November 17, 2016
Private equity’s popularity among pension plans — still the largest source of investments in private equity funds — owes much to the fabled returns the industry earned in its glory days. Private equity (PE) firms claim that investing in their funds is the path to high returns and a secure retirement for pension plan beneficiaries. Returns over the last 10 years, however, have been disappointing. Research by leading finance economists demonstrates that the median private equity fund launched since 2006 has failed to beat the stock market. PE investors could have done as well investing in a stock market index fund without having to tie their money up for 10 years and without the lack of liquidity, lack of transparency and high fees of private equity.
How does private equity manage to pull the wool over the eyes of supposedly sophisticated limited partner investors in PE funds — not just pension plans but insurance companies and university and foundation endowments? One part of the answer is that the private equity industry employs a flawed yardstick — the internal rate of return or IRR — to measure its performance. While this measure has been discredited by leading finance professors and discarded by them in favor of a truer measure of performance , the IRR has the virtue from the industry’s point of view that it exaggerates returns. This, however, is not its only virtue.
As PE firms have long known, the IRR is a mathematical algorithm that is easy to manipulate. For example, a PE fund that requires its highly indebted portfolio companies to sell junk bonds and take on even more debt in order to pay a dividend to investors in the fund in the first few years of the fund’s life will be rewarded with a boost to its IRR that bears little relation to what investors will ultimately receive. And that’s not the only trick PE firms use. Selling a profitable portfolio company early in the fund’s life will also goose returns as measured by the IRR even if holding onto the company and selling it later at a higher price would have increased the actual returns investors receive. But in the current low PE performance environment, these tricks may no longer raise the IRR sufficiently to make risky investments in PE look attractive.
Enter subscription line loans. These are loans that operate in a way that is similar to home equity lines of credit. Home owners use the equity in their homes as collateral to secure a line of credit from a bank that they can then use as needed. Similarly, PE firms use the commitments of capital by investors to its private equity funds as collateral to secure a line of credit that they can use as needed. Traditionally, when a PE firm sees an investment opportunity, it calls on the capital committed by its investors and uses this to acquire the company. Sometimes the PE firm has to move very quickly to take advantage of an opportunity. In the past, on the relatively rare occasions when the PE firm needed to act before committed funds could be called, it would use its subscription line as a bridge loan to make the acquisition. Then it would quickly call the committed capital and promptly repay the subscription line loan.
Now, however, the use of subscription line loans is surging. Subscription lines are being used by some PE firms not as bridge loans but as an alternative to calling commitments from investors in the early years of a fund’s life. In the traditional case, the IRR is negative in the early years of the fund’s life — when commitments are being called but before there are any returns. Using subscription line loans to make acquisitions in the early years, and waiting to call capital and repaying the loans until after the fund has begun to realize returns eliminates this period of negative returns and increases the fund’s internal rate of return. This sleight of hand artificially raises the fund’s IRR and its apparent performance, but does nothing to increase the actual returns earned by pension plans and other investors in the fund.
When PE firms use bank financing to acquire portfolio companies rather than calling on capital committed to the fund, it distorts fund performance and creates problems down the road for fund investors. Limited partner investors typically use reported IRRs to compare performance across funds, but funds that make this use of subscription line loans have an unfair advantage over those that do not manipulate returns this way. This makes it difficult for pension funds and other limited partners (LPs) to decide where to invest. Consulting firm TorreyCove Capital Partners provides the hypothetical example of a $100 million fund that, using capital called from investors to make acquisitions, generates a net IRR of 10.56 percent at the end of year six. By using a subscription line loan instead to make acquisitions and delaying its capital calls by two years, the PE firm will boost the fund’s IRR at the end of year six to a considerably higher 13.93 percent. Advisory firm Willis Towers Watson has raised the concern that all private equity firms will feel the need to use subscription line financing in order not to be left behind when limited partners compare IRR performance.
More troubling, perhaps, this use of subscription line loans, by exaggerating the fund’s returns, enables the PE firm to begin collecting its 20 percent share of the fund’s earnings before it is entitled to do so. Most funds have a requirement that the fund has to achieve an IRR of 8 percent (called a hurdle rate) before the PE firm can claim its share of the fund’s profits — i.e., its carried interest. Using a subscription line to purchase acquisitions helps the PE firm reach its hurdle rate more quickly and begin collecting carried interest faster. The use of a subscription line may also allow an underperforming PE fund to appear to have reached the 8 percent hurdle IRR, and to collect a share of profits that it was not entitled to. TorreyCove provides another hypothetical example in which a $100 million fund that had a 6.63 percent return after six years was able to artificially boost its return to an 8 percent IRR by using a subscription line of credit — 1.37 percent higher than without using the credit line, and high enough to collect 20 percent of the fund’s profits.
As Ludovic Phalippou, a finance professor at the University of Oxford’s Saïd Business School, observed, “With these sorts of tricks, the internal rate of return of a private equity fund can appear stratospheric, even if the amount of money returned net to investors is modest. In some cases, performance fees will be paid when they would not have been due without that trick.”
Phalippou raised the concern that some LP investors may not understand how the use of subscription line loans provides an unfair advantage to the PE firm. Other observers, however, point to another, more self-serving, reason that LPs are not raising an outcry over this practice. The bonuses or other performance pay of financial managers responsible for investing the assets of pension plans, insurance companies, or endowments in private equity are often tied to the performance of this asset class. Financial engineering that enhances PE fund performance boosts the pay of these financial managers employed by LPs to manage private equity investments. Further, as Private Equity International observes, “in some cases LPs — particularly those who measure their own performance in terms of IRR — appreciate them [subscription line loans].”
The Security and Exchange Commission (SEC) should investigate private equity’s increasing use of this financing trick to boost paper returns without increasing fund earnings. The use of subscription line loans distorts PE performance to the advantage of PE firms and the disadvantage of the funds’ LP investors. Absent guidance from the SEC, Willis Towers Watson is advising its clients to take subscription line financing into account in calculations of when private equity managers can claim carried interest.
 Finance professors, finance professionals, and some pension plans and other limited partner investors in PE use a performance measure known as the Public Market Equivalent or PME. It is described in detail and compared to the IRR in Appelbaum and Batt (2016), “Are Lower Private Equity Returns the New Normal?”