The use of so-called subscription lines — the bank loans that private equity, real estate, distressed debt, and private credit funds sometimes use to postpone calling investors’ capital — are on the rise. And they may pose systemic risks in the event of a market downturn, according to Howard Marks.
The co-chairman of Oaktree Capital Group, who has been writing his widely-read memos since 1990, writes that these bank loans have become a popular way for funds to make early investments or even pay fees and expenses without calling investors’ capital. Typically, investors commit a certain amount of money to a private equity fund, and the fund manager draws down those commitments over time as it makes investments. Bank loans are not the same as leverage, which would allow a private equity fund to actually invest more than what it raises from investors.
Funds are increasingly using bank loans, in part because big investors want higher reported internal rates of return, or IRR — the performance measure for these types of closed-end funds — as well as fewer drawdowns of their capital. Private equity and other funds, for their part, want a way to enhance returns as well as lower the hurdle to receive incentive fees. Bank loans allow them to do this. But Marks argues that bank loans can muddy performance records — along with investors’ ability to discern whether a fund manager is skilled in picking investments.
More worrying for Marks, however, is the risks that bank loans may pose to investors. First, bank loans do result in funds making fewer calls on investors’ capital, but each of those eventual calls will be larger in the end. During a market rout, investors may be less likely to make good on commitments if they’re experiencing problems in other areas of their portfolios. If a private equity fund doesn’t have access to all of the money it is due, it could default on the loans or not be able to jump on attractive deals. In addition, if a number of investors don’t make their capital calls, a fund might not be able to repay its bank loans as well.
“Could this mean that failures by some LPs would increase the likelihood of failures by others?” asks Marks in the memo. “In the extreme, if defaults on lines are widespread, could lines become a source of significant risk to banks?”
Marks argues that the bank loans do give funds flexibility in making capital calls and to quickly jump on investment opportunities. He adds that by postponing capital calls, a fund can also make their early returns as well as longer-term returns look better than they would have otherwise.
“All other things being equal, the fund’s lifetime IRR will remain higher than it otherwise would have been, since the impact of using will taper off but not reverse,” he writes. Still, Marks says that some of Oaktree’s newer funds have started using subscription lines in response to requests from clients.
