Case 069Fund, LP and portfolio analyticsHard

A fund uses a subscription credit line at 8% to delay its capital call by 180 days on a deal that turns 100 into 200 over four years. What happens to the IRR and to the money multiple?

The situation

Vriksh Growth Fund agrees to invest Rs 100 crore in a company on day 0, and the plan is to sell the stake for Rs 200 crore exactly four years later. The fund has a subscription lineA revolving loan to a fund, secured on its investors uncalled commitments, used to pay for deals before the capital is called. from a bank at 8% a year, simple interest.

Instead of calling capital from its investors on day 0, the fund draws the line, pays for the deal, and calls the money from investors 180 days later, together with the interest the line has charged, then repays the bank. A secondaries buyer evaluating the fund's track record asks you to show what the line did to the numbers investors see.

Your task

Work out the investors' IRR and money multiple with and without the line, explain where the difference comes from, and say what it means for how you read a fund's reported IRR.

Quick check

Using the line, does the investors' money multiple go up, down or stay the same?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

The IRR rises from 18.9% to 20.5%, about 1.6 points, while the money multiple falls from 2.00x to 1.92x. The line costs Rs 3.95 crore of interest for 180 days, which investors pay, so they make slightly less money. But their cash is now invested for 3.5 years rather than 4, and IRR rewards a shorter time much more than it penalises a small cost. No value was created; the clock was shortened.

Step 1What do investors pay and receive in each case?

Write the two cash flow strips, because the IRR comes from the dates as much as the amounts. Think of a friend who buys a concert ticket for you on her card and asks for the money six months later with a little interest: you still go to the same concert, you pay a little more, but your money left your account later. Without the line investors pay 100 on day 0 and receive 200 at year 4; with it they pay 103.95 on day 180 and still receive 200 at year 4. The 3.95 is 8% a year for 180 days on Rs 100 crore, the price of borrowing the time.

Without the subscription line Vriksh's investors pay 100 on day 0 and receive 200 at year 4, 2.00x and 18.9%; with a 180-day line they pay 103.95 on day 180 and receive the same 200, 1.92x and 20.5%, so the IRR rises while the multiple falls.

The relationship

\text{IRR}_{\text{line}} = \left(\frac{200}{103.95}\right)^{1/(4 - 180/365)} - 1 \approx 20.5\% \qquad \text{IRR}_{\text{no line}} = 2^{1/4} - 1 \approx 18.9\%

103.95	the investors' call on day 180: the Rs 100 crore deal cost plus 180 days of interest at 8%
4 - 180/365	the years the investors' money is actually at work, about 3.5
2^{1/4}	doubling over four years

What it says in wordsThe money multiple shrinks a little because investors pay the interest, but dividing by 3.5 years instead of 4 lifts the annual rate by more.

Step 2Why does IRR rise when the investors make less money?

Because IRR measures speed, and the line buys speed cheaply. The line costs 8% a year while the deal earns about 19% a year, so swapping six months of the investors' money for six months of the bank's raises the rate the investors earn on the money they actually put in. The multiple, which ignores time, records the cost and nothing else. Run it the other way to see the condition: if the deal had only returned 120, about 4.7% a year, borrowing at 8% would cut the investors' IRR to 4.2%. A subscription line flatters IRR only when the deal earns more than the line costs, which is usually but not always true.

As the line runs from zero to 365 days, Vriksh's IRR rises from 18.9% to 22.8% while the money multiple falls from 2.000x to 1.852x, because each extra day on the line is cheap borrowed time charged at 8% against a deal earning about 19%.

Step 3What does this mean for reading a fund's track record?

Read the multiple and the IRR together, and ask about the line. A fund that uses long subscription lines will report a higher IRR and a slightly lower multiple than an identical fund that does not, with no difference in the deals it picked. Two more effects matter to investors. First, they still had to keep the uncalled money ready, often in liquid funds earning less than the deal, so their own return on that cash is unchanged by the line. Second, the hurdle rateThe preferred return, often 8% a year, that investors must receive before the manager earns carried interest. It runs from the date capital is called. runs from the call date, so a later call makes the hurdle easier to clear and can bring carried interest forward. That is why investors now ask managers to report returns both with and without the line.

Where candidates lose it

The usual loss is saying the line improves returns. It raises IRR by 1.6 points and lowers the multiple; investors end up with Rs 96.05 crore of profit instead of Rs 100 crore, and the IRR improvement is the clock, not the deal.

The second is forgetting the condition. The trick works only while the deal earns more than the line costs; on a weak deal the same line lowers the IRR.

What the interviewer asks next

The line is kept open for a full year. What happens to the IRR and the multiple?
How would the line change when the fund clears an 8% hurdle on this deal?
Why might a secondaries buyer adjust a fund's reported IRR before pricing its interests?
What risks does a subscription line create for the fund if many investors are slow to meet a call?

Company names and figures are illustrative.