Introduction

The terms of the business arrangement between a private equity fund (a “Fund”) and an investor (an “Investor”) are generally contained in the constituent documents of the Fund, often a limited partnership agreement (an “LPA”), which sets forth the rights and obligations of the general partner and each Investor. An LPA typically will address, among other things, capital commitments, the general partner’s right to call capital, each Investor’s right to partnership distributions, transfer and withdrawal rights, and indemnification obligations. In addition to the LPA, an Investor will likely execute a subscription agreement that often includes, among other terms and provisions, a power of attorney over the Investor, which permits the general partner to execute the LPA on the Investor’s behalf. The subscription agreement and the LPA form the basis of the Investor’s commitment to the Fund and are generally consistent among all Investors in a Fund.

In certain negotiations with potential Investors where the Fund does not want to alter the LPA or subscription agreement, the Fund and an Investor will execute a side letter that will serve, separate and apart from any other Investor’s agreement with the Fund, to modify the terms of that Investor’s subscription agreement and/or the LPA. A side letter generally grants an Investor additional rights or privileges or otherwise limits the applicability of certain LPA provisions as applied to the Investor. While side letters are, by design, Investor-specific, the inclusion of a Most Favored Nations clause (“MFN”) changes that dynamic and potentially could make every provision of all side letters available to every other Investor.

MFNs have become more common with the proliferation of side letters and side letter requests from Investors. For the reasons discussed below, MFNs can have significant, negative effects on a Fund’s subscription-backed credit facility (a “Credit Facility”). In such a Credit Facility, the lenders (the “Lenders”) are granted a security interest in the uncalled capital commitments of the Fund’s Investors, and the Lenders rely on the Investors’ obligations to fund capital contributions as the primary source of repayment. The Lenders’ rights under a Credit Facility are derivative of the rights of the Fund and its general partner and, therefore, depend significantly on the substance of the Fund’s LPA and any side letters. Because of an MFN’s potentially disastrous impact on a Credit Facility’s borrowing base or viability, as discussed below, it is very important to carefully review and understand not only the MFN, but also each provision of every side letter between a Fund and its Investor where the Investor has an MFN in its side letter.

MFNs Generally

At its most basic, an MFN serves to protect an Investor’s interest by ensuring the Fund does not offer better terms to another Investor in a side letter. Accordingly, in a side letter’s MFN, the Fund agrees that the Investor will be entitled to elect any more-favorable right or privilege granted to other Investors in separate side letters. Thus, an MFN potentially allows an Investor to obtain benefits under any other Investor’s side letter. Typically, however, MFNs contain some limits, or “carve-outs,” curtailing the provisions that an Investor can elect from such side letters.

While not necessarily included within the text of an MFN, the process by which an Investor can elect provisions from other Investors’ side letters varies from Fund to Fund. Some Funds will provide that each Investor with an MFN receives copies of all other side letters, other Funds will provide a list of all side letter provisions and other Funds will circulate a list of only those provisions that an Investor is eligible to elect. In addition, Funds differ both in what is distributed to Investors eligible to make an MFN election and when such an MFN election can be made. Most Funds permit an Investor with an MFN in its side letter to make an election only after the final Fund closing.

Impact on Subscription-Backed Credit Facilities

MFNs can negatively impact, or even completely preclude, a Credit Facility in a number of ways. Because an MFN permits an Investor to elect terms and provisions from other Investors’ side letters, the presence of an MFN can have farreaching effects, particularly on the Fund’s borrowing base. In a Credit Facility with the absence of an MFN, an Investor with one or more problematic provisions in its side letter simply can be excluded from the borrowing base. While Investor exclusion is hardly ideal, excluding one Investor is rarely fatal to a Credit Facility’s viability. If, however, a similar scenario arises and an MFN exists in one or more side letters, thereby permitting other Investors to elect such problematic side letter provisions, large swaths of the borrowing base could be excluded, thus jeopardizing the feasibility of a Credit Facility. For example, if a side letter permitted an Investor to opt out of LPA provisions requiring it to fund its capital commitment without counterclaim, defense or set-off, a Lender may decide to exclude that Investor from the borrowing base.1 If there are no MFNs in other side letters, or if any such MFNs are drafted to include applicable carve-outs discussed below, other Investors will be precluded from electing such provisions for their own side letters. The Fund and Lender thus can limit the negative impact on the borrowing base. If the above scenario occurs, however, and one or more other Investors have an MFN in their side letters that allows them to elect the same provision, the ramifications could be catastrophic for the borrowing base.

The potentially far-reaching effects of MFNs on a Credit Facility mean that each provision in every side letter matters. The best practice for both Funds and Lenders, therefore, is to review any proposed side letters prior to their execution to ensure that an MFN will not impair the Fund’s borrowing base or a contemplated Credit Facility. Early and clear discourse between the Fund and Lender with respect to side letters will provide the opportunity to negotiate side letter provisions, especially MFNs. To be sure, renegotiating already-executed side letters is a difficult process for all parties, and there is no guarantee that doing so will adequately resolve potential issues. As a result, Funds and Lenders alike should consult with experienced counsel to help review each side letter, to advise and assist in negotiating a side letter’s terms, and to ensure that an MFN is well-drafted to include sufficient carve-outs to ensure the viability and success of a contemplated Credit Facility.

Carve-Outs

The most effective way to limit the potentially negative effects of an MFN is through the use of “carve-outs,” or restrictions, in the MFN that limit the types of provisions that an Investor with an MFN may elect from other Investors’ side letters. As side letters have grown in length and as more Investors have requested MFNs, Funds have sought to limit the applicability of MFNs and associated potential Credit Facility issues by including a number of MFN carve-outs, thereby prohibiting the election of certain types of provisions. Because carve-outs vary in scope and substance, an MFN should be crafted and reviewed with the assistance of experienced legal counsel to meet the unique requirements of each transaction and to limit the potential negative effects on a Credit Facility. There are a number of typical MFN carve-outs discussed below that can be helpful to both Funds and Lenders in connection with their Credit Facilities.

One very common MFN carve-out links an Investor’s ability to elect more favorable rights to the size of the Investor’s capital commitment. Such a carve-out precludes a small Investor from electing provisions that a Fund’s larger Investors may have negotiated. Such capital commitment-based carve-outs can be structured in a number of ways, including setting a minimum commitment threshold for any Investor to have an MFN in its side letter, permitting an Investor to elect side letter provisions of any Investor with an equal or lesser commitment, or establishing a commitment threshold above which an Investor may elect any provision from any other Investor, regardless of the other Investor’s commitment.

Another typical MFN carve-out imposes policy/jurisdictional/regulatory limits on side letter-electable provisions. Certain Fund Investors, by virtue of their written policies or guidelines or by jurisdictional or regulatory status, may be entitled to certain accommodations on account of such status that the Fund may not want to extend, or are otherwise inapplicable, to other Investors. Such an MFN carve-out would allow an Investor to elect additional rights only if the Investor is subject to similar policies, guidelines, or jurisdictional and regulatory schemes.2 Investors subject to the same policy, jurisdictional or regulatory regimes thus will be able to elect such provisions, but the Fund and Lender will still be protected from having to offer the same rights to additional, non-qualifying Fund Investors with an MFN. There is some debate among practitioners as to whether the broad use of policy/jurisdictional/regulatory status language to preclude election under an MFN would be enforceable in all circumstances, but such carve-outs nevertheless are utilized widely in side letters to try to limit MFN risk exposure.

Potentially most important for facilitating a Credit Facility is a carve-out prohibiting any Investor from electing additional rights that may affect provisions of the LPA related to the Fund’s ability to enter into a Credit Facility. Such a carve-out would apply to, among other things, provisions regarding funding without counterclaim, defense, or setoff, agreement to produce or deliver financial statement, investor acknowledgments, investor letters, and/or investor opinions. By preventing all Investors from electing provisions so closely linked to a Credit Facility, a Fund and a Lender can effectively limit negative impacts to the borrowing base and thus ensuring feasibility of a Credit Facility.

