Inflating Returns with Subscription Lines of Credit
By Patrick Warren and Luis O’Shea
General partners (GPs) in buyout, private-credit and real-estate funds have increasingly delayed capital calls via subscription lines of credit (sub lines).
Delays have substantially inflated internal rates of return (IRRs) for recent funds, a critical consideration for limited partners as they evaluate performance.
For recent vintages of buyout and real-estate funds, the median sub line has inflated current IRRs by approximately 100 basis points relative to the scenario where GPs had called capital instead of drawing their sub lines.
In previous research, we quantified the recent rise of sub lines in private capital using data from the Burgiss Manager Universe (BMU). While an analysis of the growth of sub-line balances is valuable for limited partners (LPs), it is the extent to which sub lines affect internal rates of return that is the ultimate concern, and the topic addressed in this blog post.
It is well understood that using a sub line to delay capital calls will amplify the reported IRR by shortening the clock over which returns are calculated. However, the extent of the amplification depends on two things: the length of the delay in capital calls and the amount of money delayed. In this blog post, we estimate the money-weighted average length of time that GPs delay capital calls via sub lines, which we refer to as the “effective sub-line term.” In essence, this is the length of time a GP’s average called dollar spent on the sub line. We then use the effective sub-line terms (specific to strategies and vintages) to shift capital calls and thus estimate how much sub lines have inflated IRRs.
Measuring effective sub-line term
To estimate effective sub-line terms we calculate the difference between the average time of a fund’s investment in portfolio companies[1] and the average time at which capital is called, with both times weighted by the size of the cash flows. For example, a fund might make two USD 50 investments into portfolio companies, the first on Jan. 1, 2018, and the second on Dec. 31, 2018. In that case, the money-weighted average of its investments was on July 2, 2018. Following an analogous procedure for capital calls, we end up with two dates. We estimate the GP’s effective sub-line term by taking the difference between the date on which the GP called the average dollar and the date on which the GP invested the average dollar.[2]
We plot the range of GPs’ effective sub-line terms by strategy and vintage in the exhibit below. Buyout funds, as expected based on our earlier research, have demonstrated a clear upward trend in delaying capital calls, with the median buyout fund using sub lines to delay calls by around 45 days in recent vintages, up from 20 days for the 2015 vintage.
In contrast, venture-capital funds have broadly remained reluctant to adopt sub lines, with the median fund consistently reflecting zero sub-line delay in their capital calls. However, we do see a nontrivial number of venture-capital GPs deploying sub lines, with the 75th percentile fund delaying capital calls around one week in recent vintages. While the median private-debt fund hardly uses sub lines, a meaningful fraction employs them heavily, delaying capital calls by several months. Last, real-estate funds have had a volatile history with sub lines, but the median delay has generally ranged between one and two months. These funds were the earliest to experiment with sub lines, but buyout-fund GPs are now catching up.
Buyout, private-debt and real-estate funds have delayed capital calls
Source: Burgiss Manager Universe
Upper and lower boundaries of shaded boxes denote the 75th and 25th percentile sub-line delay. Horizontal black lines inside the boxes denote the median. Whiskers extend to include the greatest observation, excluding outliers.
Using the effective sub-line terms we calculated, we can estimate how much these sub lines are inflating IRRs by applying them to cash flows from the BMU.[3] If the median 2018 buyout fund is using sub lines to delay capital calls by 45 days, we can approximate the ex-sub-line IRR by shifting all capital calls from those funds 45 days earlier, then recomputing the IRR. The difference between the with-sub-line IRR and the ex-sub-line IRR measures how much observed sub-line use is increasing reported IRRs. In the exhibit below, we strip out both the median and the 75th percentile sub lines by strategy and asset class, illustrating sub lines’ significant impacts on IRRs across recent vintages of buyout, debt and real-estate funds.[4] (As expected, sub lines have little effect on the IRRs of venture-capital funds.)
IRR inflation was highest for recent buyout and real-estate funds
Source: Burgiss Manager Universe
Sub lines have become increasingly popular among GPs, who are using them to meaningfully delay capital calls. Across private real-estate and buyout funds, the median sub line has inflated IRRs by more than 100 basis points for recent funds, and a significant fraction of private-debt funds have been subject to a similar amount of IRR inflation. This sizable effect is an important factor for LPs to consider when evaluating fund performance.
Related resources:
[1] In practice, we use a combination of sub-line balance and capital-call data to calculate implied investments. Using the actual flows from GPs to their portfolio companies may be complicated by other factors, like leverage.
[2] In the example, if the GP’s average capital call was on Sept. 30, 2018, that implies an effective sub-line term of 90 days; on average, the GP was investing money 90 days before calling it from LPs. While we observe capital calls with daily precision, sub-line balances are only reported at quarter-end. On average, this somewhat understates the sub line’s true effective term.
[3] We omit recent vintages because IRRs for young funds are noisy and not especially meaningful.
[4] Sub lines most dramatically inflate IRRs early in a fund’s life, when capital calls are delayed by a large proportion of the fund’s life span to date. Thus, more recent vintages will show a greater effect from sub lines, which we would expect to fade somewhat as they age. For more on this, see: Gregory Brown and William Volckmann, “Unpacking Private Equity,” Institute for Private Capital and Private Equity Research Consortium, Sept. 26, 2023.