As subscription credit facilities and other financing facilities become more prevalent in the industry, hedge fund and other private fund managers seeking to use them on their funds’ behalf must be mindful of the operational complexities that attend those structures.
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Along with subscription credit facilities, other forms of fund financing are becoming more prevalent in the asset management industry. In the hedge fund space, fund-of-funds managers are employing financing structures, and portfolio acquisition facilities and general partner support facilities are growing in use.
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A subscription credit facility (a “Facility”) is an extension of credit by a bank, financing company, or other credit institution (each, a “Lender”) to a closed end real estate or private equity fund (the “Fund”). The defining characteristic of such a Facility is the collateral package securing the Fund’s repayment of the Lender’s extension of credit, which is composed of the unfunded commitments (equity or debt “Capital Commitments”) of the limited partners to the Fund (the “Investors”) to make capital contributions (“Capital Contributions”) when called upon by the Fund’s general partner, not the underlying investment assets of the Fund itself. The loan documents for the Facility contain provisions securing the rights of the Creditor, including a pledge of (i) the Capital Commitments of the Investors, (ii) the right of the Fund to make a call (each, a “Capital Call”) upon the Capital Commitments of the Investors after an event of default and to enforce the payment thereof, and (iii) the account into which the Investors fund Capital Contributions in response to a Capital Call.
While there is no definitive United States Supreme Court or federal circuit court of appeals case law addressing this issue, parties to Facilities are generally comfortable that Investors’ equity Capital Commitments are enforceable obligations. We are not aware of any case law in contravention of the decisions discussed in our prior article on the enforceability of equity Capital Commitments in a Facility.1 Nor are we aware of any institutional Investor payment defaults under a Facility, which would have brought this issue to a head. However, the case law is less certain with respect to the enforceability of debt Capital Commitments within the Fund structure.
Tax Rationale
Some Funds are comprised entirely of debt Capital Commitments. In addition, even when a particular Investor’s commitment consists of the obligation to make an equity Capital Contribution, that equity Capital Commitment may switch in whole or in part to a debt Capital Commitment as the obligation flows from a feeder fund through blocker entities down to the Fund borrower. Including debt Capital Commitments within the Fund structure is driven largely by tax reasons.
Non-U.S. Investors can receive more favorable tax treatment of their investments when the investment is structured, in part, as a debt Capital Commitment within the Fund structure. By switching a portion of the equity Capital Commitment to debt, the Investor can effectively block connected income, which would cause the foreign Investor to be treated as a U.S. taxpayer. In addition, a blocker entity within the Fund structure can take an interest deduction on account of a debt Capital Commitment that is unavailable with respect to an equity Capital Commitment, and this deduction will minimize the tax cost of the blocker. Tax exempt entities employ debt investments in blockers to reduce their unrelated business taxable income (“UBTI”). Finally, Investors’ withholding rates on interest are lower than the withholding rates on equity.
Enforceability of Debt Capital Commitments
Despite the numerous tax reasons for employing debt Capital Commitments within a Fund structure, the lack of certainty around the enforceability of such debt Capital Commitments in a Fund bankruptcy scenario should cause parties to consider whether to require only equity commitments to mitigate the risk that debt Capital Commitments within the Fund may render an Investor’s commitment unenforceable.
Section 365(c)(2) of the Bankruptcy Code governs the enforceability of contracts between a debtor and non-debtor third parties where “such contract is a contract to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor.” 11 U.S.C. § 365(c)(2). In the event of a Facility default, a debt Capital Commitment owed directly to a Fund borrower would likely be deemed unenforceable as a “financial accommodations contract” under § 365(c)(2) of the Bankruptcy Code. The practical effect of § 365(c)(2) is to permit a Lender to decline to advance post-petition funds to a trustee or chapter 11 debtor-in-possession, even if the Lender had a pre-bankruptcy contractual obligation to do so. In the hypothetical Fund bankruptcy scenario, the feeder vehicle owing a debt Capital Commitment to a blocker below it in the Fund structure could argue that it does not need to honor its debt Capital Commitment to the blocker because the subsidiary Fund was in bankruptcy.
It is generally accepted that § 365(c)(2) permits an entity to decline to comply with a financial accommodations contract for the benefit of a debtor in bankruptcy, and prevents the debtor from enforcing that obligation following the bankruptcy filing. See, e.g., In re Marcus Lee Assocs., L.P., 422 B.R. 21, 35 (Bankr. E.D. Pa. 2009) (finding that § 365(c)(2) absolved Lender from the obligation to fund under a construction loan to the debtor borrower post-petition). What is not clear is whether § 365(c)(2) similarly permits an entity that is a party to a financial accommodations contract with a non-debtor parent of a bankruptcy entity to decline to honor its debt Capital Commitments under that contract. In other words, when an equity Capital Commitment flips to a debt Capital Commitment and then reverts to an equity Capital Commitment when made directly to the Fund, it is unclear whether a bankruptcy court would deem the obligation an enforceable equity Capital Commitment or an unenforceable financial accommodations contract.
