Infrastructure funds are private equity vehicles that invest in a wide range of assets—including assets that could be described as transportation, energy and utility, communications, and “social” infrastructure, and investments that may be specific to a particular asset or in a company that develops such assets or is otherwise involved in their operation. Like other private equity funds, they have limited lifespans, typically five to ten years. They often attract capital commitments from investors with appetites for relatively stable, long-term cash flows, many of which have liabilities stretching over several decades. General partners of infrastructure funds are often able to leverage those commitments during the investment period.

In recent years, institutional investors have felt increased pressure to search for higher returns and diversify from traditional asset categories such as public equities and fixed income instruments. After slumping in 2011, fund-raising by infrastructure funds improved significantly in 2012 and 2013, with capital raised in the first three quarters totaling $19 billion.1 Despite an increase in the average fundraising lifecycle,2 not only did capital commitments to infrastructure funds continue to grow, investors indicated that they were looking to expand their infrastructure allocation.

Pension funds are notably increasing their exposure. The Alaska Retirement Board committed $300 million to two infrastructure funds—$200 million to IFM Global Infrastructure Fund and $100 million to J.P. Morgan Infrastructure Investments Fund—and has a long-term infrastructure target allocation of 12.5% within the real assets portfolio, or 2.125% of total plan assets.3 The Kentucky Teachers’ Retirement System committed $100 million to IFM’s Global Infrastructure Fund,4 and the Missouri Education Pension Trust committed $75 million to Alterna Core Capital Assets Fund II.5 The $420 million Chicago Park Employees’ Pension Fund entered the infrastructure space by committing $10 million each to infrastructure funds managed by Ullico Investment Co. and Industry Funds Management.6 There is, however, considerable room for growth among pension funds. According to a new report from the Organization for Economic Co-Operation and Development (OECD), unlisted equity and debt infrastructure investments for the 69 survey respondents amounted to only 0.9% of total respondent assets.7

This growth is being driven by renewed demand for stable, long-term returns in a lower-yield environment, and a variety of “infrastructure” asset classes are filling that demand. With respect to power production, renewables have been popular, and the largest independent power producers were able to take operating assets into the public markets in ways that provide attractive exit opportunities. In 2013, Pattern Renewable Energy and NRG publicly listed “yieldcos,” which aggregate the cash equity return from utility-scale power projects that have debt and tax equity financing. Several other renewable energy developers are in the process of evaluating if such a structure would benefit them.

In the transportation space, several states moved forward with initiatives to facilitate private investment in toll roads and other similar assets, and successful project completions in recent years leads some to believe that future formations of such partnerships are likely. Virginia is moving ahead with a series of PPP toll road procurements following the successful completion of its I-495 Express Lanes project, which at $2 billion was delivered on time and on budget. In November 2013, the New Jersey Turnpike Authority put out a request for proposals seeking bids for toll collection services, including management of the electronic tolling system and the toll collectors.8 MAT Concessionaire, LLC (MAT) received a 35-year concession agreement, which includes 55 months for design and construction, for the Port of Miami tunnel project, one of the first to make use of availability payments. Design and construction costs are currently at $663 million. MAT will be paid $156 million in milestone payments during construction and a $350 million payment upon final acceptance of the construction works. The majority of MAT’s equity is being provided by a Meridiam infrastructure fund.

A number of infrastructure funds are also seeking to satisfy the need for debt as an alternative to traditional bank and bond financing at the project level.9 Of the 1,700+ active investors in the infrastructure asset class tracked by Preqin, as of February 2013, 285 were actively considering debt investment opportunities. Darby Overseas Investments has raised three debt funds totaling $442 million, and Allianz Global Investors is currently working on a £1 billion UK-focused debt fund that will provide debt financing to a wide range of both economic and social infrastructure projects.10

While investor appetite for the various infrastructure asset classes continues to grow, so have fundraising challenges for a variety of reasons, first among them the record number and aggregate target of all funds in market.11 (A consequence of the crowded fundraising environment is the increasing use of placement agents to assist in the fundraising process, and with reason—over the past two years, infrastructure funds that have used placement agents have been more likely to meet or exceed fundraising targets and to reach financial close.12) Investors indicate that the most attractive managers are those with cohesive and concise plans, a focus on high cash yield and defensive and predictable investments, a healthy deal pipeline, and, most importantly, strong past performance.13 (Globally, the top ten infrastructure fund managers account for 45% of capital raised by infrastructure funds in the last ten years, and the largest firm, Macquarie Infrastructure and Real Assets, raised over six times the amount raised by the tenth largest firm, LS Power Group, but that percentage has dropped in recent years as more firms have entered the asset class.14) Current portfolios of infrastructure fund limited partners demonstrate a preference for regional-focused funds, but there is increasing preference for geographic diversification as well.15

Further increasing pressure on fund managers is the trend for large, sophisticated institutional investors to bypass infrastructure funds entirely and make direct investments.16 While the motivations vary—to avoid paying fund management fees and lower carrying costs, increase control over asset disposition decisions, deploy additional capital, and avoid the disposition of assets that could continue to generate steady returns—making direct investments requires significant investments in manpower and the development of a variety of skills. In addition to performing upfront technical, legal, regulatory, and financial diligence, such investors need project management and asset divestiture expertise. While only the largest and most sophisticated investors are able to execute such a direct investment strategy effectively, direct investments and co-investments are increasingly utilized,17 and investors are conditioning fund commitments on the ability to retain control of key investment decisions, including investment horizons.18

In assessing infrastructure investments, investors and fund managers face a variety of concerns that are less relevant in other asset classes. In particular, the stability of the applicable regulatory regime, and the possibility of changes in law that may materially impact investments, are often critically important inquiries. For investments in emerging markets, the risks of adverse action by local governments come to mind fairly readily, but such actions have major impacts in developed markets as well. The renewable sector provides particularly clear examples. Spanish solar tariffs were reduced retroactively, Germany’s were cut prospectively, and elections in Ontario, Canada, were in large part a referendum on the province’s renewable energy programs. In the United States, key federal tax incentives have repeatedly been renewed and extended only on short-term bases, and there is concern about the deferral of state renewable mandates and the implementation of reliability and market-efficiency mandates by quasi-governmental grid operators. Other infrastructure asset classes present similar concerns. The privatization of government-owned assets generally requires express legislative or municipal authorization, which can be heavily conditioned, and is often subject to intense public scrutiny that may lead to renegotiation, as occurred last summer with respect to the City of Chicago’s parking concession.

Infrastructure funds face uncertainties less relevant to funds than investments in other asset classes—for example, the significant risk of statutory and regulatory change affecting existing and target assets, the prevalence of pension and sovereign investors that have strong motivations to bypass the fund structure in favor of direct and co-investments, and the range of expertise needed to diligence and manage such a broad category of assets. Their recent growth, and the momentum of that growth, suggests that that the industry is able to turn such challenges into opportunities. We expect that it will continue to do so, and that the financing structures the industry utilizes will continue to evolve as well.

Endnotes

1 The Preqin Quarterly Update: Infrastructure (Preqin, New York, N.Y.), Oct. 2013.

2 Infrastructure Fundraising: Time on the Road, Infrastructure Spotlight (Preqin, New York, N.Y.), Oct. 2013, at 2.

3 Kevin Olsen, Alaska Retirement Board Earmarks $300 Million for 2 Infrastructure Funds, Pensions & Investments (Sept. 25, 2013, 2:14 PM).

4 Infrastructure Investor Research & Analytics: Infrastructure Investor Half Year Fundraising Review 2013, 1, 7 (Ethan Koh Ke Ling ed., 2013).

5 Rob Kozlowski, Missouri Education Pension Trust Commits to Infrastructure, Real Estate, Pensions & Investments (Oct. 29, 2013, 3:17 PM), http://www. pionline.com/article/20131029/ONLINE/131029859/ missouri-education-pension-trust-commits-to-infrastructure-real-estate.

6 Kevin Olsen, Chicago Park Employees’ Pension Fund Takes First Step Into Infrastructure, Pensions & Investments (July 31, 2013, 3:04 PM).

7 Kevin Olsen, OECD: World’s Largest Pension Funds Slow to Take on Infrastructure Investing, Pensions & Investments (Oct. 18, 2013 6:43PM), http://www. pionline.com/article/20131018/ONLINE/131019864/ oecd-worlds-largest-pension-funds-slow-to-take-oninfrastructure-investing.

8 Mike Frassinelli, Toll Collector Jobs on N.J. Turnpike, Parkway Likely to be Privatized, NJ.com (Nov. 19, 2013 6:17PM) http://www.nj.com/news/index. ssf/2013/11/toll_collector_jobs_on_nj_turnpike_parkway_likely_to_be_privatized.html.

9 BlackRock Infrastructure Debt Team, BlackRock: Bridging the Gap—The Rise of Infra Funds in Privately Financed Infrastructure, CFI (Oct. 29, 2013), available at http://cfi.co/europe/2013/10/ blackrock-bridging-the-gap-the-rise-of-infra-funds-inprivately-financed-infrastructure

10 Paul Bishop, A Recipe for Infrastructure Fundraising Success in the Post-Crisis Marketplace—Placement Agents, Preqin Blog (Mar. 20, 2012), https://www. preqin.com/blog/101/4953/ infrastructure-placement-agent.