Conclusion

As discussed above, MFNs in side letters can have a potentially significant and negative impact on a Credit Facility. Although Investors may insist upon an MFN in their side letters, a Fund and a Lender can take reasonable steps, such as adding carve-outs to the MFN’s applicability, thereby protecting the Fund’s borrowing base from problematic provisions in a side letter and, by extension, the viability of a Credit Facility. Early review and, if necessary, negotiation of proposed side letter provisions by both the Fund and the Lender with the assistance of experienced and skilled counsel is the recommended best practice. In doing so, a Fund can ensure its borrowing base remains intact, and a Lender can get comfortable relying on the capital commitments of the Fund’s Investors for repayment.

Endnotes

1 For a detailed discussion of some current problematic side letter issues, see the article, “Developing Side Letter Issues”, Winter 2015 Fund Finance Market Review on page 146.

2 Common examples include (i) inapplicability of waiver of defenses or counterclaim for tax purposes, (ii) reservation of rights with respect to sovereign immunity, and (iii) variation from confidentiality restrictions.

In a typical syndicated credit facility, the lenders are generally prohibited from assigning their rights and obligations under the credit agreement without the borrower’s consent (typically not to be unreasonably withheld) unless the borrower is in default of its obligations under the credit agreement or the assignment is made to an existing lender, an affiliate of a lender or a non-natural person that meets certain other specified criteria1 (each such person, an “Eligible Assignee”). Many credit agreements provide the borrower with additional rights with respect to assignments; for example, by giving the borrower a consent right to lender assignments at all times other than if a payment or bankruptcy event of default exists, by prohibiting assignments to competitors of the borrower or its financial sponsor (if relevant) regardless of whether a default exists, by permitting assignments of term loans to the borrower’s debt-fund or other affiliates, by allowing term loan buy-backs by the borrower or by omitting any “deemed consent” provisions where the borrower’s failure to object to a request for an assignment within a short time frame constitutes consent. The nature and extent of any such borrower rights, and the degree to which lender participations are similarly restricted, will depend on many factors, including the borrower’s credit profile, industry, whether a financial sponsor is involved, general market conditions and the administrative agent’s and initial lenders’ preferences and policies.

One of the key underlying tensions in negotiating lender assignment provisions is balancing the lenders’ desire to maximize the pool of potential assignees in the event a lender needs to liquidate its position to manage its loan portfolio or otherwise, and the borrower’s desire to manage the identity and number of its lending partners and maintain the confidentiality of its proprietary information, particularly from the borrower’s (or its sponsor’s and affiliates’) competitors if they are potential assignees or participants. The administrative agent will also have practical operational concerns about the extent to which it may be asked to administer bespoke provisions governing the composition of the syndicate on an ongoing basis. As more fully described below, when a private equity real estate or private equity fund (a “Fund”) directly enters into a credit facility as a borrower or other obligor, the Fund’s need to limit assignments to competitors may be heightened as potential competitors of the Fund, such as credit funds, debt funds, hedge funds and other pooled investment vehicles, are potential assignees or participants with respect to the Fund’s debt. Accordingly, care must be taken to address the Fund’s business needs while taking the administrative agent’s and lenders’ competing objectives into account.

Background

A subscription credit facility, also frequently referred to as a capital call facility (a “Subscription Facility”), is a secured loan made by a bank or other credit institution to a Fund. What distinguishes a Subscription Facility from other secured lending arrangements is the collateral package: the Fund’s obligations are typically not secured by the underlying assets of the Fund, but instead are secured by the unfunded capital commitments (the “Capital Commitments”) of the limited partners of the Fund (the “Investors”) to fund capital contributions when called from time to time by the Fund or the Fund’s general partner (the “General Partner”), and certain related rights including collection and enforcement thereof, in each case pursuant to the Fund’s constituent documents.

Thus, the collateral package of a Subscription Facility by its very nature includes proprietary information related to the Fund and its Investors. This information includes the Fund’s Investor list and Investor details, the Fund’s constituent documents (principally the limited partnership or other operating agreement), subscription agreements, any side letters entered into between the General Partner and an Investor in connection with the Investor making its Capital Commitment to the Fund and information concerning the Fund’s overall investment and management structure. Side letters in particular have the potential to contain highly sensitive information about a Fund, such as additional or special economic, informational or other concessions the General Partner made to a specific Investor to secure its Capital Commitment.2 Because Funds and their General Partners invest significant time and resources in developing Investor relationships and negotiating constituent document and side letter terms with Investors and potential Investors, ensuring that such sensitive information is not obtained by competitors (through a debt assignment or otherwise) is of paramount importance to a Fund. If a Fund’s competitor obtained its Investor list, Investor Capital Commitment information, and other Fund documents as a result of an assignment or participation by a lender under a Subscription Facility, the competitor would instantly gain an informational and competitive advantage and could use the Fund’s trade secret information in its own business to the detriment of the Fund and the benefit of the competitor. Therefore, controlling which entities may gain access to the Fund’s non-public information through lender assignments and participations is an important business concern for a Fund. It is worth noting that these concerns may arise not only in a traditional Subscription Facility but also with other types of Fund financings,3 such as hybrid facilities, unsecured lines of credit with a Fund obligor, financings structures where a Fund provides a guaranty or other credit support and other arrangements where a lender would need to conduct due diligence on the Fund’s constituent documents, assess a Fund’s Investors from an underwriting perspective or undertake “know your customer” or similar checks on the Fund and its equity holders.

LSTA’s Model Credit Agreement Provisions

There are a variety of ways market participants may address lender assignments to competitors in Subscription Facilities and other Fund financings.4 The Loan Syndications and Trading Association (the “LSTA”) recently published a revised version of its Model Credit Agreement Provisions (“MCAPs”) on August 8, 2014 that address, among other topics, prohibitions on lender assignments to so-called “disqualified institutions” (commonly also referred to as “ineligible institutions” or “disqualified lenders”) (a “Disqualified Institution”), which specifically contemplate limitations on assignments to the borrower’s competitors. The LSTA’s new assignment provisions create a structure (the “DQ Structure”) that may be useful to Funds, their lenders and respective counsel in negotiating assignment provisions in Subscription Facilities.

In brief, prior to closing, the MCAPs DQ Structure allows the borrower to establish a list of entities that cannot own its debt (which may include both competitors and entities that the borrower desires to “blacklist”; for example, an entity with which the borrower has previously had a bad experience). After closing, the MCAPs permit the borrower to update the list of Disqualified Institutions (a “DQ List”) on an ongoing basis with entities that are “Competitors.” The MCAPs do not, however, include a definition of “Competitors,” and it is left up to the parties to negotiate how “Competitors” should be defined for the particular borrower. Assignments and participations to Disqualified Institutions are prohibited at all times, even if the borrower is in payment default. The MCAPs authorize (but do not obligate) the administrative agent to distribute the DQ List and any updates thereto to each lender and to post the DQ List to the electronic transmission platform for all lenders; the precise mechanics governing who must receive the DQ List and the amount of advance notice the borrower is required to give of a change in the DQ List, however, are left to the parties to determine. The consequences of a lender becoming a Disqualified Institution, or if an assignment is made to a Disqualified Institution, are described in detail in the MCAPs.5 The MCAPs provide that the borrower is permitted (x) to terminate the revolving commitments of the Disqualified Institution, (y) prepay or repurchase the Disqualified Institution’s term loans at the lowest of par, the amount the Disqualified Institution paid for the assignment [or the “market price”]6 and/or (z) require the Disqualified Institution to assign its commitments and loans to an eligible assignee.7 In addition, the DQ Structure sets forth various limitations on Disqualified Institutions, including prohibiting Disqualified Institutions from receiving information provided by the borrower to the lenders, barring the Disqualified Institution from attending lenderonly meetings and effectively limiting the Disqualified Institution’s voting rights both before and after the commencement of a bankruptcy proceeding of the borrower.