We are not aware of any definitive case law addressing the enforceability of debt Capital Commitments within a Fund structure. In the absence of guidance from the courts on this issue, Lenders relying on such obligations to secure their loan commitments can make several arguments in support of the enforceability of debt Capital Commitments within a Fund structure:
First, Lenders could argue that § 365(c)(2) should not apply in the context of a Fund bankruptcy because the debt Capital Commitment is not an obligation to the Fund borrower itself (the bankrupt entity) but rather to another entity upstream within the Fund structure. When courts have examined whether a contract to loan funds to a third party is a financial accommodation “to or for the benefit of” the debtor, they have focused on factors such as whether the proceeds of the loan are disbursed directly to the debtor and whether the debtor incurs any secondary liability for repayment of the loans. See, e.g., In re Sun Runner Marine, Inc., 945 F.2d 1089, 1092 (9th Cir. 1991) (holding that retail boat dealer floor plan financing agreement was a financial accommodation to the debtor boat manufacturer because the proceeds were disbursed directly to the debtor and the debtor incurred secondary liability for the repayment of the dealer loans). In the Fund context, the Fund proceeds of the debt Capital Commitment would be paid indirectly to the Fund in the form of equity Capital Commitments from a parent entity and the Fund would have no secondary liability to repay the debt, distinguishing the Fund structure from circumstances in which court have found § 365(c)(2) to apply.
In addition, bankruptcy courts are courts of equity that may look beyond the form (e.g., the tax structure) of a transaction to its substance (e.g., an equity commitment from the Investor). See, e.g., In re: Dornier Aviation (N. Am.), Inc., 453 F.3d 225, 233 (4th Cir. 2006) (“[a] bankruptcy court’s equitable powers have long included the ability to look beyond form to substance”) (citing Pepper v. Litton, 308 U.S. 295, 305, 60 S. Ct. 238, 84 L. Ed. 281 (1939)).
In our scenario, the initial and fundamental transaction is not a debt Capital Commitment from the Investor to the Fund; it is an equity Capital Commitment. The Investor makes its equity Capital Commitment to a feeder vehicle, the feeder vehicle or an intermediary entity then makes a debt Capital Commitment down to a blocker, which, in turn, makes a debt Capital Commitment to the Fund. Notwithstanding the fact that a portion of the Investor’s Capital Commitment is treated as a debt Capital Commitment for tax purposes within the Fund structure, a bankruptcy court very well could use its equitable powers to recognize that the Investor’s commitment, on which a lender relies, is a Capital Commitment.
Finally, in situations where an Investor’s commitment splits into both debt and equity components at a particular level within the Fund structure, even if the court were to find that the debt portion was not enforceable, the portion of the Investor’s commitment that remained as equity should continue to be enforceable under generally accepted theories of the enforceability of Capital Commitments. The federal district court decision in Chase Manhattan Bank v. Iridium Africa Corp., 307 F. Supp. 2d 608 (D. Del. 2004), remains good law and parties can take comfort that there has been no subsequent case law calling into question the enforceability of equity Capital Commitments in similar circumstances.
However, in order to avoid the argument that a contractual obligation to provide both debt and equity should be treated as a single financial accommodations contract (and thus be unenforceable under §365(c)(2)), parties should consider documenting the debt and equity commitments in the subscription agreement rather than solely within the applicable limited partnership agreement. Parties should also consider including in their Facility documentation a representation and warranty that the debt Capital Commitment is not a financial accommodations contract and that the applicable Investors and Fund entities waive any defenses under §365(c) of the Bankruptcy Code. We note, however, that it is unclear whether such provisions would be enforceable in a bankruptcy context.
Conclusion
While we are not aware of any definitive case law addressing whether § 365(c)(2) would render an Investor’s Capital Commitment unenforceable when that Capital Commitment is initially made as equity but is treated as debt within the Fund structure, the arguments discussed herein could be employed to defend the enforceability of the initial equity Capital Commitment. Nevertheless, parties should consider whether the tax benefits of incorporating debt Capital Commitments into a Fund structure outweigh the risks that such debt Capital Commitments could render the Investors’ Capital Commitments unenforceable in a bankruptcy scenario.
Endnotes
1 See Mayer Brown Legal Update, Enforceability of Capital Commitments in a Subscription Credit Facility, July 7, 2011, on page 1.
The following glossary is intended to serve as a reference tool for those that are new to the private equity fund finance space by demystifying some of the more commonly utilized terms in the fund finance industry. Please note that these definitions/ explanations are accurate as of the date of publication, but that these terms may evolve as applicable law and market custom change.
Account Pledgor means a loan party that has the right to receive Capital Contributions from Investors and that pledges the deposit account or securities account into which Investor Capital Contributions are to be funded to the lender.