11 Q3 2013, The Preqin Quarterly Update: Infrastructure (Preqin, New York, N.Y.), Oct. 2013, at 2.

12 Infrastructure Fundraising: Future Prospects, INFRASTRUCTURE SPOTLIGHT (Preqin, New York, N.Y.), Nov. 2012, at 2, 4.

13 Infrastructure Fundraising: Future Prospects, INFRASTRUCTURE SPOTLIGHT (Preqin, New York, N.Y.), Nov. 2012, at 2, 4; Arleen Jacobius, Heydays Past, Infrastructure Firms Feel Heat, PENSIONS & INVESTMENTS, Aug. 5, 2013, available at http:// www.pionline.com/article/20130805/ PRINT/308059979/ heydays-past-infrastructure-firms-feel-heat.

14 Press Release, Preqin, The Top 10 Infrastructure Fund Managers Account for 45% of Capital Raised by Infrastructure Funds in the Last 10 Years (July 17, 2013).

15 Infrastructure Investor Research & Analytics: Infrastructure Investor Half Year Fundraising Review 2013, 1, 7 (Ethan Koh Ke Ling ed., 2013).

16 Tim Burroughs, Infrastructure Funding: A Beast with Two Heads, ASIAN VENTURE CAPITAL J., Sept. 25, 2013, available at http://www.avcj.com/avcj/analysis/2296692/asian-infrastructure-a-beast-with-two-heads.

17 Annual Survey of Large Pension Funds and Public Pension Reserve Funds, 14 (OECD, Oct. 2013).

18 Infrastructure Investor Research & Analytics: Infrastructure Investor Half Year Fundraising Review 2013, 11 (Ethan Koh Ke Ling ed., 2013).

Due to previous challenges in the United States fundraising market for sponsors of real estate, private equity and other investment funds (each a “Fund”), many Fund sponsors have sought to expand their sources of capital to include investors domiciled outside of the United States (“Foreign Investors”). As such, Fund sponsors are increasingly requesting that the unfunded capital commitments of these Foreign Investors be included in the borrowing availability (the “Borrowing Base”) under the Fund’s subscription credit facility (a “Subscription Facility”).

While traditionally Funds have not chosen their lenders solely based upon whether such lender would include Foreign Investors’ capital commitments in the Borrowing Base, it is becoming a more critical factor. Consequently, understanding and addressing collateral enforceability issues related to Foreign Investors has become increasingly important for lenders. Below we set out our views on common concerns regarding collateral enforceability and some possible solutions for minimizing such risk.

Subscription Credit Facilities and Foreign Investors

A Subscription Facility, also frequently referred to as a capital call facility, is a loan made by a bank or other credit institution (a “Lender”) to a Fund. The defining characteristic of such Subscription Facility is the collateral package, which is comprised not of the underlying investment assets of the Fund, but instead by the unfunded capital commitments (“Capital Commitments”) of the limited partners of the Fund (the “Investors”) to make capital contributions (“Capital Contributions”) when called from time to time by the Fund’s general partner (the “General Partner”). The loan documents for the Subscription Facility contain provisions securing the rights of the Lender, including a pledge of (a) the unfunded Capital Commitments of the Investors, (b) the right of the General Partner to make a call (each, a “Capital Call”) upon the Capital Commitments of the Investors after an event of default accompanied by the right to enforce the payment thereof, and (c) the account into which the Investors fund Capital Contributions in response to a Capital Call. Such rights of the Fund and its General Partner are governed by the Fund’s constituent documents, including its limited partnership agreement or operating agreement (collectively, the “Constituent Documents”).

Lenders have become comfortable with this collateral package because of (i) their ability to select high-credit quality Investors whose Capital Commitments comprise the Borrowing Base, and (ii) in the event that an Investor fails to fund its Capital Commitments, ability to enforce payment of its Capital Contributions in and under the laws of the United States. However, as the momentum toward including Foreign Investors in the Borrowing Base increases, Lenders are facing new challenges, including (i) the ability to determine the credit quality of Foreign Investors and (ii) the ability to enforce the payment of Capital Contributions from these Foreign Investors.

Key Issues

The three primary collateral enforceability issues that arise in connection with Foreign Investors include (i) as with all Investors, obtaining financial and other information during the due diligence process necessary to properly assess such Foreign Investor’s creditworthiness; (ii) obtaining jurisdiction in the courts of the United States over such Foreign Investor; and (iii) enforcing judgments issued by a court of the United States against such Foreign Investor.

Due Diligence

The Subscription Facility due diligence process typically includes obtaining and reviewing (i) the Constituent Documents of the Fund; (ii) the form subscription agreements (“Subscription Agreements”) executed by each Investor detailing, among other things, such Investor’s willingness to be bound by the terms and conditions of the Constituent Documents and disclosing, among other things, certain information of such Investor; and (iii) other side agreements (“Side Letters” and, together with the Subscription Agreements, the “Subscription Documents”) detailing alterations or exceptions, if any, to the Fund’s partnership agreement and/or the form of Subscription Agreement.

For Investors domiciled in the United States (“US Investors”), Lenders have typically included in the Borrowing Base investment-grade, noninvestment grade and non-rated institutional Investors. Assessment of the credit quality of such Investors has been relatively uncomplicated. Conversely, with regard to Foreign Investors, Lenders have been reluctant to assess their credit quality, often citing lack of financial information, which Foreign Investors are reluctant to provide for confidentiality reasons.

Nevertheless, Fund sponsors are becoming more aware of the need to obtain financial information from their Foreign Investors and are raising the matter earlier in the solicitation process. We anticipate that acquiring financial information from Foreign Investors whom the Fund would like included in the Borrowing Base will become a more customary part of the overall diligence process. However, many Foreign Investors have and are continuing to push back on requests for non-public information. It is not uncommon for a Foreign Investor to negotiate such a provision in its Side Letter with the caveat that it will cooperate with reasonable information requests from the Fund sponsor if necessary in connection with obtaining a Subscription Facility. Lenders will almost certainly require financial information from the Foreign Investor (or its parent entity) before giving the Fund full Borrowing Base credit for such Investor (credit that is typically at a 90% advance rate). Where the Foreign Investor is a subsidiary or special purpose vehicle owned by a parent entity with substantial credit quality, a guarantee or comfort letter providing direct credit linkage to the parent will often be required by Lenders before giving full Borrowing Base credit to the subsidiary or special purpose vehicle. Lenders are more often than not gaining comfort regarding credit quality from most Foreign Investors by obtaining financial and/or other information regarding such Foreign Investors from publicly available sources. We have also seen, and expect to see more, Lenders cooperating with their foreign affiliates to obtain additional information. Lenders relying on such information are often giving creditworthy Foreign Investors some Borrowing Base credit (at times at a 60-65% advance rate), which are often subject to tight concentration limits (both individually and as a class of Foreign Investors) and sometimes even skin-in-the-game tests aimed to limit the Lenders’ risk and overall exposure to this class of Investor. We expect to see the treatment of Foreign Investors develop over the coming years as the information becomes more transparent and these Investors become more critical to a Fund’s Borrowing Base.

Jurisdictional Issues

Foreign Investors can take the form of either individuals or entities, including governmental pension plans, state endowment funds, sovereign wealth funds and other instrumentalities of foreign governments (“Governmental Investors”). Such Governmental Investors are becoming more prevalent and are often some of the largest Investors in the Investor pool. For Lenders, the common concern with including such Investors in the Borrowing Base has been whether certain sovereign immunity rights, rooted in the common law concept that “the King can do no wrong,” could provide a defense against enforcement of such Investor’s obligation to make Capital Contributions after an event of default. Although sovereign immunity in its purist form could shield a governmental entity from all liability, Governmental Investors must be evaluated on a case-by-case basis to ascertain if any sovereign rights apply and, if so, whether such Investor has effectively waived its immunity.1

With regard to Foreign Investors generally, some Lenders have been reluctant to include such Investors due to concern with litigating and enforcing judgments in a United States court. A United States court’s ability to hear a case involving allegations against a foreign person or entity is governed by the laws of the applicable state and the Constitution. The laws of most, if not all, states provide that parties to a contract may select their governing law and venue for litigating disputes arising under such contract. For this reason, most, if not all, Subscription Documents and Constituent Documents include these provisions. Most often, either New York or Delaware is selected as the governing law and venue under these documents. Furthermore, most, if not all, Constituent Documents include provisions that would allow the General Partner (or Lender in the case of a default and failure of such Foreign Investor to fund its Capital Contribution) to liquidate the applicable Foreign Investor’s partnership interest or offset damages against distributions that would otherwise be payable to the Foreign Investor.

Lenders can additionally gain comfort by obtaining Investor consent letters, also commonly referred to as Investor letters or Investor acknowledgments (“Investor Letters”), wherein such Foreign Investor would confirm its unconditional obligation to fund its Capital Contribution, in accordance with the Subscription Documents and Constituent Documents. These letters could also address forum, venue and sovereign immunity provisions directly in favor of the Lenders. To the extent that forum and venue selection provisions are included in the Subscription Documents, Constituent Documents or Side Letters, the Lender can seek to enforce such provisions against a defaulting Foreign Investor, as assignee of the General Partner’s rights, under the collateral documents of the Subscription Facility. Such Lender could file a lawsuit or arbitration claim directly against such Foreign Investor in the applicable United States court or tribunal. While service of process on such Foreign Investor is always a concern when filing such a lawsuit or arbitration claim, Lenders could gain comfort by requesting in an Investor Letter (i) the designation of a United States entity to accept service of process and/or (ii) the express waiver of any objection as to adequacy of such service of process, so long as it has been effected. Similarly, as Fund sponsors become more aware, it is likely that such Fund sponsors will include comparable provision in Subscription Documents and Side Letters. Alternatively, the inclusion of arbitral provisions in Subscription Documents, Constituent Documents or Side Letters would avoid recognition and enforcement issues in most instances and would mitigate sovereign immunity claims in the case of most Governmental Investors. Immunity concerns (except to the extent otherwise covered in the Foreign Investor’s Subscription Documents, Side Letters or Investor Letters) could additionally be overcome via the Foreign Sovereign Immunities Act of 1976 and the exceptions included within Sections 1605-1607 thereof, including an exception for commercial activity that has a nexus to the United States.

