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Howard Marks Memo: Lines in the Sand – Subscription Lines and Assessing GP Performance

Howard Marks Memo: Lines in the Sand, April 18, 2017

How do Subscription Lines Work?

  • Subscription lines are bank loans extended to funds that enable them to use borrowed money, rather than LP capital, to make early investments or pay fees and expenses
  • In general subscription lines are 1) limited as a % of the LP’s capital commitments, 2) are secured by LP’s capital commitments, and 3) generally must be repaid in the early or middle part of the fund’s life although terms are beginning to lengthen
  • A $100 million fund with a subscription line might be able to buy $50 million of assets without calling LP capital but it still can’t invest more than $100 million
    • Bottom line is that essentially all subscription line financing does is defer LP capital calling
    • These lines lever LP capital but do not lever funds in the sense of allowing funds to invest more than their committed capital (different from hedge funds that use leverage to deploy more than their committed capital)

What Are the Effects?

  • Its use does not increase the total $ profits that the fund will earn from investments over its lifetime
  • Use of subscription line doesn’t alter fund’s committed capital or invested capital – either the multiple of committed capital or the multiple of invested capital is not improved
  • Positives:
    • Original purpose was to enable GPs to make investments and pay fund fees and expenses without frequent capital calls and to prevent opportunistic funds that don’t sit on large amounts of cash from missing out on opportunities requiring quick funding
    • With calls for LP capital postponed, reported IRR in the early years (the dollar weighted return on LP capital) will increase (assuming early profits exceed the interest and expenses on the line)
    • Use of borrowed money can reduce or even eliminate the deleterious impact on early returns of the so-called J-curve
      • J-curve results from the fact that in a fund’s early years, management fees are usually charged on total committed capital while a relatively small percentage of the capital has been put to work and the tendency of private investments to take a while to show results
    • Over time, fund’s IRR will retreat from its elevated early level and move down toward what it would have been if the fund hadn’t employed a subscription line
      • All things being equal, fund’s lifetime IRR will remain higher than it otherwise would have been
    • Any return the LPs earn on the uncalled capital in excess of their share of the fund’s subscription line costs will be additive to their results
  • Negatives:
    • Interest and expenses will be paid that wouldn’t have been paid if LP capital had been called instead – since fund isn’t becoming levered, payment of costs is a permanent net negative for the fund
      • Some LPs may actually prefer to have their capital called and earn their preferred return
      • Use of a subscription line in lieu of LP capital shrinks the dollar preferred return hurdle; lowering the hurdle can increase the GP’s probability of collecting incentive fees (carried interest) and cause the payment of incentive fees to the GP to begin sooner
    • Less disciplined or less diligent GPs may be induced to lower the standards to which they subject investments because their effective cost of capital seems so low
    • Some LPs seek to avoid so-called Unrelated Business Taxable Income
    • Since each LP commitment is an essential part of the bank’s collateral, existence of a line could conceivably complicate the process of selling an LP interest in a secondary transaction
    • Many banks are requiring more intrusive information of fund LPs

Impact on Fund Performance Metrics

  • Since a fund’s total $ profits and multiple of capital are not improved by the use of a subscription line, the increase in IRR, while pleasant, might be thought of as illusory
  • While valuable, neither IRR nor MOCC nor MOC, nor any other single metric, is sufficient to tell us whether the GP did a good job
  • High IRR certainly is desirable – but this is what a fund can show if the GP only makes 1 investment with a small fraction of the fund’s committed capital and that investment produces a substantial profit
    • If a $100 million fund invests $1 million in something and sells it a month later for $2 million, this would annualize to an IRR of roughly 400,000% and if that’s the only investment GP makes, that’ll be the fund’s IRR; it certainly doesn’t mean the GP did a good job and I doubt the LP who committed $10 million to the fund will be happy with $10.1 million back in the end
    • To understand what an IRR really says about fund performance, you have to know what % of the capital and how long the GP held onto it
  • Big multiple of invested capital is good but it also may have limited significance. Say the GP of a $100 million fund invests $10 million, keeps it invested for the fund’s entire 10-year life and earns an annual return of 15% on that investment – this will result in proceeds of $40 million and thus 4x MOC. That’s great but again, if this is the only investment made, LPs get a profit of $30 million (certainly not what they had in mind when they committed $100 million)
  • Big multiple of committed capital sounds almost perfect but it too isn’t sufficient. MOCC of 3x is good but if it took 6 years, IRR is 20% and if it took 10 years to generate the same profit, IRR is just 11.6%
  • In order to be able to assess fund performance, we have to know:
    • How much capital was committed
    • How much capital was invested
    • How long it was kept invested
    • How much was returned to LPs
  • One fund with a higher IRR didn’t necessarily outperform another – and, provocatively, a fund that used a subscription line and came in with a high IRR may not have done as good a job as one that didn’t use a line and reported a lower IRR
  • Use of subscription lines sheds considerable doubt on the significance of IRR and when IRR becomes suspect, anyone waiting to evaluate fund results has no choice but to put greater emphasis on the multiple of capital

Bigger Questions

  • Suppose the fund makes $5 million of investments against an LP’s $10 million commitment – borrowing $5 million on the line – and there’s a financial crisis (or investment simply turns out to be a big loser) and investments decline in value to $2 million. Suppose the line comes due, the fund calls $5 million from the LP with which to repay it, and the LP concludes to NOT put up $5 million to secure investments now worth $2 million. Instead, it defaults on the capital call, potentially limiting the fund’s ability to repay the line and/or make further investments, and thereby possibly harming the remaining LPs (this is an extreme hypothetical)
  • Increasing use of subscription lines is altering the pattern of drawdowns and distributions. Going years without seeing much capital called could convince an LP that calls have become less likely. Suppose that, in response, rather than set aside capital equal to its commitments, the LP puts it into other investments
    • This kind of behavior can result in the LP becoming levered
    • Suppose a financial crisis brings large losses to fund investments in general – if the LP made excess commitments, it could suffer levered losses and be forced to liquidate in a bad market
  • It’s mostly during crises that weaknesses are exposed, things that are supposed to happen fail to do so, and unanticipated consequences and linkages manifest themselves
  • The key to financial security – individual or societal – doesn’t lie in counting on things to work in good times or on average. Rather, it consists of figuring out what can go wrong in bad times, and of only doing things that will prove survivable even if they materialize

Further Reading: Memos from Howard Marks: Expert Opinion

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