Considerations in Applying the MCAPs DQ Structure to a Subscription Facility

In applying the LSTA’s DQ Structure to a Subscription Facility determining who counts as a “Competitor,” the extent to which the Fund is permitted to update the DQ List post-closing and who receives the DQ List will be areas of intense scrutiny for the transaction parties. For a Fund, defining “Competitor” as expansively as possible to include any private equity fund, hedge fund or other pooled investment vehicle or any entity whose primary business is the management of such entities and their affiliates, would be appealing and highly protective of the Fund as it would permit the Fund to designate a wide universe of potential assignees as Disqualified Institutions under the DQ Structure. The lenders, however, would object that such a definition is unduly broad and would cover commercial banks that have fund affiliates (including debt funds) and many secondary market participants, in particular, credit funds, hedge funds and similar institutional investors that are likely potential purchasers of bank debt but with whom the Fund may not truly be competing in terms of investment strategy and potential Investors. Including carve-outs to expressly exclude commercial banks regardless of whether the commercial bank sponsors pooled investment vehicles or private equity funds or make private equity investments in the normal course of its/its affiliates’ business from such a definition would ensure that the borrower cannot designate commercial banks as Disqualified Institutions post-closing simply because they may have affiliates conducting private equity-type activities.

Another potential alternative would be to limit the definition of “Competitors” solely to private equity funds with the same primary investment strategy as the Fund (e.g., buyout, energy, real estate, infrastructure, etc.), which would allow for assignments to commercial banks, hedge funds and private equity funds of a type different from the Fund (which are less likely to be competing for Capital Commitments from the same Investors as the Fund). With credit funds especially, this may be a less palatable solution for the lenders, since it would enable the borrower to deliver an exhaustive DQ List that includes many likely secondary market investors. In such a case (and generally), limiting the total number of entities that may be set forth on the DQ List at any time, prohibiting the borrower from updating the DQ List after closing without required lender consent and/or otherwise limiting the frequency with which the borrower may update the list may be ways to balance the Fund’s need to limit assignments to competitors against the lenders’ interest in ensuring that most of the likely secondary market purchasers are not on the DQ List.

The transaction parties may also consider whether dispensing with the DQ List element of the DQ Structure altogether is appropriate, and instead simply prohibit assignments to all “Competitors” without specifically naming those entities on a list. While this approach may be attractive to a Fund that views its DQ List as trade secret information and does not want it shared with the lending syndicate, it injects an element of uncertainty into the deal to the extent the lenders and prospective assignees and participants are not readily able to confirm whether an assignment or participation would comply with the credit agreement. Where such heightened sensitivities exist, the transaction parties may decide to give the borrower the right at all times to review each proposed assignee or participant to determine if they are a “Competitor” prior to the effectiveness of any trade, thus giving the borrower a (limited) veto right even when the borrower is in default. At the other end of the spectrum (and in the approach outlined in the MCAPs), the parties would agree to the parameters defining “Competitors” and the administrative agent would be authorized to post the DQ List to the electronic transmission platform for all lenders to access. Where participations are subject to the same restrictions as assignments, the lenders will argue that it is only fair for a specific DQ List to be made easily accessible to them with reasonable advance notice.

In addition to determining how to handle the scope and mechanics around updating and distributing the DQ List, the transaction parties will also want to decide whether the remedies and consequences of assigning or participating in a loan to a Disqualified Institution outlined in the MCAPs are appropriate. For example, while the MCAPs include the remedies and consequences outlined above (including yank-a-bank provisions), the Fund may prefer to specify different rights and consequences or provide that offending assignments are void ab initio. Taking such an approach, however, may result in confusion later, particularly if there are multiple assignments following a trade to a Disqualified Institution that need to be unwound.

Conclusion

In negotiating lender assignment provisions in Subscription Facilities, the transaction parties may look to the MCAPs for guidance on how to structure limitations on assignments and participations to Disqualified Institutions, including a Fund’s competitors. In applying the MCAP’s DQ Structure to a particular Subscription Facility, care must be taken in balancing the competing business and operational needs of the borrower, the lenders and the administrative agent. A slight modification to one element of the DQ Structure may have unintended consequences in other areas of the credit agreement. As a result, Funds and their lenders will want to seek guidance from counsel well-versed in Subscription Credit facilities and the unique needs of Funds when negotiating limitations on assignments and participations in Subscription Facilities.

Endnotes

1 Assignments to entities commonly referred to as “Approved Funds” that are (a) engaged in making, holding, purchasing or otherwise investing in commercial loans, bonds and similar credit extensions in the ordinary course of their business and (b) managed or administered by a lender, an affiliate of a lender or an entity or an affiliate of an entity that manages or administers a lender, are often included within the scope of Eligible Assignees in a credit agreement to an operating company.

2 See article Developing Side Letter Issues for additional information about select topics commonly addressed in side letters, on page 146.

3 For more detailed discussions of other types of Fund financings, please see Mayer Brown’s Summer 2013, Winter 2013 and Summer 2014 Fund Finance Market Reviews on pages 19, 59 and 97.

4 For simplicity, as used herein, “Subscription Facilities” includes all such Fund financings.

5 The MCAPs provide that assignments may not be made to any entity “that was a Disqualified Institution as of the date (the “Trade Date”) on which the assigning lender entered into a binding agreement to sell and assign all or any portion of its rights and obligations under this Agreement.” Thus, retroactive effect is not given to the designation of an assignee as a Disqualified Institution after the Trade Date, and the parties may settle their trade without violating the credit agreement; the borrower, however, has certain rights against the Disqualified Institution assignee.

6 The reference to market price is bracketed in the MCAPs. This is an acknowledgement that it may be difficult to establish a market price for a particular loan at any given time, and the parties may prefer to remain silent on this issue in the credit agreement.

7 Note that an assignment to a Disqualified Institution under the MCAPs would not render the assignment void; instead, the enumerated consequences would apply

Introduction

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 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 (the “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 documents establishing a Facility contain provisions extending credit to the Fund and securing the related rights of the Lender. Additional documentation governs Investors’ rights and obligations to the Fund as they relate to the Facility. Specifically, Investors’ rights and obligations largely arise under the Fund’s limited partnership agreements and Investors’ subscription agreements. However, individual Investors also frequently negotiate and enter into a letter agreement with the Fund (“Side Letters”), separate and apart from other Investors, which interprets, supplements, and alters the terms of that Investor’s rights, duties, and obligations under the related limited partnership agreement or subscription agreement. Side Letters can and do have a significant impact on Facilities.

Traditionally, Side Letters have been used to address unique economic issues between Funds and their Investors (e.g., family and friends or late-closing investors) and/or issues specific to particular Investors (e.g., governmentally regulated investors). That tradition has matured with the Facility market and, as such, the frequency, sophistication and size of Side Letters have grown dramatically. With that growth, issues arising in Side Letters have continued to develop, each of which holds significance for Funds, Lenders, and Investors. As discussed in greater detail below, Side Letters can impact every aspect of a Facility, including its very existence. Nevertheless, with prior review by experienced legal counsel, nearly every issue discussed in this article arising in Side Letters can be effectively mitigated or resolved.

To that end, we recommend that Funds disclose all Side Letters to their Lenders as part of the Lenders’ due diligence review of the Investors’ documents while negotiating a Facility. It has been our experience that such a review is most constructive when begun prior to the execution of any Side Letter. During such initial review, Lenders have the opportunity to identify, analyze, and resolve any potential issue with the Fund, a scenario far preferable to renegotiating finalized Side Letters with Investors based upon Lenders’ subsequent review and comment.

In this article we discuss a number of developing issues in Side Letters and their potential impact1 on Funds and their Lenders, including (1) placement agent regulations; (2) investor documents and deliverables; (3) transfers; (4) sovereign immunity; (5) excuses; and (6) overcall and concentration limits.

