Are subscription credit facilities cash management tools or distortion tools?
BY Yaelle Gang | September 9, 2019
Private equity funds’ use of subscription lines of credit has been debated by both researchers and practitioners, specifically because of this form of financing’s impact on internal rates of return.
This is because the internal rate of return is a time-sensitive return measure, so if a firm delays its capital calls, it shortens the effective holding period of the investment, says Pierre Schillinger, a research assistant at the Technical University of Munich and co-author of a new paper on this topic.
This allows the firm to make about the same investment multiple possible in a shorter period of time. “And accordingly, your time-sensitive return measure will increase.”
However, the paper found that, when used in moderation, subscription lines don’t deserve a bad reputation.
Subscription credit facilities provide short-term loans to cover transactional costs for private capital funds, so they don’t have to make capital calls to investors.
The researchers looked at the topic because they were aware of a mechanical relationship between delaying capital calls and a rise in the internal rate of return, yet they weren’t certain to what extent there would be an impact, Schillinger says.
When used appropriately, these subscription lines can have a moderate effect on fund performance and rankings, but mainly constitute a cash flow management tool, according to the paper.
That said, it also found that, if these funds use subscription lines of credit more extensively, they can substantially increase time-sensitive return measures and also alter fund rankings.
If the maturity of the subscription line is more than one year, investors should look into it, Schillinger says. “All we’re saying is that institutional investors — limited partners in these funds — should really do their due diligence properly. And if they compare different funds with different subscription line specifications, they should incorporate that in their analysis of those funds and especially of those funds’ performance.”
The researchers came to their conclusions by developing a stochastic model based on historical data and simulating fund cash flows from 1994 to 2017 with hypothetical usage of subscription lines.