subscription facility. In response to investor requests, some managers have agreed to strict time limits on borrowing; the prevailing trend seems to be about 180 days, but we’ve seen anywhere from 90 days to 364 days. Other fund managers have tried to address investor concerns by starting the clock on the IRR calculation at the earlier of the date that capital is called or a specified number of days after the loan was made, which prevents the manager from artificially boosting IRR by keeping a loan outstanding for a longer period. I should emphasize, though, that these types of actual or implicit limits on the time that borrowings may remain outstanding still aren’t the market norm – many funds have no such time limits.
Isabel Dische: Given the relative lack of movement on terms following the publication of the ILPA guidelines, do you expect that the market will evolve further, or do you think investors are generally comfortable with where the market stands?
Patricia Lynch: While it’s always difficult to anticipate how market terms will evolve, it’s been clear to date that the ILPA guidelines have not been adopted wholesale. Nor have they limited the extent to which subscription facilities are used. One could even argue that, by encouraging the development of market standards and expectations among fund managers and investors as to how these facilities will operate, the guidelines have, if anything, facilitated the growth of subscription facilities. That said, we expect that some of the trends I’ve described will continue. In particular, we expect fund managers to continue to provide greater disclosure regarding the use of subscription facilities. Another possible development may be the evolution of mechanisms in fund partnership agreements to enable some investors to opt out of participating in subscription facilities by funding their capital calls in advance of other investors. We haven’t seen many investors request such a mechanism to date, but this could become more prevalent in the future if interest rates increase. Overall, however, we’re finding that most investors recognize the benefits of using a subscription facility when used responsibly by fund managers to provide short-term liquidity and ensure more predictable capital calls. And we expect that funds will continue to make active use of these facilities for many years to come.
Isabel Dische: Thank you, Patricia, for joining me today for this discussion. And thank you to our listeners. For more information on the topics we’ve discussed today, or other topics of interest to private funds or institutional investors, please visit our website at www.ropesgray.com. And of course, if we can help you navigate any of these areas, please do not hesitate to contact any one of us.
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