Aftercare Facility means a credit line advanced to a private equity Fund borrower whose Commitment Period has expired. Post-Commitment Period expiration, Fund borrowers typically have significantly reduced borrowing availability under a traditional Subscription-backed Credit Facility borrowing base; as such, Aftercare Facilities often have expanded borrowing base advance rates, limited or no Concentration Limits and/or rely on a net asset value covenant for additional lender protection. Aftercare Facilities are sometimes unsecured, though more frequently they are secured by one or more of a combination of traditional Subscription-backed Credit Facility collateral, distribution proceeds from the borrower Fund’s investments, equity interests in holding companies through which the borrower Fund makes investments and the equity interests relating to the borrower Fund’s investments themselves.
Bad Boy Carve-Out is an exception to the non-recourse nature of a loan that provides for a loan party to have full or partial personal recourse liability for the loan in the event certain events occur (e.g., filing a voluntary bankruptcy action). In a traditional Subscription-backed Credit Facility, bad-boy carve-outs typically apply to the General Partner of the Fund borrowers/guarantors and are limited to actual damages of the lender arising as a result of the fraud, willful misrepresentation or willful misappropriation of loan or Capital Contribution proceeds on the part of such General Partner.
Blocker is an entity, often a C-corporation, through which Tax-Exempt Investors invest in a private equity Fund so as to shield such Tax-Exempt Investors from having to pay US income tax and file a US federal tax return.
Borrowing Base is used in asset-based lending facilities to calculate the borrowing value of a borrower’s assets. The Borrowing Base determines the maximum borrowing availability under the line of credit. Typically, a Borrowing Base is calculated by applying a discount factor to each asset class (often, though not always, constituting the collateral) against which the lender will advance funds (e.g., uncalled Capital Contributions, accounts receivable, inventory, loan assets, etc.).
Capital Call means the legal right of a private equity Fund (or its General Partner) to demand from its Investors that they fund a portion of the money the Investors agreed to commit to the Fund.
Capital Call Notice is a notice issued by a private equity Fund (or its General Partner) instructing its Investors to make a Capital Contribution to the Fund to permit the Fund to make an investment or pay for Fund Expenses or liabilities. Often referred to as a drawdown.
Capital Commitment is the promise by an Investor in a private equity Fund to make Capital Contributions to the Fund over a specified period of time. The Investor receives an interest in the Fund at the time it makes the Capital Commitment.
Capital Contributions means the money or other assets transferred to a private equity Fund by an Investor with respect to the Investor’s Capital Commitment.
Cascading Pledge is an alternative tiered-collateral structure employed when tax, regulatory or ERISA concerns prevent a Feeder Fund from guaranteeing and directly pledging collateral to the lender to support a Fund borrower’s obligations under a Subscription-backed Credit Facility. In a Cascading Pledge, the Feeder Fund grants a security interest in its Capital Commitments and call rights to a Blocker entity; the Blocker entity in turn grants a security interest in its rights under the security agreement from the Feeder Fund to the Fund borrower; the Fund borrower in turn grants a security interest in its rights, including those under the security agreement, from the Blocker entity to the lender.
Clawback (either General Partner or Limited Partner) means, with reference to a General Partner or manager, a mechanism whereby a private equity manager is obligated to return a portion of its previously received Promote or performance fee payment if as a result of timing and Fund performance, the General Partner receives more carry or performance fee during the life of the Fund than the General Partner would be entitled to receive had profits and losses been allocated on an aggregate basis at the time of dissolution of the Fund. With reference to a Limited Partner, the obligation of an Investor to return previously received distributions to the Fund if the Fund requires such amounts to fulfill its indemnification obligations or satisfy expenses or other liabilities.
Closed-End Fund means a collective investment vehicle in which the total committed capital and Investors are fixed at the end of a proscribed fundraising period, wherein the Investors each commit a specified amount of capital and have limited or no rights to redeem their interest or withdraw invested capital until the dissolution of the Fund.
Collateral Account is a deposit or securities account into which collateral (Capital Contributions) is deposited and over which a lender has a perfected security interest.
Commitment Period is the time frame, typically a period of 3-5 years, during which a private equity Fund is permitted to call capital from Investors to make new investments or additional investments in portfolio companies.
Concentration Limit means, in an asset-based lending facility, a specified percentage of the total eligible Borrowing Base over which no loan value is given with respect to a particular asset or type of collateral, thereby promoting diversification in the Borrowing Base. In a Subscription-backed Credit Facility, a Concentration Limit may work to limit the aggregate unfunded Capital Commitments that a single Investor or a class of Investors (e.g., High-Net-Worth Investors) can contribute to the overall Borrowing Base.
Defaulting Investor is an Investor in a private equity Fund that has breached the Fund’s constituent documents, namely by failing to make a Capital Contribution when required pursuant to a Capital Call Notice. Defaulting Investors are subject to various remedies under a Fund’s partnership agreement, which may include a forced sale of the Defaulting Investor’s interest at a discount as well as loss of certain rights, such as participating in future investments and voting.
ERISA Fund means a private equity Fund that consists of, or is deemed to hold, plan assets and operates as a plan asset vehicle that is subject to Title I of ERISA and/or Section 4975 of the Internal Revenue Code. In the context of a Subscription-backed Credit Facility, borrowers and lenders have concerns regarding ERISA Funds and potential prohibited transactions with lenders which may subject the Fund and the lender to heavy tax penalties.