Placement Agent Regulations

In response to investigations into alleged corrupt practices involving the use of placement agents in connection with public pension funds, retirement systems, and other government fund entities (collectively, “Government Investors”), a growing number of governmental authorities have taken measures to restrict the use of placement agents and curb so-called “pay-to-play” abuses.2 A number of the resulting rules regulate the investment activities of Government Investors by banning the use of placement agents, registered lobbyists, and other intermediaries (collectively, “Placement Agents”) in obtaining investments by Government Investors. A common manifestation of such regulations requires a Fund to represent and warrant to a Government Investor that it did not use a Placement Agent to obtain such Government Investor’s investment and that no benefit was paid or promised to the Government Investor’s employees, affiliates, or advisors to obtain its investment. While the severity of a breach of Placement Agent regulations varies from jurisdiction to jurisdiction, the strictest form of remedy provides a Government Investor the unilateral right to cease making Capital Contributions to the Fund or to withdraw from the Fund altogether.

Although many Funds may be comfortable making such representations, both Lenders and Funds should be apprehensive of the consequences of potential breaches for several reasons. First, the ability of a Government Investor to unilaterally withdraw from a Fund based on its determination of the Fund’s compliance with policy or applicable law is at odds with the underwriting standards applied by Lenders when entering a Facility. Typically, such underwriting decisions are based on an analysis of Investors’ creditworthiness without accounting for the consequences of a breached Placement Agent regulation. Second, the failure of an Investor to honor a capital call is virtually always an “exclusion event” under a Facility, which could result in the removal of such Investors from the Facility borrowing base and trigger a mandatory prepayment by the Fund.

We have seen Funds and Lenders take precautions to mitigate the impact of Placement Agent regulations in Government Investors’ Side Letters. For instance, in Side Letters allowing an Investor to cease making Capital Contributions if a Placement Agent regulation is breached, Lenders may include language making clear that the termination of an Investor’s obligation to fund further Capital Contributions does not apply to liabilities relating to, and Capital Contributions called in respect of, indebtedness of the Fund incurred prior to the Government Investor’s withdrawal or cessation of Capital Contributions. In other instances, we have seen Funds make conforming representations and warranties to their Lenders that provide the Lenders with recourse to the Fund in the event that the Fund breaches its Placement Agent-related representations and warranties to its Government Investors. Alternatively, a Lender and Fund may agree that the Lender will advance a lower rate under a Facility against the Capital Commitments of Government Investors subject to Placement Agent regulations in recognition of the additional risk undertaken.

Investor Documents and Deliverables

Because Lenders are not party to a Fund’s limited partnership agreement and subscription agreements, Lenders may require Funds to deliver additional documentation from each Investor acknowledging, representing, and covenanting to certain undertakings related to the Facility for the Lenders’ benefit. For instance, we are familiar with requests from Lenders to Funds for financial statements, annual reports, investor letters, and investor opinions, among other documents and deliverables, with respect to the Fund’s Investors. Many Investors, however, have used Side Letters to resist such obligations to deliver additional documentation. Such limitations are of consequence to both Lenders and Funds because they can impact a Lender’s willingness to extend credit in a Facility based on the Investor’s unfunded Capital Commitment. As a result, Funds may find that their anticipated borrowing base and credit availability under a Facility is unexpectedly diminished should such deliverable carve-outs remain in their Side Letters.

While the consequence of a problematic limitation in an Investor’s Side Letter on its obligation to deliver investor documents can be drastic, the remedies for such situations are readily attainable. For example, in lieu of actually delivering additional documentation, Funds may incorporate the substance of such items, including the relevant acknowledgements, representations, and covenants, in the Fund’s limited partnership agreement. Such streamlining efforts can address both Lenders’ desire for additional comfort from Investors and Investors’ hesitation at providing additional documentation and deliverables.

Transfers

One of the structural issues addressed in a Fund’s formation documents is an Investor’s right to transfer its interest in the Fund. In negotiating that issue, competing interests exist. On one hand, Investors prefer that their interest in a Fund be unfettered and fluid in order to facilitate any desirable or necessary transfer. On the other hand, Funds and Lenders prefer consistency among the Fund’s Investors and Lenders may be reluctant to extend credit based on the Capital Commitments of a subsequent Investor who is unfamiliar to the Lender.

The preferred mechanics of achieving that consistency vary among Lenders. Some Lenders prefer that transfers of an Investor’s interest in the Fund be subject to the preapproval of the Fund’s general partner. Other Lenders, however, prefer that they themselves retain pre-approval and consent rights. In either case, Lenders may require a prepayment of the transferring Investor’s Capital Commitment prior to such transfer.

The impact of an unrestricted transfer of Investors’ interests in the Fund, while delayed, can nevertheless be severe. For example, although an Investor may retain its entire interest in a Fund for the majority of the Fund’s existence, a transfer of that interest months or years after a Facility is in place can trigger a borrowing base deficiency, requiring the Fund to make sizeable repayments. In light of those lurking consequences, Lenders and Funds are well-served to be mindful of provisions in Side Letters addressing Investors’ right to transfer their interests. To prevent the potential negative consequences of a transfer, Investors typically agree in a Side Letter to give their Fund the right to preapprove any transfer of the Investor’s interest in the Fund and, in turn, Funds agree not to unreasonably withhold such approval.

Sovereign Immunity

In addition to Government Investors, sovereign wealth funds and various other instrumentalities of foreign and domestic governments may become Investors in Funds. Such Investors often possess certain sovereign immunity rights that protect them against enforcement proceedings, which in their broadest form, shield the Investor from all liability, including a Lender’s attempt to collect Capital Commitments contractually due and payable under a Facility.3 For that reason, Lenders evaluating the creditworthiness of an Investor’s Capital Commitment are well-served to analyze the effect of any applicable sovereign immunity rights. To the extent that such analysis becomes problematic, Funds can address the potential complications arising from the Investor’s sovereign immunity rights in a Side Letter.

An Investor’s sovereign immunity rights are commonly addressed in a Side Letter through two mechanics. First, Funds begin by expressly acknowledging that the Investor retains all of the rights inherent in sovereign immunity. Then, however, the Investor agrees to limiting language making clear that the Investor’s sovereign immunity rights do not relieve it of its obligations under the relevant partnership agreement, subscription agreement, and other fund documents. The cumulative effect of those maneuvers is to acknowledge both the Investor’s sovereign immunity rights and its obligation to make Capital Contributions when called upon by the Fund.

Excuses

To meet their ongoing fundraising desires, Funds are turning to certain non-traditional Investors that may have unique investment constraints. Such non-traditional Investors may bring cultural, religious, and/or jurisdictional investment preferences to a Fund that prevent the Fund from using the Investor’s Capital Contributions to fund certain investments. Frequent examples of such preferences include prohibitions on investing in gambling facilities, tobacco or alcohol products, and the like. To balance their desire to expand their sources of capital to non-traditional Investors with such Investors’ investment preferences, Funds have often provided “excuse rights” to such Investors.

Excuse rights permit, under certain circumstances, an Investor to elect not to fund a capital call relating to a particular investment that conflicts with the Investor’s investment preferences. In such an arrangement, an Investor who is excused from funding a capital call often cannot be relied upon to fund the repayment of an extension of credit under a Facility used by a Fund to acquire an excused investment. The implication for Lenders of such excuse rights is that their collateral under a Facility may be diminished based solely on the investment preferences of an Investor. To mitigate that potential consequence, Funds should clearly designate how a legitimately excused Investor’s unfunded Capital Commitment will be treated after such an excuse is made. Such a designation is appropriately made in connection with the documentation of excuse rights in an Investor’s Side Letter.

Overcall and Concentration Limits

As the Facility market has expanded into the buyout and private equity industries, Lenders have more frequently encountered overcall and concentration limitations. Overcall limitations constrain the ability of the Fund to call capital from its Investors to cover shortfalls created by other Investors’ failure to fund their Capital Commitments when called.4 Similarly, concentration limitations may restrict the percentage that a single Investor’s Capital Commitment and/or Capital Contributions may comprise of a Fund’s aggregate Capital Commitments and/or Capital Contributions. For instance, an Investor may require that its Capital Commitment not represent more than 20% of a Fund’s aggregate Capital Commitments.

From the Lenders’ perspective, overcall and concentration limitations fundamentally conflict with their expectation that Investors in a Facility are jointly and severally obligated to fund capital calls up to each Investor’s respective Capital Commitment. The effect of such limitations upon Lenders is clear: they may not be able to rely on the support of the entire pool of Capital Commitments for repayment of any extension of credit under a Facility if the Fund’s Investors have successfully negotiated overcall or concentration limitations. Not surprisingly, Lenders generally take a negative view of the credit implications of such limitations.

