The use of subscription lines of credit by private equity funds could in a worst-case scenario add substantial risk for general partners and their investors, according to Howard Marks, co-chairman of Oaktree Capital Management, sister publication Private Equity International reported.
In a memo published on Tuesday on the Oaktree website, Marks explained how credit lines can impact both positively and negatively the performance of a private market fund, and added that “there are other questions surrounding subscription lines that involved investment risk, and some that have bigger consequences, even potentially systemic”.
Some of the doomsday scenarios would result from negative developments in the financial markets and struggling investments.
For one, the use of lines of credit increases the possibility that limited partners overextend their capital by committing more than the amount they have available, since GPs are typically making fewer capital calls when using credit lines.
“Going years without seeing much capital called could convince an LP that calls have become less likely,” said Marks. “Suppose that, in response, rather than set aside capital equal to its commitments, the LP puts it into other investments. This kind of behaviour can result in the LP becoming levered.”
In turn, it raises the likelihood of an LP defaulting on its commitment if an investment turns out to be a loser, depriving a fund of capital, potentially limiting the fund’s ability to repay the line of credit and thereby possibly harming the remaining LPs, Marks explained.
“Suppose a financial crisis brings large losses to fund investments in general. If the LP has made excess commitments, it could suffer levered losses and be forced to liquidate marketable securities in a crisis to satisfy capital calls in connection with their commitments to closed-end funds.”
To prevent such a worst-case scenario, Marks points to the importance of knowing what LPs do with the uncalled capital during the period before it’s drawn by the funds.
He also added that while these hypothetical examples take into account financial crises, asset meltdowns and less-than-cautious behaviours on the part of LPs, they’re all unlikely. But they might not be completely impossible.