Private Equity's Booster Shot
Performance-enhancing drugs are a no-no for athletes. But many look to gain a competitive advantage from perfectly legal substances such as caffeine, or recovery treatments like sitting in an egg-shaped pod.
For the private equity industry, its equivalent of a caffeine shot is a type of borrowing known as a subscription credit line, a topic Bloomberg News dived into in this article on Thursday:
The practice isn’t illegal, and is largely cosmetic, but it allows private equity firms to goose what’s known as their internal rate of return, or IRR. That’s the most important annual performance yardstick they trumpet to woo prospective investors. The strategy essentially uses short-term bank loans to shrink the time that investors’ money is deployed, thereby boosting annual results. It can make returns look better by 25 percent or more, a recent study shows.
To be sure, the use of credit lines has been around for more than a decade, but the definition of short term has changed: They span for as much as two years now, up from six to 12 months previously, because of banks' eagerness to extend credit during a prolonged period of low interest rates. Private equity executives' willingness to tap this extra financing indicates that firms probably aren't solely using them for their original purpose: a bridge, or temporary slab of capital that is to be quickly replaced when investors deliver on their capital commitments for new deals or smaller bolt-on acquisitions. It's true that not all private equity firms can be tarred with the same brush, but the ones using these loans to juice their returns are most likely motivated by a newfound ability to combat rising deal valuations by minimizing the equity check that they'd otherwise have to write.
Deservedly, it's becoming a point of contention for some of the industry's investors, the majority of whom manage pension and sovereign-wealth funds or family offices. Some are satisfied with firms pursuing innovation and taking advantage of inexpensive credit (less than 3 percent a year!) to chase outsize returns. But that feeling isn't unanimous, with others experiencing varying degrees of outrage that the use of such financing is a way for firms to manage, or massage, returns in a way that allows them to compensate themselves earlier.
According to private equity consultant TorreyCove Capital Partners, net internal rates of return, or IRRs, can be 300 basis points higher if firms leave the debt in place and delay taking investor capital for two years, with returns creeping even higher if the deferral period extends longer. By propping up IRRs, private equity firms can accelerate a fund's performance past a pre-agreed return hurdle, enabling them to cash in on so-called carried interest, or their share of the profits (which is traditionally 20 percent), earlier than they otherwise would.
Unfortunately for investors, they're in a weak position to bargain. Already, in-demand private equity funds have the upper hand and have been able to lower or even drop their hurdle rates, accelerating how soon they start earning their share of a deal's profits.
But simply being recipients of lower returns isn't going to be the only feature that irks investors about these credit lines. Their varying use across the industry -- frequent, irregular or anywhere in between -- is only going to make it more difficult for investors to compare performance across funds, something they already find tough. Still, if private equity firms are transparent, investors should be able to calculate the returns that funds would have achieved without the added benefit created by using these loans.
Investors should also beware of the possible, if remote, chance of losses if funds default on their credit facilities. 1 This could happen, for example, if investors were incapable of delivering on capital commitments because of a recession or other development. 2
Until interest rates rise high enough to mitigate the benefits of these credit lines, expect private equity firms to step on the gas. After all, it is fair game.
This itself would hurt returns and potentially curb a firm's ability to raise future funds.
The likelihood of this occurring is fairly low simply because pension and sovereign-wealth funds are among the best-rated institutions. Also, another instance would be if a fund's portfolio of assets was used as additional collateral and it was forced to sell stakes in publicly traded companies or hold fire sales for a business it would have preferred to own for longer.
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Gillian Tan in New York at firstname.lastname@example.org
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Daniel Niemi at email@example.com