While overcall and concentration limitations are still relatively rare in Funds’ formation documents, they require Lenders to evaluate not just the entire borrowing base of a Facility, but also the Fund and Investors themselves in order to adequately analyze the risk of Investor default. Fortunately, as rare as overcall and concentration limitations are, Investor defaults have been even more infrequent in the Facility market. That said, whenever possible, Funds should narrowly tailor overcall and concentration limitations to carve out Facility-related items, including the obligation to fund capital calls related to indebtedness incurred under a Facility.

Conclusion

This article highlighted certain issues that Lenders and Funds should consider when reviewing and/or negotiating Side Letters in connection with a Facility. For more information about those issues and the various options for effectively resolving them, please contact the authors of this article.

Endnotes

1 We note that each issue discussed in this article should be considered within the context of a most-favored nation provision as discussed in our MFN article Winter 2015 Fund Finance Market Review on page 141.

2 For a discussion of certain of these restrictions, see our Legal Update dated October 28, 2010 “California Imposes Lobbyist Registration Requirement and Contingency Compensation Prohibition on Certain Placement Agents,” available at http://www.mayerbrown.com/publications/california-imposes-lobbyistregistration-requirement-and-contingency-compensa tion-prohibition-on-certain-placement-agents-10-28- 2010/; see also our Legal Update dated July 29, 2010 “SEC Adopts Advisers Act Pay-to-Play Rule Relating to Government Plans”, available at http://www.mayerbrown.com/publications/sec-adopts-advisers-actpay-to-play-rule-relating-to-government-plans-07-29- 2010/; see also our Government Relations Update dated April 28, 2009 “New York State Comptroller Bans Placement Agents, Paid Intermediaries and Lobbyists in Investments with Common Retirement Fund,” available at http://www.mayerbrown.com/ publications/new-york-state-comptroller-bans-placementagents-paid-intermediaries-and-lobbyists-in-investments-with-the-common-retirement-fund-04-28-2009/.

3 For a more thorough explanation of the historical basis of sovereign immunity and the related implications for Funds and Lenders in a Facility, see our Legal Update “Sovereign Immunity Analysis in Subscription Credit Facilities” dated November 27, 2012, on page 9.

4 A more fulsome examination of the several varieties of overcall limitations and their unique implications on Facilities is beyond the scope of this Legal Update. For further treatment of the subject, see our Legal Update “Subscription Facilities: Analyzing Overcall Limitations Linked to Fund Concentration Limits” dated June 29, 2013, on page 24.

Capital call subscription credit facilities (each, a “Facility”) continued their post-crisis growth and positive credit performance in 2014, again achieving an excellent year as an asset class. Anecdotal reports from many of the key Facility lenders (each, a “Lender”) indicate substantial portfolio growth last year, and the Mayer Brown Facility practice closed more than 100 new transactions for the year, a first for our practice. Investor capital call (each, a “Capital Call”) funding performance continued its near-zero delinquency percentage, and, correspondingly, we were not consulted on any Facility payment events of default in 2014. Below we set forth our views on the state of the Facility market and current trends likely to be relevant in 2015.

Fund and Facility Growth

Fundraising in 2014

Overall, 2014 was a very positive year for private equity funds (each, a “Fund”). Fundraising, although down slightly from the marks set in 2013, was relatively robust. Globally, 994 Funds held their final close last year, raising $495 billion in investor (each, an “Investor”) capital commitments (“Capital Commitments”). This surpassed the fundraising levels seen in 2008-2012 but was down slightly from the 1,203 Funds raising $528 billion in 2013. The “flight to quality” trend we noted in our Summer 2014 Fund Finance Market Review (the “Summer Review”) has continued, with fewer Funds being formed but on average raising more capital. In fact, the average Fund size in 2014 was $544 million, the largest average ever recorded.

Facility Growth

While the Facility market still lacks an industryaccepted data reporting and tracking service to pinpoint exact numbers, the market undoubtedly expanded by double digits in 2014. Multiple Lenders grew their portfolios extensively, with several reporting a growth rate in revolving commitments in the neighborhood of 50%. Mayer Brown represented Lenders and Funds in new money transactions reflecting in excess of $25 billion of Lender commitments, without counting accordion upsizes or increase amendments. We believe this growth rate is at a minimum consistent with, if not in excess of, that in 2013.

Interestingly, one of the theories behind the 2014 fundraising decline involves the growth of separate accounts (each, a “Separate Account”). As Separate Accounts are often structured to obtain their own Facilities, that may explain in part how we are seeing Facility growth despite a nominal decline in fundraising. While perhaps a factor, we continue to believe that Facility growth over the past several years is most attributable to increased market penetration; that is, Fund families that in the past rarely used Facilities are awakening to their benefits. In 2014, we saw several top 30 Fund sponsors (each, a “Sponsor”) obtain their first Facility for a Fund and then look to procure additional Facilities across their platforms. Many additional Sponsors also explored and consummated their first Facility. This market penetration has clearly seeded Facilities growth over the past few years and in our view has been the primary growth driver.

Looking forward, we continue to forecast outpaced growth for Facilities in 2015, although we do expect the growth rate to slow somewhat from the double-digit and perhaps unsustainable growth rate of the recent past (especially in the United States). Absent a Facility default or a major macro-economic event, there are too many positive data trends not to be cautiously bullish. For example, at the beginning of 2015, a record 2,235 Funds were on the road fundraising, an all-time high. Dry powder increased by $128 billion in 2014 to a record $1.2 trillion. Even if one were to assume that the Facility market has hit $200 billion in global Lender commitments, we are still looking at a global advance rate of less than 17% on available dry powder. Many Lender portfolios have an average funded advance rate of 25% to 30% of uncalled Capital Commitments (“Uncalled Capital”), suggesting there is still a fair amount of growth opportunity remaining. Furthermore, with the record levels of distributions to Investors in 2013 and 2014 (nearly $200 billion ahead of Capital Calls for each year) and the continued positive investment performance of Funds as an asset class, it is hard not to forecast extensive fundraising success in 2015. These trends are all likely to combine and result in additional Facility growth in 2015.2

Facility Market Trends

Not surprisingly, many of the trends we noted in the Summer Review continued and in some cases accelerated in the latter half of 2014. We highlight these below along with a few other trends likely to be impactful in 2015.

Continuing Trends

Extensive Refinancing Activity. As predicted, we saw significant amend-and-extend volume over the course of 2H 2014 and that trend has continued its momentum thus far in 2015. Facilities of the 2011-12 vintages are increasingly coming up for renewal. In some cases, Funds are even renewing early to take advantage of the lower pricing that is generally available. While we are seeing Facilities reduce in commitment size, very few are being repaid and terminated. Facilities extending long into the Fund’s harvest period are increasingly common.

Fund Structural Evolution. Separate Accounts and parallel funds of one Investor have continued to permeate the Facility market as Investors (frequently sovereign funds and large institutional Investors) seek investment flexibility, lower fees, greater control and structuring alternatives for regulatory and tax relief. Many Lenders have gotten comfortable with these single Investor exposures and the Separate Account Facility market is flourishing. Investor credit linkage, transparency and a continuous education on the evolving structures will be key as Lenders pivot to serve this growing sub-market in 2015.

Umbrella Facilities. Facilities encompassing multiple sub-facilities for unrelated Funds advised by the same Sponsor continue to gain increased traction in the market. Mayer Brown has advised on nearly as many umbrella facilities to date in early 2015 as in all of 2014. We expect the efficiencies created by these structures to support their continued expansion.

Hedging Mechanics. Lenders and Funds increasingly want to secure trading activities with Facility collateral and several Lenders have been successful in accommodating this construct in syndicated Facilities. We expect that these secured hedging mechanics, embedded within the Facility documentation, will continue to be a popular request in 2015.

