Introduction:

The use of capital call lines has brought about significant structural changes in private fund cash flows. Subscription credit lines, obtained by General Partners (GPs) during the investment phase of a fund, have become widely adopted. These lines provide loans that GPs use to make portfolio investments. Subscription lines involve upfront fees, interest on the drawn portion of the loan, and fees on the undrawn portion. The loan is repaid using capital called from the fund's investors (Limited Partners or LPs). Lenders assess the underlying LP base when determining the terms, making them more favourable for funds with established institutional LP bases.

Subscription credit lines offer two primary benefits- Firstly, they simplify the administrative process for private funds by reducing the number of separate capital calls required from both LPs and GPs. Instead of calling capital for each deal individually, GPs can wait until a certain amount has been deployed before making a single capital call. This eliminates the need to call capital in anticipation of a deal that might not materialize. Secondly, subscription lines can potentially enhance the internal rate of return (IRR) by shortening the time frame between cash contributions and distributions to LPs. Although this may reduce the overall multiple on investors' capital due to the costs associated with the facility, the benefits to IRR usually outweigh the downsides to total value to paid-in (TVPI).

Effects on IRR and TVPI - In an extreme case of once-annual capital calls, a buyout fund model suggests that the use of a subscription line could decrease the TVPI by less than 0.05x while increasing the ultimate IRR by up to 1.2%. However, the impact on interim performance could be significantly greater. Even in a rising interest rate environment, the change in dynamic remains minimal. Based on models, a 1% increase in the base SOFR rate may result in a degradation of IRR by only 10 basis points or less. The early years of a fund's life may experience amplified IRR accretion, which appeals to GPs showcasing strong performance and LPs concerned about the performance J-curve.

Comparison with NAV Lines - While subscription lines are widely adopted, NAV-based credit lines, where GPs borrow against the overall fund's assets to expedite distributions to LPs, are emerging but less commonly used due to higher costs. The subscription line market is currently several times larger than the NAV loan market.

Cyclical Developments: Near-Term Implications for Cash Flows - Capital calls tend to decline during downturns as caution increases among buyers, lenders, and sellers. The current environment, however, presents opportunities for private capital deployment into publicly traded companies at reduced valuations. GPs may also call capital to repay outstanding subscription line balances, increasing flexibility for future cash needs. Aging dry powder levels and LP pressure to deploy capital over the next 12-18 months may lead to better investment opportunities at attractive valuations. Distributions, on the other hand, have slowed down due to fewer viable exit paths and cautious investor sentiment. Private equity exits, especially through IPOs, have declined sharply. GPs may choose to delay exits to maximize value, leading to reduced net cash flows for mature programs. However, the market dynamics may reverse once the market recovers, with distributions picking up as portfolio companies are sold in a more favourable market.

Net Cash Flows - The patterns of capital calls and distributions vary among LP programs. Programs in ramp-up mode with younger funds may experience smaller cash outlays relative to baseline assumptions. Capital calls may outpace projections two to three years down the road when recent commitments catch up to the anticipated pace. Mature programs, on the other hand, may see negative near-term cash flow impacts as decreases in distributions outweigh the slowdown in new capital calls. Market data suggests a shift from record net distributions to near cashflow neutrality for mature buyout portfolios. Exit path trends and the prominence of secondary buyouts may lead to reduced net cash distributions at the industry level. The impact of currency fluctuations on LP portfolios with USD-denominated private market investments should also be considered.

Recommended Strategies for LPs - LPs can focus on four actionable areas to manage private market portfolios effectively. First, diversification helps reduce capital call variability. Allocating capital across multiple funds can offset random deviations and make capital calls more predictable. Second, LPs should revisit approaches to managing undrawn commitments, adjusting the magnitude of cash flows associated with anticipated capital calls or the number of months of capital held in reserve. Third, exploring the secondary market for sales or liquidity options can help manage allocations and cash flows. Lastly, LPs should recalibrate their long-term commitment strategies based on evolving market conditions, return expectations, and portfolio value shifts.

Conclusion:

The use of capital call lines has brought about significant changes in private fund structures, simplifying administrative processes and potentially enhancing investment returns. LPs need to adapt to these changes by focusing on diversification, managing undrawn commitments, exploring the secondary market, and reassessing long-term commitment strategies. By actively managing their private market portfolios, LPs can navigate the evolving market landscape and mitigate the impact of unpredictable economic and market developments.

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