I recently read a Bloomberg article titled, “Buyout Firms Are Magically — and Legally — Pumping Up Returns.” It is about vehicle-level leverage creeping into the private equity business. Here, I share some related thoughts for consideration.
Early on, limited partners (LPs) allowed general partners (GPs) to arrange for small lines of credit (backstopped by the investors’ commitments) for operating purposes, primarily managing short-term capital call requirements. “Scope creep” arrived and now the credit lines have grown larger and are being used for early acquisitions. The use of credit lines has also bled over from direct partnerships to fund-of-funds.
The use of credit lines significantly boosts IRR, with a mixed bag of results…
The good:
- It dampens the J-curve.
- It reduces the perceived gross-to-net IRR return spread. (What LP does not want to boast high IRRs as soon as possible?)
The bad:
- It can “artificially” vault the GP past the hurdle rate more easily and the GP collects carry sooner (potentially a lot sooner) than a traditional “cash-and-carry” approach (pun intended).
- It can cause delayed cash distributions (real cash not “deemed” distributions) to LPs because the credit line needs to be repaid.
- It reduces the return multiple the LPs receive by the amount of credit line interest expense and fees. GPs are decreasing the LPs’ spendable economic return to boost a cosmetic non-economic return measure.
- Even though the credit line is backed by the LPs’ cash commitments, using debt as equity in buyout transactions will introduce volatility in the fund’s financial statements (you will note the article indicates that a day of reckoning may come). We saw this happen in a modestly levered mezzanine fund in the Global Financial Crisis, resulting in large interim negative returns.
- The credit lines have become another due diligence item. LPs should ensure that the loan facilities are not subject to margin calls or being called on demand, and managers can be reluctant to provide details.
To be clear, the vehicle loans outstanding can never exceed the remaining uncalled commitments. However, the LPs may get significant capital calls when their publicly traded assets are down.
As the article points out, once one GP does it, other GPs need to do it to “look” competitive, so it becomes an “arms race.” A similar phenomenon was seen with leverage re-caps, which boost IRRs but prevent portfolio company de-risking.
Because of the idiosyncratic nature of the IRR calculation (very sensitive to early cash flows, and becomes relatively static with time), and the fact that IRRs can be manipulated, we focus most heavily on TVPI and DPI in judging the quality of private equity investments for our clients (both on an absolute level and regarding gross-net spread). The ratios are less easy to manipulate.
Generally, if the TVPI and DPI are acceptable, the IRR takes care of itself, but the IRR is useful to understand the “quality” (timeliness) of the TVPI’s development. There’s an old phrase, “You can’t eat IRR.” While high IRRs are great to have, they need to be viewed in context.
As always, leverage does not add or subtract intrinsic value, it just magnifies results and adds complexity.
Oaktree Capital Management’s Howard Marks released a memorandum titled “Lines in the Sand” a few days after the Bloomberg article. It provides an in-depth discussion of capital call line of credit considerations (including, at the extreme, “systemic risk”).
