Subscription lines and IRR distortion

Key takeaways

• A subscription line is a loan to the fund secured by the LPs' unfunded commitments, used to fund investments or expenses ahead of capital calls.
• Delaying calls shortens the time LP capital is outstanding, so IRR rises even though the underlying deals are unchanged.
• The facility's interest is paid by LPs, so the multiple and dollar profit fall; in this topic's example, 180 days of borrowing lifts IRR from 17.5% to 19.2% while TVPI falls from 1.90x to 1.84x.
• The IRR effect is largest for short holding periods and for long borrowing periods, and it can move a fund across the hurdle or up a quartile without any change in deal quality.
• ILPA guidance calls for returns to be disclosed both with and without the effect of the facility, along with its size, usage and cost.
• LPs should ask for levered and unlevered net IRR, facility terms and days outstanding, and check whether the preferred return accrues from the date the line was drawn.

What a subscription credit facility is

A subscription credit facility is a revolving loan made by a bank (or a group of banks) to a fund. The collateral is not the fund's portfolio companies but the LPs' obligation to fund capital calls: the lender takes security over the GP's right to call unfunded commitments and over the bank account into which calls are paid. If the fund fails to repay, the lender can, in effect, step into the GP's shoes and call capital from the LPs directly.

Because the credit risk sits with the LPs, lenders size the facility by a borrowing base built from the unfunded commitments of LPs they judge creditworthy, typically giving higher advance rates to highly rated institutions and lower or zero rates to others. The facility size is capped by the LPA, often as a percentage of total commitments, and borrowings usually must be repaid within a limit also set in the LPA, such as a number of days after drawing. Interest is a floating rate plus a margin, and a commitment fee is charged on the undrawn amount.

The LPA controls what the facility may be used for. Typical permitted uses are bridging an investment ahead of a capital call, paying fees and expenses, funding follow-on investments, and managing currency needs. Some funds also use them to smooth distributions or to support a portfolio company guarantee.

Why GPs use them

There are sound operational reasons for a subscription line. A deal can close in days, but a capital call typically requires notice of around ten business days under the LPA. Borrowing lets the fund close on time and call capital afterward. Batching several small needs (fees, expenses, a follow-on) into one quarterly call instead of many small calls reduces the administrative burden on LPs, who must process every call. And for LPs, fewer and more predictable calls make cash management easier.

The line can also reduce the risk of a failed closing if an LP is slow to fund, and in a multi-currency fund it can bridge the timing of currency conversions.

The controversy begins when the borrowing is kept outstanding for long periods, often many months, and when its effect on reported IRR is not disclosed. At that point the line is no longer mainly a convenience. It is a form of fund-level leverage whose main visible effect is on the performance metric used to raise the next fund.

The mechanism: same deals, shorter exposure

IRR depends on when cash moves between the LP and the fund, not on when cash moves between the fund and its companies. A subscription line separates the two. The fund pays the seller on the closing date using borrowed money. The LPs pay the fund later, when the loan is repaid through a capital call, and that later call also covers the interest accrued.

Exits are unaffected: the company is sold on the same date for the same price, and the proceeds reach the LPs on the same date. So in the LP's cash flow series, each contribution moves later in time and becomes slightly larger (by the interest), while every distribution stays exactly where it was.

Moving an outflow later always raises the IRR of a conventional series, because the LP's money is tied up for less time. Making the outflow larger always lowers the multiple, because more is paid in for the same distributions. The net effect on IRR is almost always positive, since the time saved is worth far more in IRR terms than a few percent of interest, unless the facility rate is higher than the deal's own return.

A worked example: Fund D with and without the line

Fund D, a hypothetical fund, makes two investments of $50m each. The first closes on 1 January 2021 and is sold on 1 January 2025 for $100m. The second closes on 1 January 2022 and is sold on 1 January 2026 for $90m. To isolate the effect of the facility, ignore fees, expenses and carry: the unlevered case is the pure deal return.

