Link to original article: GPs grapple with costly convenience of capital call credit lines

Higher interest rates have reduced the utility of yet another instrument in the private equity toolbox: credit lines commonly used to bridge capital calls.

Subscription lines of credit have long been a portfolio management tool used by private capital funds to lower the frequency of capital calls. The bridge facility, often in the form of a revolving line of credit, enables fund managers to close transactions quickly and reduce administrative costs for limited partners.

But like many things in today’s environment, higher interest rates and tightening credit conditions have made this common fund-level financing facility more expensive, prompting private fund managers to exercise greater discretion in using the tool, according to a recent PitchBook analyst note.

“GPs just have to be a lot more careful about how they consider these subscription facilities,” said Juliet Clemens, a fund strategies analyst at PitchBook and the author of the note.

A popular instrument

It is an open secret that using subscription lines of credit, or sub-lines, can have the impact of boosting internal rates of return (IRR), an important measure for assessing fund performance, by delaying capital calls and shortening a fund’s investment horizon.

About 40% to 90% of private market funds use sub-lines, forming a market that amounted to roughly $750 billion as of the end of last year, according to Fitch Ratings.

“It just becomes more expensive to take out that money now,” Clemens said.

The overall cost of a sub-line facility has risen substantially, a product of elevated base rates and wider credit spreads. A subscription facility could charge an interest rate of 7% to 8% today, compared with about 2% before the Federal Reserve started raising rates in March 2022, The Wall Street Journal reported.

The increase in interest expenses eats into the cash-on-cash returns of a fund, leaving less money to give back to investors.

In addition, reduced risk appetite and stricter capital requirements have led commercial banks—the traditional capital providers in the sub-line market—to reduce their exposure to subscription facilities, making them more difficult to acquire.

Bridging the gap

In search of alternative ways to fill this demand for capital call facilities, some traditional sub-line lenders are exploring the possibility of securitizing deals to attract insurance capital, but the solution is still in a nascent stage, according to the note.

GPs are also getting creative, trying out hybrid structures that consist of a NAV loan plus a subscription facility to help patch the shrinking supply of traditional sub-lines. The downside is the hybrid facility is pricier and more time-consuming to structure.

In another strategy, GPs may take on a smaller amount of debt at the start and later tap into a so-called accordion feature to increase the borrowing size, allowing them to avoid paying fees on any untapped part of a loan.

Some fund managers also choose to repay borrowings under the revolver within a few months rather than holding the debt for years, which was common when interest rates were low.

“It was easy to use financial engineering when rates were low,” said Clemens. “But all of a sudden when rates are high, it requires the actual skillset to turn a company around and make a profit.”

Read more: The Changing Landscape of Capital Call Facilities