Newer Trends

CREDIT CONTINUUM

Throughout 2013, Facility structures and covenant packages were clearly drifting in favor of Funds as Lenders were becoming increasingly comfortable going further down the risk continuum. In early 2014, that trend seemed to accelerate. For example, Facilities were being consummated that included advances for Investors that would never have previously been included in a borrowing base. Lenders were far more lenient with respect to Fund partnership agreement language, Investor credit linkage and sovereign risks, as additional examples. That downward trending, however, seemed to level out somewhat toward year-end. Other than a few instances of extended tenors, Facility structures seemed to largely stabilize. Facility structure and credit trending will be interesting to watch in 2015.

HNW and Family Office Facilities. During 2H 2014 and thus far into 2015, we have seen a notable uptick in the establishment of Facilities for Funds comprised mostly or exclusively of high net worth and family office Investors (“HNW Investors”). This trend has emerged not only for middle-market Sponsors but also for some of the largest Sponsors in the market. For Funds where the HNW Investors invest directly, the transparency of the Investor, the number of Investors and the granularity of the pool have in some cases actually been credit positives for certain Lenders. For Funds where the HNW Investors invest indirectly through managed platforms of wealth management institutions, comfort with the managed institution and some level of negotiated look-through rights or bespoke exclusion events related to the platform have been present. Many of these Facilities have been bilateral and generally smaller in overall Lender commitment size, but we do expect this market to develop going forward.

Hybrid Facilities. Funds that are approaching or have passed their investment period often have ongoing liquidity needs. Lenders have historically offered “after-care” Facilities for seasoned Funds with appropriately drafted partnership agreements. The after-care Facility approach, however, offers little utility if a Fund has nearly exhausted its Uncalled Capital. Hybrid Facilities are structured on a case-by-case basis but typically include a pledge of whatever Uncalled Capital remains, as well as some form of a pledge of the Fund’s investments. The hybrid borrowing bases are typically comprised of the standard 90%/65% advance rates on the tiered credit quality of the Investors and a much lower advance rate on the NAV of the investments after a reduction for concentration limit excesses. Each hybrid Facility is structured differently and a pledge of the assets and evaluation of the collateral package will require enhanced diligence and differing underwriting criteria. Interest in hybrid Facilities, and NAV-based lending generally is clearly on the upswing.

Open-End Fund Facilities. Facilities for openend Funds, which permit Investors to redeem their equity interests at their election (typically following a “lock-up” period and sufficient notice to the Fund), are on our list as a product to watch in 2015 and beyond. While Facilities for open-end Funds have been somewhat slower to catch steam than we originally forecast, Mayer Brown advised on a number of opportunities for open-end Fund financings in 2H 2014.

LIBOR Floors of Zero. Recent activity by central banks has resulted in periodic negative LIBOR rates for certain currencies. In order to prevent unintended consequences of a negative index rate, many Lenders are now including LIBOR floors of zero in their loan agreements. The floor will specify that if LIBOR is below zero, it shall be deemed to be zero for purposes of calculating the rate under the loan agreement.

Energy Sector Watch. While 2014 represented a strong year in terms of Fund performance generally, falling crude oil and related commodity prices are stressing certain investments in energy Funds. The press has reported Investor Fund losses of greater than $12 billion in value in 2H 2014 alone.3 We think we are still in the early innings of volatility in the energy markets. While it is quite likely that the sharp downward movements to date have and will create some meaningful losses on investments for certain Funds, it may also create more realistic pricing and attractive investment opportunities for the very same Funds incurring the recent losses. The energy sector certainly warrants considerable attention in 2015.

Legal and Regulatory Developments

LSTA Model Credit Agreement Provisions

On August 8, 2014, the Loan Syndications and Trading Association (the “LSTA”) published a revised version of its Model Credit Agreement Provisions (“MCAPs”) that addresses, among other topics, prohibitions on lender assignments to so-called “disqualified institutions” (commonly also referred to as “ineligible institutions” or “disqualified lenders”) which specifically contemplate limitations on assignments to the borrower’s competitors. The revised MCAPs allow the borrower to establish a list of entities that cannot own its debt, which may include both competitors and entities that the borrower desires to “blacklist” (such as an entity with which the borrower has previously had a bad experience). For a complete summary of the revised MCAPs, please see the Mayer Brown article, Limitations on Lender Assignments to Competitors in Subscription Credit Facilities and Other Fund Financings, at page 13 hereto.

Liquidity Coverage Ratio: Final Rule

On September 3, 2014, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency (collectively, the “Agencies”) each adopted a final rule (the “Final LCR Rule”) to impose a quantitative liquidity coverage ratio (“LCR”) requirement on US banking organizations with total consolidated assets of $250 billion or more and certain other institutions (collectively, “Covered Companies”). The Final LCR Rule went into effect for Covered Companies as of January 1, 2015

Last year, at the time the Agencies circulated the proposed regulations to address this LCR requirement (the “Proposed Rule”), Mayer Brown released the Legal Update “Capital Commitment Subscription Facilities and the Proposed Liquidity Coverage Ratio” in which we expressed our view that Facilities are most appropriately classified as “credit facilities” rather than “liquidity facilities” and addressed other aspects of the regulations that could affect traditional fund finance products. The Final LCR Rule as adopted by the Agencies did not change the Proposed Rule in a manner that we believe changes this analysis for Facilities. For more information, please see the Legal Update available at http://www. mayerbrown.com/Capital-CommitmentSubscription-Facilities-and-the-ProposedLiquidity-Coverage-Ratio-12-20-2013/.

Extension of Volcker Rule Conformance Period for Legacy Funds

Section 619 of the Dodd-Frank Act, commonly referred to as the Volcker Rule, remains an area of focus for many Lenders. On December 18, 2014, the Federal Reserve Board (the “FRB”) responded to industry concerns regarding conformance with the Volcker Rule by extending the conformance period for investments in and relationships with “covered funds” and “foreign funds” that were in place prior to December 31, 2013 (“legacy covered funds”) through July 21, 2016. The FRB announced that next year it intends to further extend the conformance period for investments in and relationships with these legacy covered funds to July 21, 2017.

In our related Legal Update from August 2014, we described our belief that traditionally structured Facilities should not cause Lenders to run afoul of the Volcker Rule’s prohibition on acquiring ownership interests in a “covered fund.”4 Lenders must be aware of certain terms or structures which could give rise to an “ownership interest” under the regulation’s broad definition, but the traditional Facility structure, including the collateral and remedies associated therewith, should not rise to this level. The extension granted for conformance of legacy covered fund relationships should help mitigate risks in certain existing Facilities to covered funds where the Fund Sponsor itself is a Covered Company subject to the Volcker Rule.5

Conclusion

We forecast continued growth of the Facility market in 2015, riding a projected positive wave of fundraising for Funds, further penetration into new Fund families and expanded use of Facilities by Funds throughout their harvest periods. Facility structures are likely to continue to evolve commensurate with the growth of Separate Accounts, Open-end Funds and similar alternative investing structures. We also anticipate growth in hybrid Facilities and NAV-based lending as Lenders search for yield and utilization and Funds seek leverage and liquidity later in their lifecycles. Of course, there are a fair number of material uncertainties in the greater financial markets currently, especially in the energy sector, the Middle East and Eastern Europe, all of which could potentially spook Investors and change the fundraising landscape rather abruptly. But while these risks are real and should be monitored closely in 2015, we expect that the 2015 Facility market will trend favorably and comparably to the uptick in 2014.

Endnotes

1 See 2015 Preqin Global Private Equity and Venture Capital Report (“Preqin PE 2015”), p. 4; for our Summer Review, please go to page 97.

2 See, Preqin PE 2015, p.4.

3 Dezember, Ryan, “Buyout Shops Caught in Crude Exposure,” The Wall Street Journal, December 4, 2014.

4 For more information, please see Mayer Brown’s Legal Update, Federal Reserve Board Issues Volcker Rule Conformance Period Extension, available at http://www. mayerbrown.com/Federal-Reserve-Board-Issues-VolckerRule-Conformance-Period-Extension-12-19-2014/.

