The Institutional Limited Partners Association (ILPA) recently released additional guidance to supplement its 2017 guidelines that seek to increase transparency into what has become an important source for funding in private equity, the subscription line of credit.
The incremental guidelines seek to require quarterly and annual disclosures of internal rate of return, with or without the line of credit, and the methodology used to calculate these metrics. The guidance also requires disclosure of the size and balance outstanding on the credit facility and other specific measures that will help limited partners understand the full extent of their exposure to the fund.
The use of subscription lines has long been a feature of private equity investment. Over the past decade, this has expanded because interest rates made the cost cheaper, the increase in private equity dry powder enlarged the collateral pool for these credit facilities, and rising asset values have made use of subscription lines of credit an effective tool for enhancing a fund’s internal rate of return.
But now, their widespread use has created a disparity in the information available to limited partners from different private equity managers given lack of authoritative guidance on the information that general partners must share, including the level of detail and frequency with which this information is made available.
The ILPA initially issued guidance in 2017 aimed at closing this gap. The recommendations included calling for waterfall provisions to stipulate the credit facility draw-down date as the basis for calculating the preferred return hurdle instead of the ultimate capital call date. In addition, the ILPA recommended that general partners using credit lines disclose the following to limited partners on a quarterly basis:
- The balance and percent of total outstanding uncalled capital
- The number of days outstanding of each draw down
- The current use of the proceeds from such lines
- Net internal rate of return with and without the use of the credit facility
- Terms of the line (upfront fee, drawn and undrawn fees, etc.)
- Costs to the fund (interest and fees)
Since the release of the 2017 guidance, the use of subscription lines of credit has grown even more, so much that industry players have called for more consistency and transparency.
Other trade associations have weighed in on the issue — a sign of increasing demand for greater disclosure. In June 2019, the CFA Institute, which issues the Global Investment Performance Standards (GIPS), released a revised edition of the standards that will become effective on December 31, 2020. This edition includes enhanced disclosures on the use of subscription lines of credit similar to the ILPA’s recommendations.
Even the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE) has made subscription lines of credit an area of focus. There are cases where managers have received a finding from the compliance office’s exams related to the lack of disclosures in marketing materials on the impact of subscription lines of credit on net internal rate of return.
The recent economic downturn brought about by the coronavirus pandemic revealed how a lack of transparency can create liquidity management uncertainties for limited partners and make it difficult for them to forecast cash flows, track asset class exposures and benchmark performance relative to peers.
The ILPA’s June guidance expands on the earlier guidelines by specifying that general partners should disclose the following on a quarterly basis as part of the limited partners’ capital statements:
- Total size of facility
- Total balance of the facility
- Individual limited partners’ and general partners’ unfunded commitment financed (in dollars and percentage) through the facility
- The average number of days outstanding of each draw down
- Net internal rate of return with and without the use of the facility
The guidance also recommends that the general partner should include a supplement in the annual reporting package to limited partners that includes the metrics in the quarterly list above as well as several other details meant to provide more details on the credit facility. The ILPA recognizes the diversity in practice for the calculation of net internal rate of return with and without the subscription line of credit. For this reason, the ILPA recommends clearly defining the calculation methodology in the reporting package.
Private equity managers that use subscription lines of credit should pay attention to the increasing scrutiny and expectations for enhanced disclosures. The release of the Institutional Limited Partners Association’s guidance establishes one framework for improving the transparency and consistency of disclosures. Whether or not general partners choose to follow these guidelines, they will still need to react to the industry’s demands for more information and should plan ahead to increase the level and frequency of explicit disclosures so that limited partners can better understand their unfunded exposure, improve cash flow management and evaluate performance more accurately.