Enforcement of Judgments

If a judgment is obtained against a Foreign Investor in a United States court, it may be difficult for the Lender to enforce such judgment against such Investor in the United States, unless such Foreign Investor has assets in the United States that are not otherwise subject to immunity. Therefore, the concern for many Lenders is whether such judgment could be enforced against such Foreign Investor in its country of domicile. While there is currently no treaty between the United States and any other country regarding recognition and enforcement of judgments, the United States is a party to some multilateral treaties requiring the recognition and enforcement of arbitral awards. For this reason, it is generally advisable to include submission to arbitration provisions in Subscription Documents, Side Letters and Investor Letters, as applicable, in which Foreign Investors are a party.

To the extent that enforcement is sought in the Foreign Investor’s country of domicile, the law of such country will determine whether any judgment is enforceable. Most countries with developed legal systems do have laws that provide for the recognition of legitimate judgments issued abroad. If the amount of damages does not appear excessive, foreign countries will typically consider, among other matters, whether (i) the court had proper jurisdiction, (ii) the defendant was properly served or otherwise had sufficient notice, (iii) the proceedings were fraudulent or otherwise fundamentally unfair, and (iv) the judgment violates the public policy of such foreign country. As with most litigation involving foreign parties, local foreign counsel should be consulted as to the particular laws of the applicable country.

Conclusion

As fundraising challenges persist, Funds will continue to seek additional sources of capital, including Foreign Investor capital. As Lenders adapt to meet the changing needs of their clients, we expect to see the Capital Commitments of Foreign Investors being included in the Borrowing Bases of more Subscription Credit Facilities. Those Lenders that can quickly and effectively evaluate the creditworthiness of these investors will be well-positioned to receive additional opportunities from their Fund clients.

Endnotes

1 “Sovereign Immunity Analysis in Subscription Credit Facilities,” Mayer Brown Legal Update, November 27, 2012, on page 9.

As the subscription credit facility market matures,1 lenders seeking a competitive advantage are expanding their product offerings to private equity funds (a “Fund”) from traditional capital call facilities made to closed-end Funds to other financing products, including lines of credit to open-ended Funds, separate-account vehicles and net asset value facilities.2 Another emerging product gaining traction in the market with some Fund sponsors (a “Sponsor”) is a so-called management fee credit facility (a “Facility”). A Facility is a loan made by a bank or other financial institution (a “Lender”) to the general partner (the “General Partner”) of the Fund or a Sponsor-affiliated management company or investment advisor (collectively, the “Management Company”) of a Fund, and has a collateral package that is distinct from other types of security arrangements commonly associated with Fund Financings

The basic collateral package for a Facility consists of the General Partner’s or Management Company’s, as applicable, right to receive management fees (“Management Fees”) under the Fund’s limited partnership agreement (the “Partnership Agreement”) or other applicable management or investment advisory agreement (the “Management Agreement”), and rights related thereto, together with a pledge over the deposit account into which the Management Fees are paid (the “Collateral Account”). A control agreement among the General Partner or Management Company, the Lender and the depository bank would be needed to perfect the Lender’s security interest in the Collateral Account. Additionally, since the General Partner, the Management Company or another Sponsor-affiliated entity (a “Special Limited Partner”) generally has an equity investment in the Fund, the security for a Facility may also include a pledge by such entity or other Sponsor-affiliated investing entity’s right to receive distributions from the Fund and, in some instances, its limited partnership interest.

Background

In a typical Fund structure, the General Partner or the Management Company receives Management Fees as compensation for evaluating potential investment opportunities, providing investment advisory services and attending to the day-to-day activities of managing the Fund.3 The Management Fee also covers operating expenses (such as overhead, travel and other general administrative expenses) as well as salaries for the Management Company’s investment professionals and other employees. The Management Fee payable by an Investor is often determined by multiplying a percentage4 times such Investor’s capital commitment. In addition, some Management Fee structures include a component that is based on the Fund’s performance so as to provide additional incentive to the General Partner or the Management Company to maximize the Fund’s performance.

Facilities are becoming increasingly popular for a number of reasons. First, Sponsors may find a Facility attractive because it provides the Sponsor (or applicable affiliated entity) with immediate capital to smooth its cash flow and pay operating expenses in between the typically quarterly or semiannual payments of the Management Fees it receives. Second, post-economic downturn, Investors are increasingly interested in seeing Sponsors make larger investments in the Funds they manage to increase their “skin in the game” and further align the Sponsor’s and Investors’ interests in maximizing Fund performance. By leveraging the income stream from future expected Management Fees, a Facility may help enable a Sponsor or its Special Limited Partner to make a larger commitment to a Fund than it otherwise may be able to commit. Also, to the extent a Sponsor or its Special Limited Partner is an Investor in a Fund, a Facility may be drawn on short notice to permit the Sponsor or Special Limited Partner to honor a capital call prior to receipt of cash from the principals or employees that ultimately constitute the Sponsor or Special Limited Partner. From the Lender’s perspective, aside from earning revenue from the fees and interest income generated by a Facility, providing a Facility to a Fund is also a chance for the Lender to broaden its relationship with the Sponsor and develop a deeper understanding of the Sponsor’s business and its potential financing needs. This in turn may lead to opportunities for a Facility Lender to provide other products such as subscription credit facilities, net asset value facilities, portfolio-company level financings or perhaps even private wealth products to the Sponsor’s principals.

While there are many potential benefits to both a Sponsor and a Lender associated with a Facility, it is important to note that a Facility is best-suited for established Sponsors that have significant Fund management experience and a proven track record of receipt of the Management Fees, ideally from a diverse platform of Funds. Management experience and an uninterrupted history of receiving the Management Fees are important because the Lender is ultimately looking to the Management Fees as the source of repayment of the Facility in underwriting the risk associated with lending to a particular Sponsor.

Even though Management Fee performance history and management experience of a particular Sponsor may make it an ideal candidate for a Facility, as more fully described below, not all Funds will have Partnership Agreements, Management Agreements or Management Fee structures that are suitable for a Facility. Further, some Partnership Agreements limit the General Partner’s or Special Limited Partner’s right to pledge its equity interest in the Fund, although, a pledge of any distributions associated with such equity interest may be possible. Thus, the Partnership Agreement and/or Management Agreement must be carefully analyzed to confirm that the intended collateral can be granted to the Lender and the Lender will be able to adequately enforce its rights against the collateral.

Structure and Loan Documentation

Facilities are typically structured as revolving lines of credit to the General Partner or Management Company (depending on the Fund’s structure), secured by a pledge by the General Partner or the Management Company of its right to receive the Management Fees and the account into which such Management Fees are paid. If the Sponsor group has made an investment in the Fund through a Special Limited Partner or other affiliated entity, the collateral package may also include a pledge of the right to receive distributions from the Fund and the account into which such distributions are paid. If the Sponsor manages more than one Fund, the collateral package may include Management Fee streams from multiple Funds and the right to distributions from those Funds.

The basic loan closing documentation for a Facility will typically consist of (i) a credit agreement, (ii) a security agreement pursuant to which the General Partner or the Management Company assigns its rights under the Partnership Agreement or the Management Agreement, as applicable, to receive and enforce the payment of Management Fees and proceeds thereof, (iii) a pledge of the Collateral Account into which Management Fees are to be paid, (iv) a control agreement covering the Collateral Account to perfect the Lender’s security interest therein and permit the blocking of such account by the Lender, (v) a security agreement from the Special Limited Partner or other Sponsor-affiliated entity pledging its right to receive distributions from the Fund, if it is the part of the collateral package, together with a pledge of the deposit account into which such distributions are to be paid and a control agreement covering such account, (vi) Uniform Commercial Code financing statement(s) filed against the applicable pledging entities, and (vii) and customary opinion letters, certified constituent documentation of the Fund and pledging entities, evidence of authority and related diligence items.

In addition to the traditional collateral package, it is not uncommon for a Lender to receive a personal guarantee by one or more of the principals in the General Partner, the Management Company or Sponsor to support the Facility. The extent of such a guaranty is often negotiated, and it is not unusual for a principal’s guaranty to be limited to a capped amount based on its pro rata ownership percentage of the underlying Fund and the related outstanding balance of the Facility, as opposed to a more traditional unlimited (or joint and several) guaranty of the Facility. A guaranty may also be delivered by the Special Limited Partner, the General Partner or the Sponsor, depending on the structure of the Facility and the identity of the borrower under the Facility.

