Walking a fine sub-line

Subscription line financing has been a feature of the private debt market for some time, but the practice was thrown into the limelight in 2017 when the Institutional Limited Partner Association published a nine-point guide pushing for improved transparency around the practice, among other issues.

While the ILPA guidelines may have generated negative publicity for sub-line financing, the practice continues in the private debt sector. A December 2019 report by the Alternative Credit Council, in conjunction with law firm Dechert, found that 43 percent of private debt managers had self-reported using sub-line facilities with a duration of up to 12 months or more.

Others are convinced that the practice is far more widespread than that. Jeff Johnson, head of subscription finance at Wells Fargo, says sub-line use – at least among his firm’s clients – is a near universal practice.

“If I had to pick one factor behind the increased use of sub-line financing by private debt managers then it’s probably the greater transparency”
Jeff Johnson

“The influx of sub-line facilities for the private debt sector hasn’t really changed in the last 12 months, but has instead become part of the standard operating procedure for a debt fund manager over the course of the latest cycle,” he says, noting that most investors strongly support using subscription facilities. “There is a smaller segment of LPs that do not like sub-line facilities. This hasn’t changed. The same investors that are vocally averse to sub-line facilities today were the ones opposed to their use five years ago.”

Interestingly, despite the negative publicity generated around the use of sub-lines by the ILPA guidelines, Johnson credits the focus on transparency from both managers and investors as the driving force behind the increased use of this type of financing by private debt funds.

“If I had to pick one factor behind the increased use of sub-line financing by private debt managers then it’s probably the greater transparency,” he says. “Sub-line financing essentially came out of the shadows as a result of the ILPA-generated publicity.”

Johnson is backed in his view by Gus Black, a London-based partner at law firm Dechert. When the guidelines were published by ILPA there was pushback from the legal sector and Black still takes issue with the implication that the use of sub-line facilities is financial engineering, rather than a legitimate instrument. But he says the ultimate result of the guidelines was greater understanding of the practice by investors.

“When ILPA got involved in the guidance on sub-line facilities, there was significant media reporting around negative investor sentiment for sub-lines, because of concerns around managers gaming returns to juice up their IRR,” Black says. “But what was much less reported, but equally valid, is that investors really like these facilities because then they only have to worry about two drawdowns a year and are not being constantly pestered by managers.”

Black notes that the ILPA guidelines are only recommendations, and that managers don’t have to follow them to the letter. “There are many cases where it would be appropriate to depart from them, but what it does do is put the issue firmly onto the investors’ radar. It was already on the radar of sophisticated investors.”

In any case, Black says the increased use of sub-line financing simply reflects a broader trend of investors looking to diversify their asset base. He also points out that a minor driver behind the increased use of sub-line financing is private equity managers moving into the credit sector.

“You have private equity managers who have diversified into credit and are already using sub-line financing in equity strategies, so think why not use it in the context of their credit business, particularly as this sector often requires more rapid drawdowns, on shorter timelines, with a greater deal frequency than their private equity strategies?” he says. “What is driving the growth of sub-line financing is the combination of the need for quickly available capital and the comfort that investors, and managers, have with these facilities – particularly when the cost of such financing is relatively cheap.”

This point is echoed by fellow London-based lawyer Leon Stephenson, who says that the management structure of private equity firms lends itself to applying the same financing strategy to different parts of the business. “More private equity firms moving into credit is one reason for the expansion of sub-line financing in the latter sector,” Stephenson says. “With the big private equity funds, often the CFO for the equity business also runs the firm’s credit fund. These CFOs have relationships with the banks from the PE fund and it makes sense that they leverage off those to finance the credit fund as well.”

Growing timeline

But while Stephenson may view the rise of the sub-lines as inevitable in the private debt sector, he still has reservations. According to him, sub-line duration has expanded dramatically, and what was once seen a short-term financing tool is often being used for much longer periods.

Indeed, the ACC/Dechert report noted that over half of respondents had used sub-lines for periods in excess of six months (26 percent) or 12 months (24 percent). According to Stephenson, this is a significant difference and underlines the need for transparency by managers around their use of leverage.

“Sub-lines are now being used for a period which is in excess of the original times, which were normally bridging loans of 30, 60 or 90 days,” he says. “As soon as you have these facilities that are out there for six months or a year, that becomes a powerful tool for the fund manager, because what it can do is effectively get financing right at the top of the fund level without using the underlying assets as recourse.”

Black agrees, saying that while sub-lines are themselves not problematic, they could be if they are used for periods of 12 months or more and start to resemble another form of financing. “The issue is: how much is the line blurring between simple vanilla short-term financing that’s money repaid every 90 days, and cash that is longer term and actually used to lever the portfolio?”

Johnson is less concerned about the issue of duration, saying that longer periods could be attractive, depending on the underlying strategy deployed. What is, and isn’t sub-line financing, may still be a topic for debate, but according to Johnson, the continued expansion of sub-line facility use by private debt managers is inevitable as part of the secular shift that has driven the expansion of the private debt market over the last decade.

“An important factor behind the expansion of sub-line facilities in the private debt sector is the growth of AUM in that market,” Johnson says. “Ten years ago, private debt was a fifth the size of today, so the increasing number of sub-line facilities lent in dollars, and number facilities, is more a function of the growth of the private debt market in general, rather than anything that is specific to sub-line financing itself.”