Surveying the Medley of Sub Lines in Private Funds
Key findings
Subscription lines of credit (sub lines) are usually understood as cash-flow-management tools for general partners (GPs), but in practice, GPs deploy their sub lines in extremely varied ways.
In addition to variation in sub-line behavior across private-capital strategies (such as venture capital), there is significant variation in how different GPs utilize sub lines within strategies.
Given the wide range of GP behavior, it is critical for limited partners (LPs) to maintain visibility into sub-line usage when forecasting cash flows; in turn, delaying cash flows may inflate GPs’ positive internal rates of return.
Conventionally, a subscription line of credit (sub line) provides bridge loans for general partners (GPs) to make investments without having to wait on limited partners (LPs) to meet capital calls; a sub line also saves LPs the administrative burden of meeting frequent capital calls. As such, it seems natural that GPs would draw on their sub lines during funds’ investment periods, revolving through multiple drawdowns and repayments, before finally extinguishing the lines around year four or five of a fund’s life.
Examining the rise of sub lines at the strategy level can provide a useful perspective for LPs worried about sub lines’ distorting effects on return measures. However, it is important to note that, in practice, GPs use sub lines in a wide variety of ways. In this article, we present fund-level data demonstrating the divergence in sub-line deployment across not only private-capital strategies, but also GPs.
Investment activity and sub-line balances varied across and within strategies
Investment activity and sub-line balances of nine anonymized funds from the Burgiss Manager Universe. All values are normalized by fund size (total LP commitments) and years since each fund’s first activity.
Real estate funds
Of the nine funds, Real Estate 1 best approximates how sub lines are conventionally understood. It draws the sub line early, revolves through the sub line during the investment period (drawing, then simultaneously paying down the drawn portion and re-drawing for additional investments), then starts to extinguish it promptly at age five as the fund switches from calling capital for investments to collecting fees.
In contrast, Real Estate 2 maintains a surprisingly large sub-line balance long after its major investments are made. Interestingly, this fund does not engage in much revolving after age three. Between ages one and three, the fund revolves through its sub-line balance by calling capital and re-drawing the line of credit. After age three, however, the fund makes no further capital calls, with paid-in capital topping out at just over 80% of fund size; that corresponds neatly to the fund’s sub-line balance from ages four to nine, of just under 20% of fund size. The sub line’s extinguishment after age nine is also not a result of capital calls; this is a clear example of a GP using exits to pay down the balance.
While less extreme as a fraction of fund size than Real Estate 2, Real Estate 3 similarly uses its sub line long after its investment period ends. This fund behaves “normally” during its investment period (like Real Estate 1), paying down the line around age four with capital calls. But after a late investment at age six, the fund pays itself fees with the sub line and pays down the balance using exits.
Buyout funds
Instead of carrying persistent sub-line balances like the Real Estate funds above, Buyout 1 consistently makes brief draws: when a big investment arises, the fund uses very short-term borrowing to split it into two smaller capital calls, then quickly extinguishes the sub line. While this fund does not use its sub line heavily, the way it uses it is extremely regimented.
Though Buyout 2 looks superficially like Buyout 1, it is not actually smoothing capital calls, it just briefly delays them, giving LPs an extra few months to manage liquidity. This is still very short-term borrowing in comparison to the real estate funds discussed above, but different in character from Buyout 1.
Surprisingly, Buyout 3 starts off without a sub line but opens a credit facility almost two years into its life. To compensate for its initial lack of a sub line, it uses the credit facility to “un-call” capital from the initial three investments with a reverse contribution — refunding previously called capital. After that, the fund operates a fairly conventional sub line until age six. From then on, it revolves the balance for investments and management fees, which are quickly called.
Venture capital funds
Unlike funds in other strategies, venture capital funds often call capital in larger chucks and invest from that cash balance, leaving little use for sub lines. When used, sub lines are short-term bridge financing until capital calls arrive. That is exactly what we see in Venture Capital 1 and Venture Capital 2.
Unusually for a venture capital fund, Venture Capital 3 uses its sub line quite intensively; however, it is still used for relatively short-term borrowing. In this case, the fund uses the sub line to batch investments into consistently sized capital calls rather than calling that capital in advance. This may seem like an obvious application for a sub line, but many other venture capital funds — including the two discussed above — appear to prefer to call capital in advance rather than draw on a sub-line facility.
The importance of visibility
We know that sub-line utilization varies widely across asset classes from our previous research, but even within asset classes there remains huge dispersion in how GPs deploy sub lines. This has important implications for LPs forecasting cash flows and returns, making their fund-level visibility into sub lines critical. Using sub lines to delay cash flows would inflate GPs’ positive internal rates of return, but the magnitude of this effect depends on how the sub line is deployed, a topic we plan to address in future research.