The terms of a Facility will typically include customary representations, warranties, affirmative and negative covenants and events of default that a Lender would expect to see in any secured financing, along with a few provisions that are tailored to address the unique features of a Facility’s collateral package. Such provisions may include a requirement that the General Partner or the Management Company receive a minimum amount of Management Fee income, or that the amount of Management Fees received does not fall below a certain specified percentage of the aggregate commitments of the Fund’s Investors. A Facility will normally include limitations on amending the Partnership Agreement or the Management Agreement, and prohibitions on terminating or waiving the General Partner or the Management Company’s right to receive payment of Management Fees. Additionally, so that the Lender can monitor the Fund’s overall performance (and have advance warning of potential performance issues that may give rise to a reduction in Management Fees or Investors balking at paying Management Fees), a Facility will usually require regular financial reporting and may also include a minimum net asset value test with respect to the Fund’s investments or a similar financial covenant with respect to the General Partner, Management Company or Special Limited Partner, as applicable, and its investment in the Fund. Some Facilities that include a pledge of distribution rights may contain a maximum loan-to-value or similar metric measured by looking at the Special Limited Partner’s pro rata share of the underlying portfolio investments in the Fund.

Partnership Agreement & Management Agreement Diligence

As part of due diligence for any Facility, a Lender must carefully review the Partnership Agreement and Management Agreement for any restrictions on the right of the General Partner or the Management Company to pledge its right to receive Management Fees or the Special Limited Partner’s ability to pledge its right to distributions. For example, a potentially problematic, though not uncommon, restriction is that the General Partner or Special Limited Partner cannot pledge its economic interest in the Fund, which would include its equity interest, without the consent of a certain percentage of the other Investors in the Fund. Some Partnership Agreements allow for such pledges without the consent of the other Investors while others do not. To the extent Investor consent is required, it may be an impediment to entering into a Facility.

In addition, the Partnership Agreement or the Management Agreement should be reviewed to determine how Management Fees are paid, and whether they may vary over time. For example, the Management Fee may decrease upon termination of the period in which the Fund is permitted to make new investments. It is important for the Lender to understand whether Management Fees are paid by the Investors directly to the General Partner or the Management Company, or if Management Fees flow through the Fund and/or the General Partner (or another affiliated entity) to the Management Company, as applicable, so that the relevant Fund-related entities are included within the scope of the collateral documents to minimize potential leakage, if necessary.

Some Partnership Agreements provide for Management Fee offsets, whereby receipt by the Sponsor, its principals, employees or other affiliates of advisory, break-up or other similar fees and income related to the investment activities of the Fund may reduce the amount of the Management Fee. The Partnership Agreement and the Management Agreement should be reviewed to determine if such offsets exist, and the Lender should consider whether the loan documentation should prohibit the General Partner or the Management Company from applying any discretionary offsets if possible. Alternatively, the Lender may consider requesting that any such advisory fees or other income or proceeds that may be offset against Management Fees be included as part of the collateral package in addition to Management Fees if the Fund’s documents permit it.

In underwriting a Facility, Lenders will want to keep in mind that while the Partnership Agreement and the Management Agreement will dictate whether a Facility is permissible and how and when Management Fees are to be paid, exogenous events may occur that could affect the payment of Management Fees. For example, in the late 2000s during the market downturn, Sponsors with troubled Funds in fact suspended or eliminated their Management Fees. Even though such activities would be prohibited by the loan documentation for a typical Facility, it is important for Lenders to consider the overall investment and economic environment in which a Fund operates, as market conditions may stress the underlying underwriting assumptions of a Facility.

Conclusion

While Management Fee Facilities have not been very common to date, they are becoming increasingly popular and offer an opportunity for a Lender to kick off or expand its relationship with a Fund Sponsor. With a careful review of the relevant operating and constituent documentation of a Fund, it may be possible to structure a Management Fee Facility to offer a seasoned Fund Sponsor increased liquidity while satisfying a Lender’s underwriting criteria. Please don’t hesitate to contact any of the authors with questions regarding these Facilities, including the various structures that can be implemented in connection with their establishment.

Endnotes

1 A subscription credit facility, also known as a capital call facility, is a loan made by a bank or other credit institution to a private equity fund, for which the collateral package is the unfunded commitments of the limited partners in the fund (the “Investors”) to make capital contributions when called by the fund’s general partner (as opposed to the underlying investment assets of the fund). For a more detailed description of the subscription credit facility market and features of the subscription credit facility product in general, please see Mayer Brown’s Fund Finance Markets Legal Update “Summer 2013 Market Review” on page 19.

2 For an in-depth analysis of certain alternative Fund financing products, please see Mayer Brown’s Fund Finance Market Legal Updates “Structuring a Subscription Credit Facility for Open-Ended Funds,” on page 31, “Separate Accounts vs. Commingled Funds: Similarities and Differences in the Context of Credit Facilities” on page 35 and “Net Asset Value Credit Facilities” on page 44.

3 Depending on the Fund’s structure, Management Fees may be paid by the Investors through the Fund or GP to the Management Company or directly to the Management Company.

4 Historically, the percentage has usually ranged from 1.5% to 2% per annum.

Capital call subscription credit facilities (each, a “Facility”) continued their positive momentum in 2013 and had an excellent year as an asset class. As in the recent past, investor (“Investor”) funding performance remained as pristine as ever, and the only exclusion events we are aware of involved funding delinquencies by noninstitutional Investors (in many cases subsequently cured). Correspondingly, we were not consulted on a single Facility payment event of default in 2013. In addition to the very positive credit performance, the asset class seemed to enjoy significant year-over-year growth. Below we set forth our views on the state of the Facility market and the current trends likely to be relevant in 2014

Material Growth and Its Drivers

While the Facility market currently lacks an industryaccepted data collecting and reporting resource making it difficult to pinpoint the exact size of the market, we are confident based on our experiences as well as anecdotal reports from multiple Facility lenders (each, a “Lender”) that the Facility market expanded materially in 2013. As one available data point, the Mayer Brown LLP Facility practice was up 66% in 2013 compared to 2012, measured by volume of consummated transactions. This positive growth for Facilities in 2013 was driven by a confluence of factors, not the least of which was the uptick in the fund formation market (especially in the United States). According to Preqin data for the U.S.-based fund market, 485 closed-end real estate, infrastructure and private equity funds (each, a “Fund”) raised an estimated $261 billion in gross capital commitments in 2013, which represents the highest levels seen in the market since 2008. This baseline growth in the number of prospective Fund borrowers clearly seeded the Facility market’s growth, but other factors contributed extensively as well. We believe the Facility market would have expanded in 2013 even had the Fund formation market remained stagnant, as penetration into Funds that have historically not availed themselves of Facilities increased. Growth in 2013 was also supplemented by an increased recognition by Lenders of the quality of Facility collateral and, in reliance on that collateral quality, a greater comfort with customized Facility structures. Lenders clearly consummated Facilities in 2013, and included Investor capital commitments (“Capital Commitments”) in borrowing bases, that would not have satisfied underwriting requirements previously. Similarly, Funds extended many of their existing Facilities upon their maturity instead of calling capital and paying them off, in many cases even well after the termination of their investment periods. This continuity of use of Facilities throughout a Fund’s life cycle clearly contributed to 2013 growth as well.

Challenges

2013 was not all roses and champagne for the Facility market however, as certain very real challenges emerged. Fund formation was not up uniformly across the globe; Europe and Asia still report very challenging fundraising environments for Funds, especially for relatively new fund sponsors (each, a “Sponsor”). These challenges resulted in the deferral and in some cases impracticability of potential Facilities. For Lenders, spread tightening had a very real impact on internal returns, as virtually every amend and extend consummated in 2013 priced flat to down from its precedent. And Facility structures trending downward on the credit spectrum created challenges for virtually every Lender in terms of internal credit approvals and policy adjustments. But on the whole and despite these challenges, 2013 was a very positive year for the Facility market.

Key Trends

In our Summer 2013 Market Review, we identified four key trends that were impacting the Facility market: (i) the general maturation of the Facility product and market; (ii) the continuing expansion of Facilities from their real estate Fund roots into other Fund asset classes, and particularly, private equity; (iii) Fund structural evolution, largely responsive to the challenging fundraising environment and Investor demands; and (iv) an entrepreneurial approach among Funds to identify new Investor bases and new sources of Capital Commitments.1 We think these trends hold.

They bear repeating here because they will continue to have a material impact on the Facility market in 2014 and beyond.

But there are a number of additional trends that either presented or accelerated in the second half of 2013 that we believe will become increasingly relevant in the Facility market in the year ahead, including the following: (i) an improving global fund formation market, which will drive Facility growth in 2014, especially in international sub-markets; (ii) an influx of new market participants in particular Facility sub-markets, bringing different structuring standards and mixing up existing competitive balances; (iii) an expansion of Investor interest in Facilities, including the exercise of influence into Facility terms and structure; (iv) Lender recognition of the positive historical credit performance of Facilities and a resulting comfort in expanding traditional frameworks and going further down the credit spectrum; (v) a constantly evolving regulatory environment for Lenders coupled with real difficulty applying promulgated regulation to Facilities; and (vi) continuing stress on some of the largest Investors—municipal pension funds—and accelerating interest in procuring defined contribution plan monies for Funds. We analyze each below.

An Improving Global Fund Formation Market

We are seeing increased Fund formation activity globally, including in Europe and Asia which have been somewhat slower to emerge from the crisis. Based on 4th Quarter 2013 experiences and certain recent macroeconomic data, we are optimistic this positive trend will continue into 2014. According to Preqin data, non-North American based and focused Funds raised approximately $144.4 billion in capital in 2013, up slightly from 2012. Additionally, according to Preqin surveys, 34% of all expected Fund launches in the market are targeted with a geographic focus in Asia. Thus, our expectation is that a moderate to healthy increase in consummated Funds will lead to additional expansion of the Facility market in 2014, perhaps with the biggest growth occurring outside of the United States.

