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.

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