5 For more information about the Volcker Rule’s impact on Lenders, please see Mayer Brown’s Legal Update, Subscription Credit Facilities and the Volcker Rule, on page 103. For an in-depth analysis of the Volcker Rule’s final regulation, please see Mayer Brown’s White Paper, Final Regulation Implementing the Volcker Rule.

A feeder fund (“Feeder”) is an investment vehicle, often a limited partnership, that pools capital commitments of investors and invests or “feeds” such capital into an umbrella fund, often called a master fund (“Master”), which directs and oversees all investments held in the Master portfolio. A Master/Feeder structure is commonly used by private equity funds or hedge funds (“Funds”) to pool investment capital. The Master’s profits may be split on a pro rata basis among its Feeders in proportion to their investment. A Feeder is a separate legal entity from the Master and is relevant to both lenders and Funds when discussed in the context of lending relationships, particularly in structuring a subscription-backed credit facility (“Facility”).

Investment managers choose to form Feeders for a variety of reasons. For example, Feeders offer flexibility with respect to investor tax status, ERISA status, minimum capital investments, fee structures or other administrative features that can be tailored to the specific needs of any investor. In this article, we will focus on certain tax, ERISA and aggregation issues as they relate to the Master/Feeder structure of Funds.

Tax Concerns1

Tax-exempt investors and foreign investors are two significant sources of capital in the United States and both groups invest heavily in Funds. Most tax-exempt investors will want to minimize or eliminate the realization of unrelated business taxable income (“UBTI”) with respect to their investments. Similarly, most foreign investors will want to minimize or eliminate the realization of effectively connected income (“ECI”) and structure their investments in a manner that does not require them to file US income tax returns. If a Fund makes its investments in or through pass-through entities, the Fund’s tax-exempt investors may realize UBTI or its foreign investors may realize ECI and have to file US tax returns if the Fund is engaged in a trade or business in the United States.

In order to attract UBTI- or ECI-sensitive investors, many Funds offer Feeders through which such investors may participate in the Master’s investments. Properly structured, these Feeders operate to “block” UBTI and ECI with minimal tax leakage.

Although Feeders formed to act as blockers are usually formed in a low tax jurisdiction (such as the Cayman Islands), the domicile and precise structure and tax classification of the Feeder will depend on the nature of the Fund and its investments, as well as the tax structuring objectives and/or regulatory requirements applicable to the prospective investor(s). A variety of UBTI and ECI blocking strategies exist, including the use of debt and equity to capitalize the Feeder and forming separate Feeders for each fund investment. In addition, tax treaties may reduce the overall tax cost of a Feeder formed for foreign investors. Each approach to the structuring and implementation of Feeders to accomplish tax objectives carries with it advantages and disadvantages that a Fund sponsor should discuss with its tax advisors.

ERISA Concerns2

Once a Fund or a Feeder accepts investors that are subject to the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), or Section 4975 of the Internal Revenue Code of 1986, as amended (the “Code”), the entity could itself become subject to the fiduciary and prohibited transaction rules under ERISA and Section 4975 of the Code if the assets of such Fund or Feeder are deemed to be “plan assets” of such investors. The rules governing when the assets of an entity are treated as plan assets are generally set forth in Section 3(42) of ERISA and a regulation, known as the “plan asset regulation,” published by the US Department of Labor.3 The plan asset regulation sets forth a number of exceptions on which a Fund may rely to avoid plan asset treatment. The exceptions most commonly relied upon for Funds are the “less than 25% exception” and the “operating company” exception.4

In a Master/Feeder structure, it may be difficult for a Feeder to satisfy an exception to holding plan assets because (i) the Feeder may be too passive to qualify as a “venture capital operating company” (“VCOC”) or a “real estate operating company” (“REOC”) and (ii) investment by benefit plan investors in the Feeder may be too significant to satisfy the less than 25% exception. In such a case, a Fund manager may permit the Feeder to operate as a plan asset vehicle that is subject to Title I of ERISA and/or Section 4975 of the Code. The Master, which will aggregate capital from all of its Feeders and investors, may still be able to rely on the less than 25% exception or may be able to qualify as a VCOC or REOC. If a Feeder is operated as a plan asset vehicle, such Feeder is typically “hard-wired” to invest in the Master, so that all investment activities will take place (and all fees and expenses will be calculated) at the Master level. Accordingly, although the Feeder may be subject to ERISA, the manager of the Feeder will not be acting as an ERISA fiduciary with respect to the investment of the Feeder’s assets.

If a Master satisfies one or more exceptions under the plan asset regulation, it would not be subject to the prohibited transaction rules of ERISA and Section 4975 of the Code. A plan asset Feeder, however, would nonetheless be subject to such prohibited transaction provisions.

Except where specifically exempted by statute or by the US Department of Labor, ERISA and Section 4975 of the Code impose prohibitions on specified transactions between benefit plan investors and a wide class of persons (alternately referred to as “parties in interest” or “disqualified persons”) who, by reason of position or relationship, might be in a position to influence a plan fiduciary’s exercise of discretion. One of the specified transactions is any loan or other extension of credit.

With respect to lenders, financial institutions often have relationships with benefit plan investors that cause them to become parties in interest or disqualified persons, as applicable, such as providing trustee, custodian, investment management, brokerage, escrow or other services to such benefit plan investors. A party in interest or disqualified person that enters into a nonexempt prohibited transaction with a benefit plan investor is subject to initial excise tax penalties under the Code equal to 15 percent of the amount involved in the transaction and a second tier excise tax of 100 percent of the amount involved in the transaction if the transaction is not timely corrected. In order to correct the transaction, the transaction must be unwound, to the extent possible, and the benefit plan investor must be made whole for any losses. In addition, if a transaction is prohibited under ERISA, it may not be enforceable against the benefit plan investor.

In the case of a plan asset Feeder, there may not be a prohibited transaction exemption available to permit an extension of credit between such Feeder and a lender that is a party in interest or disqualified person. In such circumstances, a cascading pledge structure, which is described in more detail below, may be used to avoid an extension of credit transaction between a plan asset Feeder and a lender.

High Net Worth Individuals

Feeders may also allow Funds to tap into an increasingly relevant investor segment: high net-worth individuals (“HNWI”). A HNWI is defined as an individual that has investible assets in excess of $1 million and these individuals are increasingly seeking the opportunity to invest in Funds.5 Minimum capital requirements for Funds are customarily in amounts that even HNWI may have difficulty satisfying, often requiring a minimum capital commitment of $5 million. In an effort to bridge the gap between the traditional minimum capital requirements that Funds require and the desire of HNWI to have access to the investment portfolio that Funds offer, Feeders that aggregate the capital commitments of HNWI (“HNW Aggregator Funds”) have become an increasingly popular investment vehicle.

A HNW Aggregator Fund may be organized by a private bank or brokerage firm; it allows HNWI to commit assets held in a traditional brokerage or retirement account in amounts as little as $50,000 to an investment that will ultimately be aggregated with similar commitments from other HNWI and pooled into a HNW Aggregator Fund. The popularity of such HNW Aggregator Funds can be seen in the increased level of capital pouring into them. In the 12 months ending September 2014, Blackstone raised $10 billion through such HNW Aggregator Funds run by brokers and through its other retail offerings, out of a total of $54.8 billion Blackstone raised. This represented a sharp increase from 2011, when Blackstone raised just $2.7 billion through these channels out of a total of $49.5 billion.6 Sensing the growing demand for the HNW Aggregator Fund product, the broker-dealer arms of financial institutions, such as Goldman Sachs, Citibank, Morgan Stanley and Merrill Lynch, are offering opportunities for HNWI to participate in such Feeders.