New Market Participants

The Facility market has for some time noted the efforts of new entrants (Lenders, law firms, etc.) trying to establish themselves in the space, each with different strategies and often with varying levels of success. In 2013 however, certain new entrant movements occurred or accelerated that have the potential to be disruptive to the historical competitive dynamics, at least at the margins. For example, multiple European Lenders are investing in and building their capabilities in the United States. Unlike some of their new entrant predecessors, these Lenders have real, demonstrable execution capabilities, if primarily in a different sub-market. Similarly and in reverse, many of the dominant US Lenders are increasingly attentive to Europe and Asia, recognizing the positive opportunities those sub-markets may hold. Several US-based Lenders had demonstrable success in 2013, at least in Europe. As Lenders emigrate in both directions, they bring their historical Facility structures and underwriting guidelines to the new sub-market. As a result, Funds are increasingly finding themselves with term sheets for Facilities that are no longer distinguishable only by Lender name and pricing. Funds are now weighing significant structural variation (a traditional borrowing base vs. a coverage ratio, as a simple example) in their Facility proposals.

Along a parallel path, multiple regional US Lenders are expanding beyond their historical geographies and middle-market Fund roots, often in efforts to keep up with the growth of their Fund clients. Many of such regional Lenders have increased their Facility maximum hold positions to levels comparable to that offered by the money center Lenders, at least for certain preferred Funds. In fact, several of the regional Lenders made substantial progress increasing their relevance in the greater Facility market in 2013. As their Facility structures and underwriting parameters often differ from a traditional Facility, they are also altering the competitive landscape. Correspondingly, variances in Facility structure dictate the syndication strategy and prospects for a particular Facility, adding additional complexity to a transaction.

Expansion of Investor Influence Into Facilities

Investor recognition and consideration of Facilities is increasing, and Investors are taking a more active look at how Facilities are structured and what their delivery obligations are in connection with a Facility. Investor side letters (“Side Letters”) now routinely incorporate provisions addressing the Facility, often displaying Investor efforts to carve back their delivery obligations to Lenders. We often see entire Side Letter sets with a limitation that Investors only need deliver financial statements made publicly available. Further, a few tax-exempt Investors have inserted themselves into Facility structuring, insisting that the parallel fund they invest through be only severally liable for borrowings under the Facility so as to preserve a more favorable tax structuring analysis with respect to the separation between the multiple parallel funds. Whether facilitated through the work of the Institutional Limited Partners Association or just via greater investing experience, Investors appear increasingly aware of the Facilities their Funds are entering.

Extension of Credit Guidelines

No doubt partly in response to both the excellent historical credit performance of Facilities and the competitive landscape, Lenders are increasingly willing to go further down the risk continuum than they have in the recent past. While this has been true for some time now with respect to the historical requirements for delivery from Investors of acknowledgment letters (“Investor Letters”) and legal opinions, we are now seeing a greater acceptance of less than ideal Fund partnership agreements (“Partnership Agreements”). Many Lenders are no longer requiring a near-verbatim recital of a historical form Investor Letter in the Partnership Agreement, but instead are accepting less explicit authorization and acknowledgment language. Similarly, Lenders are increasingly finding ways to get comfortable including municipalities with sovereign immunity issues, certain sovereign wealth funds and fund of funds in a borrowing base that have historically been excluded. We have also seen some shifting in view on Investor withdraw/ cease funding rights in relation to a Fund’s breach of its representations regarding placement agents and political contributions, with some Lenders now willing to partially accept this risk, at least in limited concentration scenarios. Further, we have seen a relatively significant expansion in the underwriting consideration of Fund assets, both in terms of supporting more aggressive borrowing bases and for mitigating other perceived credit weaknesses in a particular Facility, such as a tight overcall limitation. Notably, many Lenders are now actively considering NAVbased facilities or hybrid variations (especially for Funds later in the life cycle), and we expect these trends to continue as Lenders look for higher yielding opportunities.

Importantly, in our view, we think the data supports these trends. We see this as a rational expansion based on the greater availability of positive historical Investor funding and Facility performance data; we have not yet seen many Facilities consummated which we deemed unduly risky or reaching.

The Regulatory Environment

Lenders are, and have been since the crisis, facing a regulatory environment as challenging as we have seen in a generation. Many of the regulations emanating from the crisis are now moving to the finalization and implementation stages, and Lenders are having to adapt.

Moreover, additional regulations continue to be proposed. Virtually every post-crisis law and regulation that has been proposed or implemented is not express as to Facilities, and judgment must be applied to determine the appropriate impact. For example, the Volcker Rule’s application to Facilities, whether a Facility constitutes a “securitization” under the European securitization risk retention regulation CRD 122a and what outflow rate is appropriate under the recently proposed US Liquidity Coverage Ratio requirements are all occupying significant time at present.2 We think it is quite possible some of these regulations will lead Lenders to offer structural variations to their Facilities, such as uncommitted Facilities or uncommitted Tranches within Facilities, as a means of counteracting some of the regulatory capital burdens accompanying changing regulation. We expect the regulatory environment will be increasingly relevant in 2014, as Lenders adapt to the shifting landscape.

Municipal Pensions

Municipal pension funds (“Municipal Pensions”) in the United States, often the flagship Investors in Facilities, are under ever-increasing economic pressures. Despite the relatively robust performance of the equity markets in the United States and the significant rebound in many real estate markets in 2013, the outlook for Municipal Pensions to meet their prospective funding obligations seemed to get bleaker on a real-time basis last year. Many states are actively making efforts to enact reform, but such reforms are severely limited by constitutional protections for earned and accrued benefits, let alone political gridlock. The initial holding by the U.S. Bankruptcy Court for the Eastern District of Michigan that Detroit has the ability to alter its pension obligations under Chapter 9 of the U.S. Bankruptcy Code combined with Illinois’ massive funding deficiencies and reform struggles have furthered the uncertainty.3 We expect Municipal Pensions to occupy the headlines throughout 2014 and for a considerable period of time to come. We think these funding deficiency challenges are ultimately (although not promptly or easily) solvable, and we expect a major part of any solution will include a greater emphasis on defined contribution plans (“DC Plans”) for employees going forward. As a result, our expectation is that the credit profile of many Municipal Pensions will continue to trend negatively in 2014 and that Sponsors will be increasing their speed of pursuit of a Fund product for DC Plans. We forecast breakthroughs in this regard in 2014 and think Facility market participants should all be thinking about how the connection between DC Plans and Funds could best be structured to positively impact the Facility market.

Additional Trends

In the coming years, we also expect to see healthy growth in the volume and frequency of commitments to Funds by sovereign wealth funds and in the use of separate accounts by Investors.4 Preqin estimates show that in 2013 sovereign wealth funds surpassed the $5 trillion mark for total assets under management, a number which is up more than $750 billion from 2012 and nearly $2.5 trillion since 2008. Meanwhile, 19% of Investors surveyed by Preqin currently invest through separate accounts, as opposed to only 7% a year ago. 64% of those surveyed indicated that separate account commitments will become a permanent part of their investing strategy going forward. Thus, including sovereign wealth funds in Facility borrowing bases and single Investor exposure when lending to separate accounts will become increasingly relevant for Lenders going forward.

Conclusion

We project a robust Facility market in 2014 building on the growth and positive momentum experienced in 2013, but with challenges at the margins. We expect the number of Facilities consummated will continue to grow at a solid clip as fundraising improves, the product further penetrates the private equity asset class and a greater number of existing Facilities get refinanced. But we expect that Fund structural evolution, Investor demands and competitive dynamics will continue to challenge Facility structures and ultimately drive Facilities somewhat further down the credit continuum.

Endnotes

1 Summer 2013 Market Review, please refer to page 19.

2 For an in-depth review of applying the Liquidity Coverage Ratio to Facilities, please see Mayer Brown’s Legal Update, Capital Commitment Subscription Facilities and the Proposed Liquidity Coverage Ratio, on page 75.

3 For more information about the initial holdings in the Detroit, Michigan bankruptcy proceeding, see Mayer Brown’s Legal Update, Detroit, Michigan, Eligible to File Chapter 9 Bankruptcy, on page 127.

4 For more information regarding separate accounts, please see Mayer Brown’s article, Separate Accounts vs. Commingled Funds: Similarities and Differences in the Context of Credit Facilities, on page 35.

Despite continued challenges in the fundraising market for sponsors of real estate, private equity and other investment funds (each, a “Fund”), the positive momentum capital call subscription credit facilities (each, a “Facility”) experienced in 2012 has continued and perhaps accelerated in early 2013. And for good reason: on all the panels at the Subscription Credit Facility and Fund Finance Symposium in January of 2013 in New York City (the “SCF Conference”), mention by panelists of institutional investor funding delinquencies could be counted on one hand.

This type of historical investor (each, an “Investor”) funding performance of course translated to near perfect Facility performance through and coming out of the financial crisis. Yet despite the excellent Facility performance and the measured growth of the Facility market generally, there is growing recognition that certain trends in the market are creating very real challenges. Below we set out our views on the Facility market’s key trends, where they intersect and the resulting challenges and opportunities we see on the horizon.

