The private equity industry has doubled in size over the past decade, but some insiders are calling for more transparency into acquisitions funded by certain bank loans, which they say could pose a threat to the sector’s health.

These loans – often called subscription lines or bridge facilities – have become ubiquitous in the $2.5 trillion industry, with major L.A. private equity players such as Ares Management, Oaktree Capital Management, Platinum Equity, and Leonard Green Partners all using them to some degree. Firms utilize these short-term, low-interest loans as an alternative to calling on the capital commitments of limited partners such as insurance companies, government pension funds, and university endowments, which contribute on a deal-by-deal basis.

Howard Marks, co-chairman of Oaktree, distributed a public memo last month laying out not only how subscription lines are used and what they can accomplish, but also reasons for caution as their use becomes increasingly standard practice.

“There’s no question that the increasing use of subscription lines is altering patterns of drawdowns and distributions,” Marks wrote. “Going years without seeing much capital called could convince (a limited partner) that calls have become less likely.”

That expectation, he added, could result in limited partners putting money into other illiquid investments instead of holding cash in reserve. In the unlikely – but not impossible – event of another financial crisis, banks could scramble to call in debts, forcing private equity firms to ask limited partners to pay up. But if their capital is tied up in an illiquid investment, limited partners could wind up defaulting.

Under radar

The practice of using subscription lines has been around for decades without much controversy. Firms use them to avoid having to call in commitments on short notice to get a deal done or pounce on an opportunity that could be lost without immediate action. They have traditionally been repaid quickly with capital drawdowns from the funds’ limited partners.

But with interest rates at historic lows, bridge loans are cheap money that can also help firms bolster their performance metrics by allowing for returns generated without limited partner capital.

Positive metrics, particularly in the early years of a fund, can trigger bonus fee payouts and help with marketing efforts for future fundraising. Limited partners often like the arrangement, according to Craig Enenstein, chief executive of West L.A.’s Corridor Capital, because it allows them to show better returns on their money, too.

“The time value of money is always a positive for an investor,” he said. “The later they can put their money in, and the earlier they can pull it out, the happier they are.”

However, as the use of subscription lines has gone from a fallback option to a default play, some private equity players are re-evaluating how they are implemented.

Limited partners have started to ask for more information in order to judge whether firms’ performance metrics, namely the all-important internal rate of return, are being juiced up as a result.

“Limited partners are not against the use of subscription lines, but they do deserve transparency around the use of them,” said Jennifer Choi, managing director of industry affairs for the Institutional Limited Partners Association of Washington, D.C. “More information about how often and in what way these facilities are being used, as well as what a fund’s net (internal rate of return) is on both an unlevered and levered basis, would help limited partners understand how these lines of credit benefit their interests.”

Raul Anaya, president of Bank of America Corp.’s regional operations in Los Angeles, countered that the likelihood of Marks’ doomsday scenario is minute. While there could be some consequences should it play out, he said the extent of the damage would mostly serve to depress the future deal market.

“The reason a firm is calling on a line of credit is because they are buying a company or making an acquisition of some sort, and if there’s a financial crisis, they might not make that deal,” Anaya said. “In any transaction, there’s always risk, but with these facilities, it’s very manageable and one we all understand.”

A bridge facility comes with little risk for banks because it is assessed against the creditworthiness of both a fund and a fund’s limited partners. Bank of America, for example, has tens of billions of dollars in active subscription line loans, according to Anaya. The practice also helps banks get a heads up on private equity deal flow, which can lead to pole position on even more lucrative loans leveraged against the acquired company.

“It’s another way to enhance and solidify our relationships with the private equity industry,” Anaya said. “We already have relationships with all the major PE firms in L.A. – Platinum, Oaktree, Leonard Green, Ares – and have been providing traditional banking services to them, but this is a nice way to augment that relationship.”