ERISA Limited Partner is an Investor that is (i) an “employee benefit plan” (as defined in ERISA) subject to Title I of ERISA; (ii) any “plan” defined in and subject to Section 4975 of the Internal Revenue Code; or (iii) any other entity whose assets include or are deemed to include the assets of one or more such employee benefit plans in accordance with ERISA and related regulations.
Feeder Fund is an upper-tier special-purpose entity formed by a private equity Fund to facilitate investment in the Fund by one or more Investors, usually to address a tax concern. As such, the Investors to a Feeder Fund invest in the Fund indirectly through the Feeder Fund.
Follow-On Investments are investments in an existing portfolio company of a private equity Fund that are made to protect or enhance the value of the Fund’s investment. Follow-On Investments are often permitted to be made throughout the life of the Fund, though the amount of capital that may be called to fund a Follow-On Investment may be limited after the Fund’s Commitment Period has expired and Concentration Limits may apply to the overall investment in any given portfolio company that is the subject of a Follow-On Investment.
Fund means a private collective investment vehicle formed to make equity and/or debt investments in accordance with the criteria and investment objectives set forth in the Fund’s constituent documents, including a private equity Fund and a Hedge Fund, as the context may require.
Fund Expenses broadly refers to the liabilities incurred in connection with (i) establishing a private equity Fund (frequently referred to as “organizational expenses”) and (ii) operating a Fund (frequently referred to as “operating expenses”). Organizational expenses generally include the out-of-pocket costs incurred by the sponsor in forming the Fund, such as legal, accounting, filing, travel and similar expenses; organizational expenses are often capped at a specified amount. Operating expenses generally include liabilities related to acquiring, maintaining and disposing of investments, Management Fees paid to the sponsor, taxes, third-party service providers and borrowing costs, expenses and principal amounts. Both organizational expenses and operating expenses are paid by the Fund’s Investors.
Fund of One means a private equity or hedge Fund that has a single dedicated Investor. The General Partner or manager controls the vehicle that holds the assets in a Fund of One and makes investment decisions on behalf of the vehicle. Some primary benefits of a Fund of One over a comingled investment vehicle are that the investment mandate of the Fund can be customized for the Investor and the Investor is protected from co-Investor (default) risk. A Fund of One shares many of the same qualities as a Separate Account.
Funding Ratio is a metric used to measure the financial condition of an Investor that is a retirement system or pension plan for purposes of inclusion (or exclusion) from the Borrowing Base in a Subscription-backed Credit Facility. The Funding Ratio is often defined as the actuarial present value of the assets of the retirement system or pension plan over the actuarial present value of the system or plan’s total benefit liabilities.
General Partner means the one responsible for making investment decisions, issuing Capital Call Notices and managing portfolio investments in a private equity Fund structured as a limited partnership. The General Partner (sometimes referred to as the sponsor) owes various legal duties to the Fund and is typically compensated for its services through receipt of a Management Fee and a percentage of the Fund’s profits. The General Partner may also have an equity commitment to the Fund.
Guarantor is one that promises performance or payment of the obligations of another. One who provides a guaranty.
High-Net-Worth Investor means an Investor that is a natural person with a high net worth. There is no definitive dollar threshold or methodology for determining high net worth, though an individual with at least $1 million of investable assets (excluding the value of any homes and illiquid assets) is often considered to be a High-Net-Worth Investor.
Initial (Fund) Closing Date means the date on which a Fund first accepts Capital Commitments from Investors, typically after the Fund manager has raised the minimum amount of capital needed to execute the Fund’s investment program. A Fund may hold multiple Investor closings in order to reach the manager’s desired aggregate commitment amount. The fundraising period is usually limited to a period of six months to one year from the date of the initial closing in a Closed-End Fund.
Investment Limitations are provisions in a Fund’s governing documents that place restrictions on the types of investments the Fund may undertake, which may include limitations on the size, geography, industry, concentration or return characteristics of investments or restrictions arising out of applicable regulations or law.
Investment Period is the time frame, typically a fundraising period of 12 months, during which a private equity Fund is permitted to accept new Investors or subscriptions.
Investor means one that makes a commitment to contribute capital to a Fund in exchange for an equity interest in the Fund. Also referred to as a Limited Partner.
Investor Letter is an undertaking agreement or acknowledgement made by an Investor in favor of a Subscription-backed Credit Facility lender whereby the Investor makes representations, acknowledgments and covenants in favor of the lender as a condition to the Investor being included in the Borrowing Base. Typically, an Investor Letter will include an acknowledgement of the existence of the Subscription-backed Credit Facility and the pledge of the right to receive and enforce the Subscription-backed Credit Facility collateral, and the Investor will agree to make Capital Contributions upon notice by the lender during an event of default.
Investor Opinion is a letter issued by legal counsel to an Investor stating various legal conclusions with respect to the Investor, delivery of which is often a condition to the Investor being included in the Borrowing Base of a Subscription-backed Credit Facility. Under certain circumstances, an authority certificate can be delivered in lieu of an Investor Opinion.