Key Trends

There are four key trends in the market we see creating material impact: (i) the general maturation of the Facility product and market; (ii) the continuing expansion of Facilities from their real estate Fund roots into other Fund asset classes, and particularly, private equity; (iii) Fund structural evolution, largely responsive to the challenging fundraising environment and Investor demands; and (iv) an entrepreneurial approach among Funds to identify new Investor bases and new sources of capital commitments (“Capital Commitments”). We analyze each below

The Maturing Facility Market

Many Facility lenders (each, a “Lender”), Funds and other Facility market participants have for a long time benefited from the under-the-radar nature of the Facility market. While the market was certainly sizeable—for example, in 2011 Mayer Brown LLP alone worked on Facilities with Lender commitments in excess of $16 billion—it remained a niche in which only a subset of Lenders participated and was largely unknown to the greater financial community. That has certainly changed. The Facility product and its market recognition have matured and are continuing to grow rapidly for a variety of reasons, not the least of which was the publicity created by the sale of the WestLB AG, New York Branch Facility platform to Wells Fargo Bank, N.A. in 2012. Five years ago, the Facility market was operating in virtual obscurity; today it is a common staple familiar to nearly the entire finance community. DBRS has published rating criteria, an insurance company has approached Lenders offering to write credit enhancement on transactions or even individual Investor Capital Commitments and 400 people registered for the SCF Conference, up from 60 in 2010. There are certainly benefits to being in a more recognized market, but there are also growing challenges. On the plus side, management now fully understands the product, and has context when considering requests for resource allocations. A Fund sponsor’s (each, a “Sponsor”) CFO no longer needs to explain the product to his partners; they now understand the timing and internal rate of return benefits. Credit personnel analyzing Facilities now have a better grasp of both the embedded risks and the practical performance, leading to better structured and more accurately priced Facilities. But challenges abound. New entrants (Lenders, law firms, etc.) are eager to join the market, some with extensive understanding from lateral hiring and others with more limited degrees of experience. This creates pricing pressure (a positive or negative, depending on your side of the aisle), as new entrants are often forced to compete on price when they cannot credibly demonstrate execution capabilities. It also tends to lead to Facilities being consummated with security structures and collateral enforceability issues that are different or weaker than what has traditionally been deemed “market,” as newer participants are less tied to historical structures. Further, as the product matures and garners increased managerial attention, the inherent channel conflict at certain Lenders as to where within the institution to house the product often surfaces. Such channel conflict often leads to centralization of execution, as management realizes the disparities of credit standards and structures in different areas within the institution. Centralization of course leads to challenges, as both Fund relationships and execution experience are critical to a successful overall platform. Finally, a number of Lenders have become quite adept at providing Facilities, and have amassed impressive portfolios. In connection with these increasing exposures, these Lenders have rightfully garnered increased attention from the credit and risk management departments within their institutions. This increased attention often results in the creation of policies and procedures setting guidelines for what a Lender is able to do for the product and what items are outside of policy and require special considerations. Not surprisingly, these types of policies are being tested by the next several material trends.

Continued Expansion into Private Equity

Facilities are sometimes seen as a commodity product in the real estate Fund space, as some real estate Sponsors have been using the product for many years. This extensive experience has lead to provisions in limited partnership agreements (“Partnership Agreements”) that tend to adequately contemplate a potential Facility and incorporate the Investor acknowledgments and agreements that a Lender would like to see for a Facility. As real estate Fund Sponsors form new Funds, the precedent Partnership Agreement typically already has these provisions, they carry forward, and the new Fund is ready for a Facility upon its initial Investor closing. But other asset classes are different. As private equity, mezzanine, infrastructure, energy, venture and other Funds (and especially buyout Funds) have traditionally enhanced returns with asset level leverage and less so with Fund level debt (if they used leverage in the first instance), their predecessor Fund Partnership Agreements are frequently less explicit or developed with respect to a Facility. And, of course, when the next Fund is to be formed, Sponsors naturally want to keep revisions to the precedent Partnership Agreement as limited as possible so as to minimize the changes that need to be presented to prospective (and in many instances recurring) Investors. This often leads to a minimal language insertion authorizing the incurrence of debt and the pledge of Capital Commitments; language far less robust compared to what Lenders are traditionally used to seeing and relying on from real estate Funds. Further, Sponsors outside of real estate have more frequently included overcall limitations and other structural complexities, which prove challenging for Lenders.1 Thus, as Lenders continue to expand Facilities into Funds focused on private equity and other asset classes, they are increasingly challenged by Partnership Agreements that are less conducive to the Facility structure Lenders have grown to expect. This challenge is presenting almost weekly and standard setting for acceptability is going to be a key element for any Lender in the near future.

Fund Structural Evolution

Depending on your data source and region, 2012 fundraising was between flat globally and at best up just incrementally, especially in the United States. And while our fund formation practices have certainly seen some robust activity in early 2013, we remain guarded as to whether 2013 fundraising will materially outpace last year. The increased negotiation leverage of Investors derived from a difficult fundraising environment and their increased coordination facilitated in material part by the formation and advocacy of the Institutional Limited Partners Association is resulting in significant structural evolutions for Funds (especially outside of the real estate space, where traditional structures seem to be holding more firmly). Funds are increasingly structuring more tailored options for particular Investors (often to accommodate their particular tax or regulatory needs), leading to more Fund entities and more complicated Fund structures. We continue to see Investors making larger commitments to fewer, more seasoned Funds, increased use of separate accounts, sidecars and other co-investment vehicles, Investors committing through special purpose vehicles (each, an “SPV”), formation of Funds as open-ended or evergreen, and extensive concessions provided to material Investors. We have seen structures where certain parallel funds are “funds of one” that cannot be cross-collateralized, where Investors have cease-funding rights in the event the Sponsor fails to fund a capital call (a “Capital Call”), and where an Investor invests directly into a separate, newly formed SPV, created specifically for such Investor on a deal-by-deal basis. These are just a few examples of some of the trends.

To a Facility Lender, of course, “fund structural evolution” means: “Your collateral package is changing.” And, when you have a Lender-led trend toward the centralization of the product and the establishment of policies and guidelines, combined with a Fund trend of increased structural complexity designed to accommodate Investors (i.e., not accommodate Lenders), you have a natural tension. Thus, Lenders are working on getting their arms around things like the credit linkage between an SPV and the actual creditworthy Investor, how to efficiently add alternative investment vehicles as borrowers, and how to handle withdrawal rights related to violations of placement agent regulations. So an emerging challenge—and opportunity—is how to best manage this natural tension. How do Lenders develop policies that incorporate optionality into their product suite to accommodate a rapidly evolving Fund structural environment? For example, how does a securitization group tackle a Facility with a parallel fund of one that cannot be joint and severally liable but which has an investment grade Investor? How do Facilities with tight overcall limitations price compared to standard Funds without overcalls? How do you structure a Facility to an open-ended fund?3 And while these issues are certainly challenging, they clearly trend away from a commodity product, and, thereby, create opportunity. Bespoke structures require customized solutions, and because customized solutions cannot be provided by all, they afford the potential for attractive returns.

New Sources of Capital

As Sponsors have sought to expand their sources of capital, the private wealth divisions of the major banks have not missed a beat and have created a variety of product offerings to bridge the gap between high net worth individual Investors (“HNWs”) and Funds. Many major banks have created or are creating feeder funds (“Aggregator Vehicles”) whereby a large number of HNWs can commit directly to the Aggregator Vehicle (or make an upfront one-time investment in the Aggregator Vehicle) and the Aggregator Vehicle in turn commits to the Fund.2 This enables the HNWs to obtain exposure to Funds whose minimum Capital Commitment threshold they could not otherwise meet. In certain circumstances Aggregator Vehicles can even offer more liquidity than a traditional investment in a Fund by including redemption and transfer rights that would be atypical at the Fund itself. The banks sponsoring Aggregator Vehicles customize the opportunity to the wishes of the Sponsor and the HNWs, and Aggregator Vehicles may be structured to facilitate participation by the HNWs in a single Fund, in a series of Funds sponsored by the same Sponsor, or in multiple Funds sponsored by unrelated Sponsors. There are Aggregator Vehicles being marketed with minimums as low as $50,000. The Aggregator Vehicles often make material Capital Commitments to Funds, and hence their inclusion or exclusion from a Facility’s borrowing base can have a material impact on Facility availability. While Aggregator Vehicles are not rated institutions and can be challenging for traditional Facility underwriting guidelines with respect to Investors (including for those Lenders that advance against HNWs that commit directly), they clearly have inherent value worthy of some level of advance or overcollateralization benefit. In fact, it could be argued that in some ways they could be more creditworthy than a traditional institutional Investor, as their source of funds comes from a diversified pool, typically with overcall rights to cover shortfalls created by any particular HNW’s failure to fund. Figuring out the right level of advance rate and concentration limit for Aggregator Vehicles is clearly an emerging challenge and opportunity. And the development of similar vehicles and concepts that deliver HNW Investor Capital Commitments to Funds is likely to continue and increase.

Along similar lines, we expect that the continuing shift from defined benefit plans to defined contribution plans will ultimately lead Sponsors and their advisors to create products that allow defined contribution plans and related individual investor savings accounts access to Funds. While the challenges are real: the lack of redemptions does not sync well with the portability of 401(k)s, the accredited investor standard, etc., we believe the challenges are not insurmountable. And while we do not anticipate a sudden change anytime soon to open access to this source of funds, it does seem that the historically favorable rate of return provided by Funds, combined with the sheer size of long-horizon assets invested in IRAs and 401(k)s, makes their eventual connection somewhat inevitable over the long term. Whether the ultimate vehicles and structures formed to facilitate this source of funding involve Capital Commitments or something similar that would enable application for a Facility remains to be seen.

