Internal Rate of Return (IRR) is the most popular method used to measure the performance of private investments. The problem is that IRR can be manufactured by manipulating the timing of cash flows, which makes it difficult to discern between managers who create value and managers who financially engineer returns. The most common abuse across the private equity industry, both in real estate and other sectors, involves the use of a subscription line.
A subscription line is a credit facility provided by a bank and is collateralized against investor commitments. Fund managers use subscription lines to close on deals quickly and manage cash flow. Managers don’t want to burden investors with small capital calls equivalent to 1% to 2% of their commitment, and investors don’t want this either. Additionally, there are situations where the manager may need to close on a deal quickly and they can tap into the subscription line at a moment’s notice to do so.
Subscription lines are a function of the size of the investor commitments and some banks are willing to lend 60% or more of the outstanding commitments, meaning a fund with $300 million in commitments could have a credit line in excess of $180 million to acquire deals. The bank knows the fund manager can always call capital from investors to pay down the line, which is why they are willing to extend them cheap credit. Typically, the bank won’t extend credit until the fund manager has called at least 5% of the investor’s capital because they want to know that the investor is ready, willing and able to fund their commitments.
Here is how manipulating internal rate of return through a subscription line works in practice:
Instead of calling capital from investors when the manager acquires a deal, the manager instead funds the deal through the subscription line and holds the deal there for as long as possible. Subscription lines generally mature at the same time the fund’s investment period ends, which can be three to five years after the fund’s final close. The investor’s IRR is calculated based on the timing of contributions and distributions, and a manager can delay calling capital for years with a flexible subscription line. This greatly enhances the investment’s official IRR at the expense of the investor, who sits on their capital commitment and pays fees while the manager loads up the subscription line with deals.
The examples below illustrate how a manager can easily manipulate internal rate of return with the use of a subscription line. In both cases, the investor commits $100,000 and all deals are acquired in the first year. In the first scenario, instead of using the subscription line, all of the capital is called from investors resulting in an IRR of 9%.
|Year 1||Year 2||Year 3||Year 4|
In the next scenario, all of the deals are acquired in the first year, but instead of calling capital from investors, the manager utilizes the subscription line to fund the deals. In this example, the investor contributes capital in the third year and the distribution happens in the fourth year, resulting in an IRR of 30%.
|Year 1||Year 2||Year 3||Year 4|
The second manager didn’t create any additional value for the investor, they just leveraged the investor’s subscription agreement to manufacture a higher IRR. Even worse, the manager will most likely be paid a much higher incentive fee in the second example because those fees are generally tied to IRR. Essentially, the manager is using the investor’s balance sheet to obtain cheap capital so they can make more fees.
Watch Dave Scherer explain how managers can manipulate IRR to show higher returns.
All managers use a subscription line and some use them for their intended purpose, while others are notorious for using it to manipulate IRR to their benefit. A fund manager who produces a 30% IRR will have a much easier time raising capital than one who generated a 14% IRR, even if it is financially engineered. Investors need to look under the hood of all managers to better understand how the IRR is actually achieved.
Private equity managers need to be evaluated not only on their ability to produce IRR, but also on their ability to invest capital in a reasonable time period. No investor wants to make a commitment and then wait five years for the capital to be called, and no one signs up to have their personal balance sheet levered so they can pay a manager more money.