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The Private Equity Tool Distorting Returns

Long-term use of subscription lines of credit can “mislead investors with regard to the buyout industry’s true skill and return opportunities,” new research shows.

Private equity firms are increasingly using subscription lines of credit – or short-term loans that limit the number of capital calls they make to investors.  

Data provider Preqin made note in June that the use of these loans has more than tripled. But as the use of these loans has increased, so too has public scrutiny. 

New research published on August 7 by BlackRock and the Technical University of Munich shows that subscription lines of credit used in the short term – around six months – have a moderate effect on a company’s performance and amounts to little more than cash flow management.  

However, those used for at least a year show signs of distorting a company’s metrics, the research shows. 

“If not properly understood by investors, extended subscription lines could distort future fundraising outcomes,” according to the paper. “In addition, the higher reported performance may mislead investors with regard to the buyout industry’s true skill and return opportunities.” 

Researchers Pierre Schillinger and Reiner Braun of the Technical University of Munich and Jeroen Cornel of BlackRock Private Equity Partners in Switzerland looked at 6,353 buyout deals across 700 different funds and 250 private equity firms.  

They used this data, as well as deal-level cash flow data from 1994 to 2017, to create a simulation of hypothetical subscription lines of credit across different vintage years, even when subscription lines of credit weren’t in common use.  

The group measured both final fund performance and fund rankings based on internal rates of return.  

“Our clients that we’ve spoken with about the research find it interesting, intuitive, and substantial,” Cornel said by phone. “This is the first academic work that looks at this in-depth.” 

The researchers found that when subscription lines of credit were used for six months or less, the median net internal rate of return improved by 0.20 percentage points, while the mean net IRR improved by 0.47 percentage points.  

When subscription lines of credit were used for six months or less, 10.4 percent of funds saw their rankings improve by at least one percentage point.  

By comparison, if subscription lines of credit maturities are stretched to two years, 44.4 percent of all funds had their rankings improve by at least one decile. 

According to the paper, the fund rankings suggest that using subscription lines of credit can be favorable for buyout funds, which could lead to increased use. 

[II Deep Dive: Private Equity Returns Are Being ‘Distorted’ by Loans, Research Finds

Despite the ability to improve performance, the use of subscription lines of credit can still be costly. 

“Due to the costs incurred by subscription lines, net multiples inevitably deteriorate for every fund that employs them,” the research showed. The researchers noted that the impact on funds is “marginal.” 

Certain fund measurements, like net fund multiples and public market equivalents, are “hardly influenced” by funds using subscription lines of credit. According to the research, this highlights the importance of not relying simply on internal rates of return to evaluate a fund.  

“It is very important for LPs to have experience with best practices, to screen fund documentation, and to be very thorough in their due diligence,” Cornel said by phone. 

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