Conclusion

The Facility market is maturing and evolving in ways that create challenges and significant opportunities. We expect that the Facility market will continue to grow at a solid clip as fundraising improves, Fund formation increases and the product further penetrates the various private equity and other asset classes. But we expect that the evolution of Fund structures and new sources of Capital Commitments will challenge the historical Facility structures, leading to more customized and tailored and less standardized Facility constructs. Those Lenders nimble enough to move with these tides will have significant opportunities.

Endnotes

1 For an in-depth review of overcall limitations, please see Mayer Brown’s Legal Update, “Subscription Facilities: Analyzing Overcall Limitations Linked to Fund Concentration Limits.” on page 24.

2 Sponsors tend to refer to these HNW vehicles as “feeder funds.” We prefer to refer to them as “Aggregator Vehicles” to avoid confusion with traditional feeder funds formed by a Sponsor itself.

3 For further information about open-ended funds, please see Mayer Brown’s Legal Update, “Structuring a Subscription Facility for Open-Ended Funds.” on page 31.

A subscription credit facility (a “Facility”), also frequently referred to as a capital call facility, is a loan made by a bank or other credit institution (the “Lender”) to a private equity fund (the “Fund”). The defining characteristic of such Facilities is the collateral package, which is composed not of the underlying investment assets of the Fund, but instead by the unfunded commitments (the “Capital Commitments”) of the limited partners of the Fund (the “Investors”) to make capital contributions (“Capital Contributions”) when called from time to time by the Fund or the Fund’s general partner.

The loan documents for the Facility contain provisions securing the rights of the Lender, including a pledge of (i) the Capital Commitments of the Investors, (ii) the right of the Fund or the Fund’s general partner to make a call (each, a “Capital Call”) upon the Capital Commitments of the Investors after an event of default accompanied by the right to enforce the payment thereof and (iii) the account into which the Investors fund Capital Contributions in response to a Capital Call.

As recovery from the financial crisis continues, fundraising activity is up markedly, due to increases in both the Capital Commitments made by Investors to existing Funds and the number of new Funds being formed. Consequently, this activity is driving an increase in the number of Facilities sought by such Funds given (i) the flexibility such Facilities provide to Funds (in terms of liquidity and consolidating Capital Calls made to Investors) and (ii) the proven track record in regards to Capital Commitment collateral’s reliability. The reliability of such collateral is due in part to the typically high credit quality of Investors in such Funds and low default rates of such Investors.

Many Funds are at least partially comprised of Investors that are subject to the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and/or Section 4975 of the Internal Revenue Code of 1986, as amended (the “Code”). As discussed below, understanding a Fund’s status under ERISA, as well as the status of individual Fund Investors under ERISA and Section 4975 of the Code, is critical from a Lender’s perspective because of the prohibited transaction rules contained in these statutes.1 A violation of the prohibited transaction rules under ERISA could result in severe consequences to the Fund and to Lenders under a Facility, including the possibility that the Facility be unwound and/or of excise tax penalties equal to 100% of the interest paid under the Facility being imposed on the Lender. Despite these potential pitfalls, ERISA issues can be effectively managed through awareness of these rules and regulations and guidance from seasoned counsel specializing in ERISA and experienced in these Facilities. This newsletter outlines some of the basic ERISA considerations of which Lenders and Fund borrowers should be aware in connection with these Facilities.

Background

ERISA was adopted by Congress to protect the interests of participants in employee benefit plans that are subject to ERISA. Concerned with the difficulty of enforcing a law based on good faith or arm’s-length standards, Congress imposed:

1. fiduciary status on all persons who exercise control over employee benefit plan assets (whether or not they intend or agree to be fiduciaries); 2.stringent fiduciary standards and conflict of interest rules on such fiduciaries;

3.except where specifically exempted by statute or by the Department of Labor, prohibitions on all transactions between employee benefit plans and a wide class of persons (referred to as “parties in interest” in ERISA and “disqualified persons” in the Code)2 who, by reason of position or relationship, might, in Congress’ view, be in a position to influence a fiduciary’s exercise of discretion over plan assets; and

4.onerous liabilities and penalties on both fiduciaries who breach ERISA and third parties who enter into transactions that violate the prohibited transaction rules.

ERISA Prohibited Transaction Rules

The most significant issue for a Lender to a Fund that is or may be subject to ERISA is the impact of the prohibited transaction rules under ERISA, which strictly prohibit a wide range of transactions, including loans or other extensions of credit, between an ERISA plan and a person who is a “party in interest” with respect to such plan, unless an exemption is available (as described below). Financial institutions often have relationships with ERISA plans that cause them to be parties in interest, such as providing trustee, custodian, investment management, brokerage, escrow or other services to the ERISA plan.

A party in interest that enters into a nonexempt prohibited transaction with an ERISA plan is subject to an initial excise tax penalty under the Code equal to 15% of the amount involved in the transaction and a second tier excise tax of 100% of the amount involved in the transaction, if the prohibited transaction is not timely corrected. In order to correct the prohibited transaction, the transaction must be unwound, to the extent possible, and the ERISA plan must be made whole for any losses. In addition, if a transaction is prohibited under ERISA, it may not be enforceable against the ERISA plan.

As discussed below, a Fund that accepts ERISA plan Investors could, itself, become subject to these prohibited transaction rules under ERISA. During the negotiation of the term sheet and initial due diligence for a Facility, it is critical to understand the Fund’s structure, the current ERISA status of the Fund and, if the Fund has not closed in all of its Investors and/or made its first investment, the intended ERISA status of the entities within the Fund’s structure. Such information is necessary to draft appropriate representations and covenants in the loan documents. The representations and covenants will assure the Lender that either the Fund is not subject to ERISA or the Fund may rely on an exemption from the prohibited transaction rules under ERISA that will apply to the transactions contemplated by the Facility. Lenders may also require certain ERISA-related deliveries as a condition to the initial borrowing under the Facility, as well as annual deliveries thereafter.

Plan Asset Rules

A Fund that accepts ERISA Investors could itself become subject to ERISA if the assets of the Fund are deemed to be “plan assets” of such ERISA Investors. The rules governing the circumstances under which the assets of a Fund 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 Department of Labor. Section 3(42) of ERISA and the plan asset regulation set forth a number of exceptions on which a Fund may rely to avoid being deemed to hold the plan assets of its ERISA Investors.

COMMON EXCEPTIONS TO HOLDING PLAN ASSETS

The exceptions to holding plan assets most commonly relied on by Funds3 seeking to admit Investors subject to ERISA are the “less than 25%” exception and the “operating company” exception. Prior to permitting the initial borrowing under a Facility, a Lender may require evidence of compliance by the Fund with these exceptions in the form of a certificate from the Fund’s general partner (in the case of the less than 25% exception) or an opinion of qualified ERISA counsel to the Fund (in situations involving the “operating company” exception). In addition, the Facility may require annual certificate deliveries by the Fund to confirm the Fund’s continued satisfaction of the conditions of an exception to holding plan assets. Regardless of the deliveries requested by the Lender, the Facility should contain representations, warranties and covenants from the Fund to the effect that the Fund satisfies an exception to holding plan assets and will continue to satisfy such an exception throughout the period any obligations under the Facility remain outstanding.

Less Than 25% Exception

The less than 25% exception is available to a Fund4 if less than 25% of each class of equity interests in the Fund are owned by benefit plan investors. For the purpose of the less than 25% exception, Investors that are treated as “benefit plan investors” include, among others, private pension plans, union-sponsored (or Taft Hartley) pension plans, individual retirement accounts, and certain trusts or commingled vehicles comprised of assets of such plans. Government plans and non-US plans are not subject to ERISA or Section 4975 of the Code and are not counted as benefit plan investors for the purpose of the less than 25% exception. In addition, when determining the size of the class of equity interests against which benefit plan investor participation will be measured, the interests of the Fund manager or general partner and other persons who exercise discretion over Fund investment or provide investment advice to the Fund, and affiliates of such persons, are disregarded. The percentage ownership of the Fund is measured immediately after any transfer of an interest in the Fund. Accordingly, a Fund relying on the less than 25% exception must monitor the percentage of its benefit plan investors throughout the life of the Fund.

Operating Company Exception

A Fund5 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.” A real estate operating company (“REOC”) is an entity that is primarily invested in actively managed or developed real estate with respect to which the entity participates directly in the management or development activities. A venture capital operating company (“VCOC”) is an entity that is primarily invested in operating companies (which may include REOCs) with respect to which the entity has the right to participate substantially in management decisions. It is common for real estate-targeted Funds to rely on the VCOC exception by investing in real estate through subsidiary entities that qualify as REOCs. Both VCOCs and REOCs must qualify as such on the date of their first long-term investment and each year thereafter by satisfying annual tests that measure their ownership of qualifying assets and their management activities with respect to those assets. If a Fund does not qualify as a VCOC or REOC on the date of its initial long-term investment or fails to continue to qualify as a VCOC or REOC, as applicable, on an annual testing date, the Fund is precluded from qualifying as a VCOC or REOC, as applicable, from that date forward. Accordingly, a Fund relying on an operating company exception must properly structure and monitor investments and test for compliance annually.

