Bank Pullback Leaves Buyout Firms Starving for Bridge Loans

Some big banks, most notably Inc., have scaled down their sub-line lending over the past year, people familiar with the bank’s activities said. The failures last month of Silicon Valley Bank and Signature Bank, both significant sub-line lenders, worsened the shortage of this type of credit.

The result is a widening gap between private-equity demand for these loans and banks’ willingness to provide them, said Greg Fayvilevich, head of the global funds group at Fitch Ratings, which rates this type of loan.

“The demand for subscription lines has increased materially but the supply of banks willing to provide them has not kept pace,” Mr. Fayvilevich said. “The market now is characterized as massively supply-constrained.”

Fitch estimates that worldwide sub-line debt totaled $750 billion by the end of last year, an 88% increase from five years earlier. A trade group for private-equity investors said a 2021 survey of its members showed 98% of funds use these lines of credit.

At first, sub lines provided private-equity firms with simple bridge loans, but now the credit lines are commonly used—some say abused—to artificially juice a fund’s paper returns.

Regulators and limited partners have complained for years that such use of sub lines makes it hard to assess a firm’s real investment performance. But firms like the loans because higher returns—even if only on paper—are good for marketing.

Sub lines make it easier for private-equity firms to do deals. Rather than asking dozens of limited partners to wire cash every time a firm wants to make an acquisition, it can tap a sub line instead, and only needs to ask investors to send cash every quarter or two. The credit lines allow firms to close transactions quickly and without the risk that a fund investor will forget to send a wire.

This use of sub lines has become standard practice and that is unlikely to change even if borrowing costs continue to rise, industry observers said.

But a more controversial use faces challenges. Buyout firms have discovered that borrowing money for longer—in effect, drastically postponing the day when they ask investors for money—makes paper fund returns look higher by increasing a metric called the internal rate of return. Calculations of IRR depend on the length of time investor money is used to achieve a profit. By using sub lines to reduce this length of time, fund managers can pump up the apparent returns of their funds.

Now that borrowing costs have risen, though, the artificial boost to a fund’s paper performance might no longer be worth the expense of the loan, said Oliver Gottschalg, a professor at the HEC School of Management in Paris, who studies private equity.

“The big temptation to use these credit lines for anything more than convenience of cash-flow management is substantially diminishing,” Mr. Gottschalg said.

Most sub lines are pegged to overnight bank-lending rates, which have risen from near-zero at the beginning of 2022 to roughly 5%. Spreads on sub lines, or the cost on top of the baseline rate, have widened to around 3 percentage points from 1 to 2 percentage points, people who work in the field said. That means sub-line borrowing that might have cost around 2% a year ago can now cost 7% to 8%.

As a result, “the rationale to use the subscription line for a long period to boost IRR is reduced,” Mr. Fayvilevich said. “Fund managers are looking to minimize the costs that [their funds] bear.”

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