In the levered case, the fund draws its subscription line on each closing date and calls capital 180 days later, on 30 June 2021 and 30 June 2022. The facility charges 6 percent per year, simple interest, actual/360. Exits and distributions are unchanged.

When the distortion is largest

Two factors drive the size of the effect: how long the line stays drawn and how long the investment is held. The longer the borrowing, the more of the holding period is removed from the LP's cash flows, so the IRR rises more (from 17.5 to 21.6 percent when Fund D's borrowing extends to a full year), while the multiple erodes further (to 1.79x). The shorter the holding period, the larger the share of that period the borrowing removes.

The short-hold case is dramatic. A deal held one year that returns 1.20x has an unlevered IRR of exactly 20.0 percent. Finance the first 180 days with the line and the LP's money is outstanding for only 185 days, so the same 1.2x deal reports an IRR of 35.2 percent. The LPs' multiple falls to 1.17x because of the interest.

Effects beyond the headline IRR

The preferred return. Most LPAs accrue the hurdle from the date capital is contributed by the LPs. If the line delays contributions, the pref clock starts later, the hurdle amount is smaller, and the GP reaches carry sooner and more easily. For Fund D's first deal, the pref that would have accrued on $50m in the 180 days the line was outstanding is 50 x (1.08^(180/365) - 1) = $1.93m, and that forgone accrual would itself have compounded until the distribution date. That is pref the LPs no longer receive ahead of carry, from one draw alone.

Benchmarking and fundraising. Quartile rankings are usually based on net IRR. A GP that uses a line heavily can rank higher than a GP with better deals that calls capital promptly. Because the effect is concentrated in the early years, a young fund's IRR, the figure most visible when the next fund is being raised, is where the distortion is largest.

Risk. A subscription line is leverage, even if short-dated. If many funds draw lines and then call capital at the same moment (for example, when banks tighten terms in a downturn), LPs can face a cluster of larger calls exactly when their own liquidity is under pressure. And because the LP's obligation to fund is the lender's collateral, the LP's legal exposure to the facility agreement deserves review.

ILPA guidance and disclosure

ILPA, the Institutional Limited Partners Association, has published guidance on subscription lines of credit. In general terms, it recommends that GPs disclose returns both with and without the use of the facility, so that LPs can see the IRR the deals would have produced if capital had been called when investments were made. It also recommends regular disclosure of the facility's size, the amount drawn, how long borrowings have been outstanding, the cost of the facility and its purpose, and it encourages LPAs to set limits on the size and duration of borrowings. It has also suggested that the preferred return should be calculated from the date the facility is drawn, so that the hurdle is not diluted by the delay.

Separately, performance standards and regulators in several jurisdictions have moved toward requiring or encouraging disclosure of the effect of fund-level borrowing on reported returns. Requirements differ by jurisdiction and change over time, so an LP should check the current rules that apply to a given manager rather than assume a particular disclosure is mandatory.

The key idea to take from the guidance is simple: an IRR computed with a subscription line and one computed without it are different numbers, and both should be on the page.

What LPs should ask for

At due diligence, ask for the prior funds' net IRR both levered and unlevered, and for the multiples, which are the most robust comparison across managers with different borrowing habits. Ask for the full dated LP cash flow series so the IRRs can be recomputed. Ask for the facility history: size relative to commitments, average and maximum amount drawn, average and maximum days outstanding, all-in cost, and the uses of each drawing.

In the LPA, look for a cap on facility size and a maximum number of days a borrowing may remain outstanding, a statement of permitted uses, and the treatment of the preferred return. In ongoing reporting, ask for quarterly disclosure of the facility balance, days outstanding and interest paid, alongside levered and unlevered returns.

When comparing managers, put the unlevered IRRs side by side, or compare on multiples and dollar profit. A manager whose unlevered IRR is close to its levered IRR is producing returns from its deals. A manager whose levered IRR is far above its unlevered IRR is producing part of its reported return from the calendar.