Challenges Facing Lenders and Funds in a Facility with a Feeder

The variety of Feeders (and their related investors) that ultimately invest in a Master have important implications for both lenders and Funds in structuring a Facility where the borrowing base is directly correlated to the lender’s reliance on the ability of investors to fund capital commitments. In a typical Facility, for instance, a lender will advance cash to a Fund on the basis that the Fund can make a capital call with respect to the capital commitment of its investors in order to satisfy its repayment obligations. The borrowing base of the Fund will be calculated based on such lender’s view of the probability that the investors in such Fund (and therefore the ability of the investors in each Feeder) will make capital contributions when required by the Fund.7

When developing a borrowing base formula for any given Fund, a lender will be focused on the sufficiency of the “know-your-customer” (“KYC”) and financial reporting information that it receives with respect to the investors in a Feeder. As part of the diligence process that all lenders undertake when establishing a Facility with any borrower, a lender will customarily gather KYC and financial information that allows such lender to make both regulatory and commercial decisions regarding a potential borrower. Such information may include the tax status of such entity or individual, sources of income or funds for purposes of repayment of any obligations owing to the lender, the intended use of any loan proceeds and the assets, liabilities and financial strength of the investor. The ability of a lender to collect KYC and financial information is critical for such lender not only to ensure compliance with any regulations applicable to it, such as the Foreign Corrupt Practices Act of 1977 or the Foreign Account Tax Compliance Act, but also to properly underwrite the investor pool forming the borrowing base.

Gathering KYC and financial information with respect to investors in an HNW Aggregator Fund may present additional challenges to both lenders and Funds. Collecting KYC information with respect to HNWI in a Feeder requires lenders (and to a certain extent, the Fund itself) to rely primarily on the HNW Aggregator Fund sponsor (i.e., the brokerdealer that has established the Feeder comprised of HNWI) to provide KYC information with respect to relevant HNWI. The HNW Aggregator Fund sponsor must be able to properly gather KYC information that the lender will rely on to make a commercial decision about the liquidity and financial strength of such HNWI and their ability to meet capital commitments to the HNW Aggregator Fund, but also to ensure that such lender is in compliance with applicable regulations. In some cases, lenders rely on HNW Aggregator Fund sponsors to make representations with respect to HNWI creditworthiness. Lenders may find it difficult to place such a high reliance on a third-party HNW Aggregator Fund sponsor to provide such critical information.

An additional area of concern for lenders with respect to Feeders is the ability to directly enforce capital calls related to the investors that comprise such Feeder. In a typical Facility, if a Fund defaults on its obligations to the lender, the lender has the ability to enforce the Fund’s rights to make capital calls on investors in the Feeder. The ability of a lender, however, to exercise this right when facing a Feeder may be limited, if not entirely restricted, due to the relationship that the Feeder has with the Fund and/or the Fund sponsor. A Feeder may be unwilling or unable to grant a lender the ability to enforce capital calls related to the capital commitment of its investors. Removing this important security feature from the remedies available to a lender in the event of a default by a Fund creates uncertainty for a lender when relying on investors in a Feeder as a source of repayment under a Facility.

Potential Structures for Feeder Funds in Subscription Facilities

There are a few different approaches that can be taken with respect to integrating a Feeder into a Facility. The specific approach can be determined by Funds and lenders, with input from experienced legal counsel, depending on a number of factors, including the borrowing base needs of the Fund. Below, we detail a few common approaches.

Treat as a Non-Included Investor and Disregard. A lender and Fund may choose to exclude a Feeder from the borrowing base under a Facility and disregard the capital commitment of the investors in such Feeder for purposes of repaying any obligations thereunder. This approach, while not preferable from the standpoint of a Fund, might be the easiest solution if the Fund determines that the borrowing base would not be significantly increased by the inclusion of such Feeder, or that any increase in the borrowing base is not desirable given the Fund’s anticipated borrowing needs.

Treat as an Included Investor with a Reduced Advance Rate. Instead of electing to exclude a Feeder from the borrowing base entirely, the concerns of a lender may be mitigated by negotiating a lower advance rate against the capital commitment of any investor that is included in a Feeder. For example, a lender under a Facility may advance against the commitments of an HNW Aggregator Fund based upon representations of the sponsor of such HWN Aggregator Fund as to the identity and financial strength of the investors.

Add to the Facility as a Loan Party. Beyond borrowing base concerns related to Feeders, lenders and Funds will also need to consider how best to structure the security package to accommodate the Feeder and give borrowing base credit to the investors in such Feeder. The security package that a lender may receive in connection with a Facility that includes Feeders will typically be structured as that of a direct guarantor or a cascading pledge.

Direct Guarantor. In a direct guarantor structure, each Feeder will make a direct guaranty in favor of the lender of the obligations of the Master, as borrower, under the Facility. This approach will create privity between the lender and each Feeder with respect to the obligations under the Facility. Documenting this security structure will require a guaranty issued by each Feeder in favor of the lender and creates joint and several liability among the Master and the Feeders for the Facility obligations. In the event that a default occurs under a Facility, the lender would have the ability to call on the investors of each direct guarantor Feeder to repay the obligations of the Master.

Cascading Pledge. The ability of a Feeder to give a direct guaranty to a lender under a Facility may not be permitted in some instances, specifically in instances where the assets of a Feeder constitute plan assets under ERISA (as discussed in greater detail above) and prohibit such a direct transaction with the lender under such facility or where there may be tax concerns related to a Feeder. In such instances, a cascading pledge structure may be used instead, whereby each Feeder will separately pledge its rights with respect to the capital call commitments of its investors to the Master, or to any intermediate entity. In turn, the Master will pledge its assigned rights of enforcement to the lender. Such a structure will avoid any direct transaction between the Feeder and the lender under a Facility.

The documentation of a cascading pledge structure typically includes separate security agreements between each Feeder and the Master, with a back-to-back security arrangement between the Master and the lender. The cascading pledge structure will only result in several liabilities on behalf of the individual Feeders, and will ultimately give the lender enforcement rights with respect to the capital commitments of all the relevant investors. In a cascading pledge structure, the obligations of the Feeder will be limited solely to the amount of the capital commitment of such Feeder to the Master or applicable intermediate entity and will not be directly tied to any obligations incurred by the Master (or any other Feeder) under the Facility.

A properly structured security package will allow a Fund to fully leverage the capital commitments of all investors in Feeders and allow lenders to rely on the capital call commitments of all investors in Feeders to secure the obligations of the Master under a Facility.

Conclusion

The growing complexity of Funds and their increased reliance on Feeders requires that lenders and Funds recognize the dynamics of the capital call commitments for investors in Feeders and the implications Feeders can have on the borrowing base and security structure of any Facility. Experienced legal counsel can assist both lenders and Funds in balancing the needs of a lender for adequate security and diligence with respect to investors against the ability of a Fund to utilize the available borrowing base of investors in Feeders to the fullest extent. Properly structuring and documenting these types of Facilities can facilitate and meet the needs of both lender and Fund.

Endnotes

1 This article is not intended to be used, and should not be used, for tax advice under US tax law.

2 For a general description of ERISA issues related to lending to real estate, private equity and other investment funds, please see our Fund Finance Market Review, Summer 2013, starting on page 19.

3 See 29 C.F.R. § 2510.3-101. For ease of reference, references to the “plan asset regulation” should be deemed to include Section 3(42) of ERISA.

4 The “less than 25% exception” is available for an entity if less than 25 percent of each class of equity interests in the entity are owned by “benefit plan investors” (as defined under ERISA). A privately offered investment fund relying on the operating company exception will typically do so by seeking to qualify as either a “real estate operating company” or a “venture capital operating company” (each as defined under ERISA).

5 Form ADV requires each investment adviser to state how many clients of such investment adviser are “high-net-worth individuals.” The Form ADV Glossary of Terms explains that a “high-net-worth individual” is an individual with at least $1 million managed by the reporting investment adviser, or whose net worth the investment adviser reasonably believes exceeds $2 million (or who is a “qualified purchaser” as defined in section 2(a)(51)(A) of the Investment Company Act of 1940).

6 Alden, William, “Private Equity Titans Open Cloistered World to Smaller Investors,” October 20, 2014, New York Times, http://dealbook.nytimes.com/2014/10/20/ private-equity-titans-open-cloistered-world-to-smallerinvestors/?_r=1.

7 For a more detailed description of the subscription facility market and features of the subscription-backed credit facility product in general, please see our article “Summer 2013 Market Review,” in Fund Finance Market Review, Summer 2013 on page 19.