Key Person Event means the departure of a certain number of specified investment professionals from a Fund sponsor that triggers certain rights granted to the Investors under the Fund’s governing documents, such as the right to terminate the Commitment Period or replace the Fund manager. Key Person Events may also encompass minimum requirements for devotion of time to the Fund by specified investment professionals or the occurrence of bad acts by a key person (e.g., fraud).
Limited Partner is an Investor in a private equity Fund that takes the form of a limited partnership. Limited Partners of a limited partnership are generally not personally liable for the obligations of the limited partnership. As such, a Limited Partner’s liability to make payments or contribute capital to a limited partnership is limited to its Capital Commitment and its portion of the assets of the Fund (subject to applicable law and certain exceptions).
Limited Partner Excuse means the right by which an Investor is permitted to opt-out from an investment on a case-by-case basis, often as a result of regulatory issues or due to a policy of the Investor that would prohibit the Investor from participating in a particular investment. Also used to describe the right a General Partner has to exclude an Investor from participating in investments on a case-by-case basis for regulatory or other legal reasons.
Limited Partner Transfer is the legal sale, assignment, pledge or disposition of all or an undivided portion of an Investor’s interest in a Fund, including its obligation to make Capital Contributions and its right to receive distributions of Fund assets. The constituent documents of a private equity Fund will place limitations on an Investor’s ability to transfer or encumber its interest, except in accordance with the terms and conditions set forth therein and with the General Partner’s consent.
Limited Partner Withdrawal is the termination of an Investor’s participation in a private equity Fund. Rights of withdrawal (either mandatory or voluntary) are typically limited to situations where the Investor’s continued participation in the Fund would result in the Investor or the Fund violating applicable regulations or law.
Lock-Up Period is the period of time during which an Investor in an Open-End Fund is not permitted to redeem or sell its equity interest.
Management Fee is the compensation paid to a Fund’s manager for providing management and investment advisory services. The Management Fee varies based on a number of factors but has historically equaled approximately 2 percent per annum of the total amount of capital committed to the Fund (it may be higher or lower or based on other metrics).
Most Favored Nations Clause is a contract provision by which a Fund sponsor promises to provide an Investor with terms no less favorable than the terms provided to any other Investor in the Fund. Most Favored Nations Clauses entitle an Investor to elect to have any more-favorable right or privilege granted to another Investor by the Fund apply to it. There are often numerous exceptions, qualifications and exclusions to rights granted under a Most Favored Nations Clause.
Open-End Fund is a collective investment vehicle in which interests are continuously offered and Investors are generally permitted to redeem their equity interests subject to limited timing and notice requirements.
Parallel Fund is a Fund investment vehicle generally established to make the same investments and dispositions of assets at the same time as the main Fund to which it is related. Parallel Funds have substantially the same terms as the main Fund, and are formed to accommodate the tax, regulatory or other requirements of the Investors that are investing through the Parallel Fund.
Parent (of Investor) Comfort Letter (also known as a Parent Keepwell or Parent Guaranty) is an agreement in favor of a lender by which a credit-worthy parent agrees to provide credit support to, or guarantee the obligations of, an affiliate that is investing in a Fund. Delivery of a Comfort Letter from a credit-worthy parent will often enable a lender to include a less credit-worthy Investor or special purpose vehicle in the Borrowing Base.
Placement Agent is the person or entity hired by a Fund manager to assist in raising capital for the Fund.
Promote is the compensation paid to a Fund General Partner in the form of an allocation of the profits of the Fund, typically calculated as a set percentage of the profits of the Fund (often 20 percent) after returning the Investors’ Capital Contributions and a preferred rate of return. The Promote will be set forth in a distribution Waterfall in the Fund’s constituent documents, and it is often subject to significant negotiation between the General Partner and the Investors. Also known as “carried interest,” “carry” and “performance allocation.”
Qualified Borrower is a Fund vehicle (often a holding company for an investment or a portfolio company) that is a borrower under a Subscription-backed Credit Facility whose obligations are guaranteed by the Fund vehicle itself. Qualified Borrowers do not typically provide collateral.
Redemption Period is the time frame after an initial Lock-Up Period during which an Investor may withdraw its capital (in whole or in part) from a Fund, usually on a quarterly basis. Typically applies to hedge Funds, core real-estate Funds and other Open-End Fund investment vehicle structures.
REIT or “real estate investment trust” is a company that owns and often operates realestate assets, and that must annually distribute at least 90 percent of its taxable income to its shareholders.
Separate Account is an investment vehicle with only one Investor (commonly an institutional Investor) that is willing to commit significant capital to an investment manager subject to the terms of a two-party agreement (commonly referred to as an investment management agreement). It is not atypical for a Separate Account to be non-discretionary in terms of investment decisions made by the manager (with Investor approval being required on a deal-by-deal basis).
Side Letter means any letter or other agreement of any type that amends or supplements an Investor’s Subscription Agreement and/or the partnership agreement or other applicable constituent document of a Fund.
