Subscription-Secured Credit Facilities: Financial Reporting Considerations

Published: May 9, 2017
By: Ari Samuel; Jeffrey Stomski
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There has been an increasing trend of private equity funds’ utilization of subscription-secured credit facilities. The use of these credit facilities provides fund managers with the ability to timely and effectively act upon investment opportunities rather than waiting 10 or more days to receive the capital called from limited partners. Although such credit facilities are commonly used as a short-term bridge, we have recently seen situations where limited partners are allowed to bridge capital contributions for a longer term – 30, 60, or even 90 days – and have even noted certain funds allow limited partners to bridge capital contribution with such line of credit for the entire investment period of the fund.

The use of a subscription credit facility creates several unique financial reporting considerations.

BACKGROUND: SUBSCRIPTION-SECURED CREDIT FACILITIES

The facility is a revolving line provided by a lender and collateralized by a pledge to call and receive the unfunded capital contributions from the fund’s investors. The lending institution will typically require that it has access to a particular fund’s deposit account, as well as the right to make capital calls and enforce the obligations of investors to contribute capital.

The borrowing base and rates are a function of a particular private equity fund’s unfunded commitments, investor credit ratings and composition of limited partners (high net worth, ERISA, sovereign wealth funds, etc.). We have seen new launches incorporate a lender’s required representations, acknowledgements and covenants needed from investors into the fund’s governing documents and subscription agreements, while legacy funds are required to obtain such items from each limited partner.

QUESTIONS & ANSWERS

Q: When calculating the Internal Rate of Return (“IRR”), should a private equity fund’s IRR be calculated based on the date capital was drawn from the credit facility or the date the cash was paid in by the limited partner to settle the credit facility (the actual capital contribution date)?

A: Accounting literature does not provide a bright line determination on the timing of cash flows used in the IRR calculation. Rather, it requires that the calculation be based on a consistent assumption about the timing (no less frequently than quarterly) of cash inflows and outflows and that such assumptions are disclosed in the fund’s financial statements. Management must adopt an appropriate policy that is consistently applied over the life of a particular fund and fully disclosed in each fund’s financial statements. When calculating the IRR, funds using the date a limited partner settles the credit facility as the date of cash inflow (and not the date the credit facility was drawn down) results in a higher, levered IRR due to the time value of contribution based on the date of contribution. Management should consider disclosing both the levered and unlevered IRR in the financial statement.

Q: How are interest expense and fees associated with the credit facility reported on a fund’s statement of operations?

A: A fund generally enters into the credit facility with a lender and is responsible for the payment of principal and interest, the interest expense, and any fees associated with the credit facility. It is reported on a fund’s statement of operations as interest expense and included in the expense ratio in the financial highlights disclosure.

Q: Which event “starts the clock” on the accrual of the preferred return: drawing down from the credit facility or calling capital from limited partners to pay back the credit facility?

A: We have noted that there is diversity in practice as to when funds begin the preferred return accrual. Most funds will start the accrual when the line of credit is drawn down (considered as the capital contribution date) while others will start the accrual when capital is actually contributed by the limited partners. We suggest that funds disclose the method of calculating the preferred return in the appropriate fund documents as well as in the financial statements.

Asset Management Intelligence – Q2 2017