Andrea Auerbach
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In short, no—their use isn’t going away any time soon. Rather than avoid them, incorporate new elements to more clearly assess the manager’s true investment skill.
Commitment facilities, also referred to as subscription line financing, are credit lines allowing a private investment fund (private credit, private equity, real estate, etc.) to borrow against limited partner (LP) capital commitments. These facilities have been around since the institutionalization of private investing decades ago, and were traditionally used to ease the capital call process for a fund and typically repaid within 30 days of use. Many general partners (GPs) still use them in this manner.
However, driven by competition to be top quartile and the availability of inexpensive credit, GPs have been hard at work exploring all potential uses of commitment facilities and their positive impact on net internal rates of return (IRRs) to limited partners. By using commitment facilities to make investments and repaying the line at least six months later, we estimate that GPs could boost a fund’s net fund IRR by an average of 200 basis points (bps) (with a wide variation around that average). Using commitment facilities to prepay a distribution ahead of a known exit event (that’s correct, they are now using them to pull exits forward) can further improve the net fund IRR by an estimated 100 bps or more.* Depending on the size and terms of the facility, GPs could potentially lift returns by 300 bps or more, perhaps move up a quartile, or at the very least look better than their competitors on this measure. GPs are pursuing this in droves, like a Black Friday shopping mob.
LPs know better than to rely on one indicator of investment performance. As we have always maintained, properly assessing private investment performance requires looking at more than just fund-level IRRs. The net fund IRR goes hand-in-hand with the total value to paid-in (TVPI) multiple and, taken together, these two metrics can reveal a contrast that requires further inquiry, as the impact of commitment facilities on TVPI due to their cost is still negative, but much more muted. To better understand how the use of a commitment facility has altered LP returns, investors can also ask their GPs to provide net fund IRRs as if no commitment facility were used (unlevered net fund IRR). One thing is certain, greater transparency at the fund level will be necessary to assist investors in their efforts to clearly assess fund performance.
LPs also need to evolve their approach to assessing performance, with the goal of determining if their GPs are delivering on what they were originally hired for: to make good (preferably great) investments in line with their stated strategy. This requires a return to basics—investors should consistently review individual investment-level performance (gross IRR, gross multiple, operating metrics) alongside fund-level information. All of this information should be as of the dates the investments were made and held by the fund, not adjusted for when LP capital was used. Data like these allow for a more holistic review of performance and reveal more of the manager’s true capabilities, which are ultimately what we are all seeking to understand.
The reality is, until interest rates rise to a point where the costs of using commitment facilities make them less economically attractive, their popularity is likely to continue. Even then, it is my view that we have not seen the end of fund-level performance engineering. The siren song of easily increasing IRRs by using a currently inexpensive financial solution is just too great for a competitive GP to ignore. But investing isn’t going to get easier; without actual talent and capability, the IRR “head start” provided to a manager by a commitment facility will eventually be eroded and exposed. Private investors can and should employ additional tactics to understand whether fund-level performance is an accurate reflection of the manager’s true ability to deliver on its stated strategy.
For more detail on private investment performance, read our 2017 report “A New Arrow in the Quiver: Investment-Level Benchmarks for Private Investment Performance Measurement.”
* We derived these estimates of the potential impact on net IRRs and multiples via a simple model of hypothetical fund-level cash flows.
Andrea Auerbach is a Head of Global Private Investments Research at Cambridge Associates.
Originally published on June 19, 2018 This report is provided for informational purposes only. The information presented is not intended to be investment advice. Any references to specific investments are for illustrative purposes only. The information herein does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. This research is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction. Some of the data contained herein or on which the research is based is current public information that CA considers reliable, but CA does not represent it as accurate or complete, and it should not be relied on as such. Nothing contained in this report should be construed as the provision of tax or legal advice. Past performance is not indicative of future performance. Broad-based securities indexes are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index. Any information or opinions provided in this report are as of the date of the report, and CA is under no obligation to update the information or communicate that any updates have been made. Information contained herein may have been provided by third parties, including investment firms providing information on returns and assets under management, and may not have been independently verified.