Sidecar Fund is an investment vehicle used in a private equity Fund structure to provide for co-investment opportunities by one or more Investors in the Fund, which investments are generally made alongside investments by the main Fund.
Special Limited Partner is an Investor in a private equity Fund that is an affiliate of the Fund’s sponsor. The Special Limited Partner is generally used to receive Promote or other carried interest distributions and typically has no Capital Commitment to the private equity Fund and limited obligations under the Fund’s constituent documents.
Subscription Agreement is the document pursuant to which an Investor makes a Capital Commitment to a private equity Fund in exchange for an interest in the Fund. The Subscription Agreement sets forth the amount of an Investor’s proposed Capital Commitment that is accepted by the General Partner on behalf of the Fund. The Subscription Agreement includes various representations made by the Investor that enable the Fund to comply with applicable securities laws.
Subscription-backed Credit Facility means a loan or line of credit made by a bank or other credit institution to a private equity Fund that is secured by (i) the unfunded commitments of the Investors to make Capital Contributions to the Fund when called from time to time by the Fund or the Fund’s General Partner, (ii) the rights of the Fund or its General Partner to make Capital Calls upon the commitments of the Investors and the right to enforce payment of the same and (iii) the account into which Investors fund Capital Contributions in response to a Capital Call.
Tax-Exempt Investors means an Investor, or any Investor that is a flow-through entity for US federal income tax purposes that has a partner or member, that is exempt from US federal income taxation under Section 501(c) of the Internal Revenue Code of 1986, as amended. Tax-Exempt Investors are generally not subject to US taxation, but they may be required to pay taxes on UBTI. Examples of Tax-Exempt Investors are pension plans, universities, private foundations and charitable endowments.
UBTI or “unrelated business taxable income” is generally defined under the Internal Revenue Code of 1986, as amended, as income earned or derived from a trade or business that is unrelated to an Investor’s tax-exempt purpose, which income is subject to US taxation as UBTI. Money earned from dividends, capital gains and interest income is not treated as UBTI, however, income derived from assets that are subject to certain types of indebtedness will be included in UBTI. Investors will often require a Fund to covenant in its partnership agreement that the Fund will not incur, or will minimize, UBTI, which may impact the overall Fund structure and the use of indebtedness by the Fund.
Uncalled Capital Commitment of an Investor, is the portion of such Investor’s Capital Commitment that is unfunded and may be subject to a Capital Call, excluding any amounts subject to a pending Capital Call that have not yet been funded as a Capital Contribution. The Borrowing Base in a Subscription-Backed Credit Facility is determined by reference to the Uncalled Capital Commitments of the included Investors.
VCOC or “venture capital operating company” is a term used in the context of a private equity Fund that is relying on the operating company exception to holding “plan assets” under ERISA. A VCOC is a private equity Fund that is primarily invested in operating companies with respect to which the entity has the right to participate substantially in management decisions. To maintain such exception, a private equity Fund must qualify as a VCOC as of the date of its first investment and each year thereafter by satisfying annual tests that measure its ownership and management with respect to qualifying assets.
Waterfall means, when used with reference to a loan agreement, the priority of payment of amounts received from or on account of the borrower among creditors to the borrower; when used with reference to a Fund, it means the economic agreement between the Investors and the General Partner as to the priority of payment of distributions of Fund assets as between the Investors and the General Partner (often called a “distributions waterfall”).
Former U.S. Treasury Secretary Timothy Geithner is preparing to borrow from JPMorgan Chase to help fund his new career in private equity.
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Among private investors, the term “infrastructure” denotes a wide range of physical assets that facilitate a society’s principal economic activities — transportation, energy and utility, communications and “social” infrastructure, for example. Historically, funding for these projects has been the domain of governments, multilateral institutions, official lenders, and large commercial banks providing debt alongside such other institutions. However, with an estimated $57 trillion needed to finance infrastructure development around the world through 2030, according to a report from McKinsey & Co., private investors have an unprecedented opportunity to fill some of the gap created by public-funding shortfalls, and the last decade has been witness to a flurry of innovation in private funding methods and structures, with varying degrees of success. As the asset class matures, some infrastructure funds—private equity vehicles that attract capital commitments from investors and deploy that capital to invest in these assets—will need to explore new ways to create and demonstrate value in order to capture some of that capital.
