Just when we thought the upcoming Uber IPO was the biggest news in private markets, we get a hot take from the Oracle of Omaha. At the annual meeting of Berkshire Hathaway Inc., Warren Buffett noted “[w]e have seen a number of proposals from private equity funds where the returns are really not calculated in a manner that I would regard as honest; [i]f I were running a pension fund, I would be very careful about what was being offered to me.” Though used almost exclusively by Private Markets managers, the transparency of an internal rate of return (IRR) as a return metric is not a new topic. Much of the focus of this discussion relates to leverage, specifically the use of subscription lines to delay the calling of capital from underlying investors. Mr. Buffett is clearly pointing to a lack of transparency, from the perspective of investors, around how this type of fund-level financing impacts the overall returns that are presented (both before and after fees).
Subscription lines, or bridge financing, represent a fund level financing resource used to delay capital calls from investors. In the memo titled “Lines in the Sand,” Howard Marks notes the “key element is that a subscription line can substitute for LP capital, but it can’t be used to allow the fund to invest more than its committed capital.” However, perhaps the most impactful quote from the memo relates to comparing returns across multiple investment managers in a world where bridge financing is used:
"One fund with a higher IRR didn’t necessarily outperform another. And, proactively, a fund that used a subscription line and came in with a higher IRR may not have done as good a job or made its LPs as much money – as one that didn’t use a line…"
Mr. Buffett is making much the same argument in the quotes available from the BH annual meeting. IRR alone does not tell the story of how an investment did for two main reasons: 1) there is no indication of how much of committed capital is put to work; and 2) it does not communicate the impact a fund-level credit facility would have on the return generated for a fund or specific investment.
While there is no industry consensus on how to handle this issue, the Global Investment Performance Standards (GIPS®) offer a solution in the pending 2020 GIPS Standards update. The GIPS standards historically allowed the use of a money-weighted return (MWR), which IRR represents, for specifically defined assets. This included equity investments in real estate and private equity. The updates move to a structure built around investment vehicle, and the ability to present IRR is based on the ownership of the timing of cash flows (with a few other caveats that private markets investments would meet). In addition, the proposed changes to the GIPS standards will require the presentation of a group of investment multiples whenever firms decide IRR is the most relevant performance metric. These investment multiples help reduce some of the ambiguity associated with IRR by providing insight into the amount of capital invested and distributed for specific funds. The exposure draft for the 2020 GIPS Standards even goes as far as to require the calculation of performance returns “without” the use of a subscription line to remove the return generated strictly by using these bridge financing facilities.
The use of a subscription line provides no ability for investors to receive a different set of distributions at the end of the life of an investment (i.e. does not act as traditional leverage). However, there is potential for the general partner to meet or exceed a preferred return or hurdle rate sooner, in part because the use of a subscription line does reduce the investment period and will amplify a return stream. While IRR does give a good indication of the trajectory of capital at work, there is also a limitation based on the opportunity cost associated with uncalled committed capital left in short-term securities. As noted by Howard Marks, “In order to figure out the full impact of the use of subscription lines, one would have to know what LPs do with the uncalled capital during the period before it is drawn by the funds.” Therefore, investor focus should also include the capital contributed against the capital distributed across the life of an investment or fund. The impact of subscription lines on performance can be material depending on the terms and how long capital can be held on a line of credit.
ACA recommends always providing investment multiples alongside IRRs at both the investment and fund level, as well as the following disclosures relating to the use of subscription lines:
- The existence of the subscription line
- Extent of use (i.e.: to consolidate cash flows, ease of transactions, etc.)
- Impact of the use of a subscription line on returns
This is in line with the proposed requirements of the 2020 GIPS Standards update. While we don’t know what the final guidance holds, we do know that there will be greater focus on the use of credit facilities within the standards. We have recently observed firms proactively providing IRRs, with and without the impact of sub lines, to be best in class with regard to transparency. More often, firms are at least completing an internal analysis of the impact of their use of subscription lines on overall performance to provide context internally for enhanced disclosure, and upon request to investors.
The intent of the GIPS Executive Committee and the concerns of Mr. Buffett are one and the same: investors need a clearer view into the performance of private markets assets. Many of our clients are starting to examine the impact of subscription lines on performance, and as the amount of capital earmarked for private markets continues to expand, the reporting requirements from investors will certainly grow as well. ACA Performance Services encourages firms seeking help or advice on calculation methodologies, disclosures for unlevered returns, or other private market-related performance issues to reach out. For more information on this matter, please contact Christie Dillard at +1 (866) 279-0750.
About ACA Performance Services
ACA Performance Services provides GIPS compliance verification and consulting services to investment managers around the globe. Our team — comprised of more than 80 professionals with extensive GIPS standards and performance experience — is the largest group of GIPS compliance professionals in the world solely dedicated to GIPS compliance verification and related services.