Boosting your PE IRR- by using subscription lines -is it a good idea?

August 1st, 2017

Private Equity often charges say 1.5% per annum management fees and 20 percent carry, usually over say an 8% preferred return to Investors. The annual management fee is generally calculated on committed capital ie when an LP (investor or “Limited Partner”) subscribes to a fund, the General Partner (“GP”) (the PE group) can usually ask for money any time they like for up to 5 or 6 years from the first close date.

Eliminate or reduce the management fee IRR drag

The management fee can create a notable drag on IRRs, as if say an LP commits $100m to a fund, then 1.5% is drawn down in management fees (plus other fees such as deal abort fees). So say the first year is a slow year for investing, and say only $10m of the $100m committed is drawn down for investments. So the management fees and expenses might be say 2%, so $2m in fees, on $10m invested, means that the first year fees to investors are 20% on deployed capital! This IRR drag can be reduced, where the PE group gets a bank to advance them these fees and expenses, where the bank charges a very low rate of interest, as the loan is “guaranteed” by the GPs Lps, which in many groups are triple AAA investors, and defaults are very rare.

Better still, buy your companies with much less equity

Indeed, where it can really count, some GPs can really max out returns, by boosting debt on a deal, (or not drawing the equity required from Lps) by again using the LPs “guarantees”. Say it is a $100m deal, and a bank will only lend $50m, so $50m equity is required, and the returns don’t look that great. The banks may lend another say $20m, with the additional debt implicitly guaranteed by the final LPs. So your returns are based $30m of equity, rather than $50m of equity, with cheap debt. Of course, as the Lps guarantees are often triple AAA, some Lps may persuade their bankers to lend much more. One can do the math on the huge IRR boost if more is lent by the bank with the LPs as guarantor.

As IRR is extremely time dependent, the longer you delay asking for money, and the sooner you hand it back, the better the IRR. So if you have your capital calls for your deals supplied by a bank instead, then you can hugely boost your IRRs. The bank is happy to supply the capital as they get to lend more and it has great creditworthiness. Imagine doing this on all of your deals, and the IRR effect. Also, as very many Private Equity GPs will not be allowed any carry at all by their LPs unless they first exceed an 8% IRR on the LPs investment, then there is even more incentive for GPs to manipulate their IRRs higher to ensure they actually get carry if their funds underperform. Of course there are other ways of calculating IRRs (4 principal ones) and many investors do not know the difference, where the difference in reported returns can be huge. Of course, as they say, “you cannot eat IRRs.” In other words, your IRRs go up, maybe a lot, but your multiple of money can drop as you have been paying out some of your multiple (and carry) in payments to the bank. So the GP sacrifices some of his carry to get a higher IRR that will allow him to raise much more money more easily (and therefore get more management fee which will offset some of the loss of carry).

Some very large Lps are very focussed on IRR performance as they are remunerated on the IRR outperformance of benchmarks, so they will likely be supportive of techniques that boost IRRs. But woe betide the GP that overgears / overlevers their deal using extra bank debt “guaranteed by the LPs”, and the portfolio company goes bust. I would not want to be the guy calling the LP to say “we lost all your money on this deal, and by the way please wire a bunch more money, which you will immediately lose, as we also need to wire that to bank to cover the guarantee..”

Systemic risk?

So does this extra leverage in portfolio companies create systemic risk? Without the statistics it is hard to say. But at the very least any investors in buyout funds should look a bit deeper and assess the real risk/ return dynamics. What if the subscription lines were pulled by the bank in a downturn? Lots of GPs would suddenly have to make large capital calls on their LPs. Those LPs, depending on the size of the capital calls might then have to sell other liquid assets eg treasuries, corporate bonds or equities, further inducing rapid market falls across the board. If that were to happen then one can expect a change in LP terms.