Fewer unlisted infrastructure funds reached final close in 2014 than in 2013, and the level of institutional investor capital secured by those funds fell by almost 16% when compared to 2013; however, the aggregate $37bn raised by unlisted infrastructure fund managers was still 23% higher than the $30bn raised in 2012, and the amounts raised by funds reaching interim close increased for the twelvemonth period ending January 2015. An increasing proportion of that capital is concentrated among a few large players, and the market remains crowded, with 144 unlisted infrastructure funds in market as of January 2015, targeting aggregate capital commitments of $93bn. And while the average fundraising lifecycle shortened to 19 months in 2014, as of January 2015 40% of funds in market had been fundraising for over two years.1
Although fund managers face increased competition, investor appetite for infrastructure remains strong, with investors continuing to indicate an interest in expanding their allocations to this asset class. Many have increased their target infrastructure allocations to 3-8% of total assets under management over the next decade, up from around 1% today. There has also been an influx of new entrants. Preqin now tracks more than 2,400 institutional investors actively investing in infrastructure, more than double the figure from 2011 when it began tracking the asset class.2 While the main route to market for investors, especially new entrants, is through unlisted vehicles,3 some larger investors are opting for direct investments. According to a survey conducted in the second quarter for Aquila Capital Concepts GmbH, about 57% of institutional investors said direct ownership is the best way to invest in real assets, including infrastructure.4 While the avoidance of expensive management fees is certainly an incentive, the driving force behind direct investments seems to be control over the portfolio. In addition to concerns over time horizon and liquidity, the use of leverage can be an issue of contention, especially after the recent financial crisis. Investors disappointed in the performance of infrastructure assets during the financial crisis pointed to high leverage and lack of transparency in financing arrangements as reasons for their disappointment.5
In addition to adding infrastructure teams to their staffs in order to make unilateral direct investments, large investors are also looking at new and more sophisticated ways to club together and increase investment power. Theoretically, the benefits from club investing relative to those of investing through a conventional fund manager include improved alignment of interest with other, similarly situated investors, including with respect to investment horizon and fees, larger average commitments and local knowledge, and the spread of risk relative to unilateral direct investment.6 Consequently, club investment platforms and research groups have started to emerge. Examples include The Long Term Investors Club (Global), Pension Infrastructure Platform (UK), Global Strategic Investment Alliance (Canada HQ), and the Fiduciary Infrastructure Initiative (USA).7 The most recent example is the California State Teachers’ Retirement System (CalSTRS), which announced plans to develop a multibillion-dollar global syndicate for infrastructure investing. The syndicate is intended to be comprised of public pension funds and to invest in North American infrastructure, similar to the IFM (Investors) model, which invests on behalf of institutional investors and is owned by 30 major Australian superannuation funds.8 With total funds under management of A$23bn and control of 44 board seats across 29 infrastructure investments with operations on four continents, IFM is one of the largest infrastructure investors in the world.
Another example, the Global Strategic Investment Alliance (GSIA), was launched by the Ontario Municipal Employees Retirement System (OMERS), one of Canada’s largest pension funds with more than C$65bn (US$59.8bn) in net assets. The alliance, a US$12.5bn-plus infrastructure club investment program, has an investment period of five years followed by a holding period of 15 years, and then an exit period of five years,9 and allows its investors to choose the deals in which they wish to participate on a transaction-by-transaction basis.10 The investment opportunities are sourced and actively managed by OMERS through its various investment arms—Borealis Infrastructure will originate and manage the investments, and Rosewater Global will provide administrative support services. Marketed at 50 basis points and a carried interest fee for performance at a later date,11 the platform offered limited partners the opportunity to put their money to work at a rate structure more favorable than what a fund manager would offer. However, collaboration with like-minded investors and size of investment power were touted as the main drivers. By targeting “alpha assets” of $2bn plus, the thought process was that these assets would be out of reach for almost anybody else, and therefore GSIA would be able to get superior returns. While theoretically appealing, there are typically only two or three such assets that are put on the market each year, and with a typical five-year investment period, GSIA will need to close at least one or two deals a year, which could undermine its leverage with sellers. The alliance’s maiden transaction was the acquisition from OMERS of a one-third stake in Midland Cogeneration Venture (MCV), a US combinedcycle gas-fired power plant. OMERS retained the remaining two-thirds equity in MCV. This strategy, where OMERS buys the asset first and then syndicates the equity to its GSIA partners, is expected to be repeated.12
With increased capital flowing into direct and club investment platforms, and a crowded fundraising market continuing with wellestablished managers garnering the majority of investor commitments, opportunities for fund managers to create and demonstrate value do exist. However, they may require creativity and a willingness to depart from the traditional closed-end infrastructure fund model with 10- to 15-year “lockup” periods. While providing a known investment period with defined entry and exit dates — which are well-suited to higher-risk investment strategies that don’t provide stable, predictable cash flow — this structure is not ideal for all investors or all infrastructure assets. Open-end funds, on the other hand, offer periodic opportunities for acquisition or redemption of shares and the absence of a fixed investment horizon. The in-place income streams associated with traditional infrastructure assets are thus often a better fit for the open-end structure. Though infrastructure fundraising for closed-end funds has increased in recent years, industry observers believe that the lack of open-end funds has kept on the sidelines significant additional capital that would otherwise be committed to infrastructure investments.13
In addition to the open-end model, some fund managers are addressing investor liquidity concerns by taking their private equity infrastructure funds public. Not only does this allow investors to liquidate their investments at any time, the funds are also not forced to sell at a time when valuations may be unfavorable. Fortress Investment Group LLC (NYSE: FIG), for example, plans to convert its Fortress Worldwide Transportation and Infrastructure Investors private equity infrastructure fund into a publicly traded vehicle with the prior approval of the fund’s limited partners. We expect smaller fund managers to continue to innovate.
In prior years, we have noted the growth of infrastructure funds focused on providing debt rather than equity investments, which arose during a prolonged period of diminished bank liquidity and concerns over the impact of new capital maintenance requirements. Investment opportunities for debt funds, however, have been scarcer than anticipated as a result of increased bank liquidity and shrinking margins. Further, debt funds are not able to offer the same flexibility as banks due to stricter investment parameters, and borrowers have found that their pricing and fees are often higher. New debt fund entrants are trying to complement banks instead of competing with them by entertaining subinvestment grade type transactions and offering longer terms. In addition, many of these funds are buying debt in the secondary market, which is pushing up the price.14 The impact of new capital maintenance requirements are just beginning to take effect, however, and they are likely to present opportunities for infrastructure debt funds, albeit somewhat later and perhaps less broadly than anticipated. Further, as infrastructure continues to mature as an asset class in the United States, we anticipate that sponsors of infrastructure projects will demand – and be willing to pay for – debt other than the traditional, senior secured structures that continue to be most prevalent, including mezzanine debt, term loan B, and other subordinated loans. Infrastructure debt funds will be particularly well positioned to take advantage of such opportunities.
Despite movement toward open-end funds, direct investments, and club deals, the majority of private equity infrastructure investments continue to be made through closed-end structures. Within such funds, we see room for growth in the subscription-based financing structures that have been so successful in other private equity asset classes, and we likewise anticipate that substantial opportunities will develop to finance the alternative structures as they continue to develop.
Endnotes
1 The 2015 Preqin Global Infrastructure Report: 2014 Fundraising Market (Preqin, New York, N.Y.), at 14-16.
2 The 2015 Preqin Global Infrastructure Report: 2014 Fundraising Market (Preqin, New York, N.Y.), at 37-38.
3 Evan Barker, North America-Based Infrastructure Investors – January 2015, PREQIN INFRASTUCUTRE ONLINE (Jan. 22, 2015), https://www.preqin.com/ blog/101/10616/north-america-infrastructure.
4 Arleen Jacobius, Infrastructure OMERS Infrastructure Program Writes New Page in Investing, PENSIONS & INVESTMENTS, Sept. 1, 2014, available at http://www. pionline.com/article/20140901/PRINT/309019980/ omers-infrastructure-program-writes-new-page-in-investing.
5 Eric Knight & Rajiv Sharma, Retooling In-House Investment Teams Inside Institutional Investors: Three Perspectives on the Shift Towards Direct Infrastructure Investment, CHARTERED ALTERNATIVE INVESTMENT ANALYST ASS’N: ALTERNATIVE INVESTMENT ANALYST REV. (Q4 2014, Vol. 3, Issue 3), at 15.
6 Pooling of Institutional Investors Capital – Selected Case Studies in Unlisted Equity Infrastructure, 49 (OECD, Apr. 2014).
7 Eric Knight & Rajiv Sharma, Retooling In-House Investment Teams Inside Institutional Investors: Three Perspectives on the Shift Towards Direct Infrastructure Investment, CHARTERED ALTERNATIVE INVESTMENT ANALYST ASS’N: ALTERNATIVE INVESTMENT ANALYST REV. (Q4 2014, Vol. 3, Issue 3), at 15.
8 Hazel Bradford, CalSTRS Kicks Off Infrastructure Consortium at White House Summit, Pensions & Investments, (Sept. 9, 2014, 4:21 PM), http://www. pionline.com/article/20140909/ONLINE/140909873/ calstrs-kicks-off-infrastructure-consortium-at-whitehouse-summit.
9 Douglas Appell, Japan’s GPIF to Invest $2.7 billion in Infrastructure Alongside OMERS, DBJ, Pensions & Investments (Feb. 28, 2014, 4:14 PM), http://www. pionline.com/article/20140228/ONLINE/140229855/ japans-gpif-to-invest-27-billion-in-infrastructure-alongside-omers-dbj.
10 WURTS ASSOCIATES, Infrastructure Manager Search: Fresno County Employees’ Retirement Association (Nov. 2013).
11 Pooling of Institutional Investors Capital – Selected Case Studies in Unlisted Equity Infrastructure, 39 (OECD, Apr. 2014).
12 Matthieu Favas, The Gorilla That Wants More Bulk, INFRASTRUCTURE INVESTOR, May 2014, at 24.
13 Arleen Jacobius, Infrastructure Funds Not the Kind Investors Prefer, PENSIONS & INVESTMENTS, July 7, 2014, available at http://www.pionline.com/article/ 20140707/PRINT/307079973/infrastructure-fundsnot-the-kind-investors-prefer.
14 Sarah Tame, Crowded In, Then Crowded Out, 351 IJ GLOBAL: INFRASTRUCTURE J. AND PROJECT FIN. MAG. 16 (Oct./Nov. 2014), https://ijglobal.com/ Magazine/Download/1.
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