Certain Timing Considerations Related to Exceptions to Holding Plan Assets

To avoid the application of the prohibited transaction rules and risks described above to the transactions contemplated by a Facility, the Fund must satisfy an exception to holding plan assets at the time of the initial borrowing under the Facility and throughout the period any obligation under the Facility remains outstanding.6 With respect to the operating company exception, the timing of the initial investment, the initial Capital Call from Investors and the initial borrowing must be carefully monitored.

As noted above, a Fund cannot qualify as a VCOC or a REOC until the date of its initial long-term investment. Accordingly, benefit plan investors typically will not make Capital Contributions to a Fund intending to qualify as a VCOC or REOC until the date such Fund makes its first investment that qualifies the Fund as a VCOC or REOC, as applicable. To call capital in advance of the initial investment, such a Fund would need to establish an escrow account to hold the Capital Contributions from its benefit plan investors outside of the Fund until the first qualifying investment is made by the Fund. Since the escrowed funds have not been contributed to the Fund, the escrow account may not be pledged by the Fund as security to the Facility. The escrow account used for this purpose needs to satisfy certain conditions set forth in an advisory opinion issued by the Department of Labor in order to avoid causing the Fund to be deemed to hold plan assets. Depending on the facts and circumstances, a Fund may not be able to make an affirmative representation in the Facility documents that it does not hold ERISA plan assets until the date on which the Fund makes its initial investment that qualifies the Fund for an operating company plan asset exception.7

PROHIBITED TRANSACTION EXEMPTIONS FOR PL AN ASSET FUNDS TO ACCESS A FACILITY

A Fund that has admitted ERISA Investors and does not satisfy the conditions of an exception to holding plan assets is subject to ERISA. An ERISA Fund would not necessarily be precluded from accessing a Facility if such Fund could rely on one of the prohibited transaction exemptions described below. As noted above, financial institutions provide a variety of services to many ERISA plans, causing such institutions to be parties in interest to such ERISA plans. Accordingly, in connection with a Facility with an ERISA Fund, it is imperative that the Facility documents contain representations and covenants from the ERISA Fund to support the conclusion that a prohibited transaction exemption is available for the transaction.

QPAM Exemption

One frequently used exemption is referred to as the “QPAM exemption.”8 This class exemption from the prohibited transaction restrictions of ERISA was granted by the Department of Labor for certain transactions between a plan and a party in interest where a qualified professional asset manager or “QPAM” has the responsibility for negotiating the terms of and causing the plan to enter into the transaction. If a loan constitutes a prohibited transaction, ERISA would preclude the ERISA plan from indemnifying the Lender for the excise taxes or other losses incurred by the Lender as a result of the violation of the prohibited transaction rules. For this reason, the Lender may require the QPAM itself to make representations and covenants confirming compliance with the QPAM exemption and to indemnify the Lender for any breach of such representations and covenants.

Service Provider Exemption

Another exemption potentially available is a statutory exemption (the “Service Provider exemption”)9 that provides broad exemptive relief from ERISA’s prohibited transaction rules for certain transactions between a plan and a person who is a party in interest solely by reason of providing services to the plan, or by 42 Fund Finance | compendium 2011-2018 subscription credit facilities: certain erisa considerations reason of certain relationships to a service provider, provided that the plan receives no less or pays no more than adequate consideration. The Service Provider Exemption is available for a broad range of transactions, including loans or a Facility. As noted above, one of the conditions of the Service Provider Exemption is that the plan neither receives less nor pays more than “adequate consideration.” In the case of an asset other than a security for which there is a generally recognized market, “adequate consideration” is the fair market value of the asset as determined in good faith by one or more fiduciaries in accordance with regulations to be issued by the Department of Labor.10 To date, the Department of Labor has not issued such regulations. Until applicable regulations are promulgated by the Department of Labor, Lenders may not be comfortable relying on the Service Provider Exemption.

STRUCTURING ALTERNATIVES FOR INCLUDING INVESTORS: MASTER/FEEDER FUNDS

Certain Funds are structured with one or more feeder funds through which Investors invest in the Fund. Frequently, the feeder funds may not limit investment by benefit plan investors and may be deemed to hold the plan assets of such Investors. Accordingly, the prohibited transaction rules will apply to any feeder fund that does not satisfy the less than 25% exception to holding plan assets discussed above. The activity of such feeder funds is typically limited to investment into the master Fund, which is designed to satisfy an exception to holding plan assets. Since the Fund manager does not have discretion over feeder fund investments and transactions, the QPAM exemption would not be available for loans to the feeder fund. In such cases, the feeder funds generally do not enter into lending transactions directly, or even provide guarantees of master Fund loans. However, there are structures that can be established to make sure the Fund receives credit/borrowing base capacity for the feeder fund. For instance, the feeder fund may pledge the unfunded Capital Commitments of its Investors to the master Fund. The master Fund, in turn, pledges those assets to the Lenders. Accordingly, the Lenders are entering into a transaction only with the master Fund, which does not hold plan assets, but the Lenders still have access to the feeder fund Capital Commitments to the extent included in the pledged assets.

Investor Consents

For various reasons, Lenders may require an Investor consent letter (also commonly referred to as an Investor letter or Investor acknowledgment), where an Investor confirms its obligations to fund Capital Contributions after a default to repay the Facility. To the extent that these Investor consents are sought from benefit plan investors, it is important to consider the ramifications of the plan asset regulation.

Even if a Fund satisfies one of the exceptions to holding plan assets set forth in Section 3(42) of ERISA or the plan asset regulation, an Investor consent directly between a Lender and a benefit plan investor could be deemed to be a separate transaction that may give rise to prohibited transaction concerns under ERISA and/or Section 4975 of the Code. Certain Lenders have obtained individual prohibited transaction exemptions from the Department of Labor to eliminate this prohibited transaction risk in connection with Investor consents, provided the conditions of the exemption are satisfied. Each of these individual prohibited transaction exemptions assumed that the assets of the Fund were not deemed to be ERISA plan assets. Without an individual prohibited transaction exemption, it is essential that the Investor consents with benefit plan investors be structured so that such Investors are merely acknowledging their obligations under the governing documents of the Fund. Investor consents carefully drafted so Investors are acknowledging obligations arising under the Fund documentation (instead of being styled as an agreement between such Investor and the Lender) should not be viewed as “transactions” with the Lender for prohibited transaction purposes under ERISA or Section 4975 of the Code.

Loans Funded With Plan Assets

Typically Facilities are funded out of general assets of one or more Lenders, and not with ERISA plan assets. However, it is important to note that if a loan were funded in full or in part from, or participated to an account or fund comprised of ERISA plan assets, the ERISA prohibited transaction considerations discussed above would be triggered, regardless of whether the borrower Fund is deemed to hold plan assets. For this reason, borrowers often request Lenders to represent and covenant that the loan will not be funded with ERISA plan assets.

Conclusion

A Fund that contemplates taking advantage of the benefits associated with a Facility must be mindful of ERISA issues. Beginning with structuring the Fund with an eye towards the inclusion of ERISA Investors, through the selection and timing of Fund investments coinciding with the term of the Facility, careful consideration of the impact ERISA rules and regulations may have on the Fund can increase (or limit entirely) the available amount of the loan. Lenders must also pay particular attention to ERISA issues commencing with due diligence of the Fund and Investor documentation, through execution of final loan documents for the Facility and the necessary representations, warranties, covenants and required deliverables related thereto for purposes of limiting exposure to a violation of ERISA rules and regulations. With careful planning and attention to ERISA issues (including to those described above), the closing and execution of a Facility should not be hindered by these complex rules and regulations.

Endnotes

1 The prohibited transaction rules under ERISA are similar to the prohibited transaction rules of Section 4975 of the Code. For ease of reference, this newsletter will discuss ERISA.

2 The definition of “disqualified persons” in the Code differs from the definition of “parties in interest” under ERISA. For ease of reference, this newsletter will only refer to parties in interest.

3 In this newsletter, we discuss the Fund as though it is a single entity. If a Fund is comprised of multiple parallel funds, feeder funds and/or alternative investment vehicles, each entity that is a party to the Facility would need to satisfy an exception to holding plan assets or would need to rely on a prohibited transaction exemption in connection with the Facility.

4 For this discussion of the less than 25% test, we assume that the Fund is a single entity. If a Fund were comprised of multiple parallel funds and each parallel fund intended to rely on the less than 25% exception to holding plan assets, each parallel fund would be tested separately.

5 Again, we assume that the Fund is a single entity. If a Fund were comprised of multiple parallel funds, for example, and more than one parallel fund intends to operate as a VCOC, each such parallel fund would be tested separately.

6 We are assuming that the Lender did not fund the loan with plan assets of any benefit plan investor. See Section VI.

7 Nevertheless, a Lender may permit a Fund to make a small borrowing under the Facility (typically for purposes of paying costs and expenses incurred prior to closing of the Facility) before such initial qualifying investment, with the balance of the Facility available after the Fund demonstrates that it qualifies for an operating company plan asset exception following the qualifying investment.

8 See Class Exemption for Plan Asset Transaction Determined by Independent Qualified Professional Asset Managers, 49 Fed. Reg. 9494 (Mar. 13, 1984), amended by 70 Fed. Reg. 49,305 (Aug. 23, 2005) and 75 Fed. Reg. 38,837 (July 6, 2010).

9 See ERISA § 408(b)(17) and Code § 4975(d)(20).

10 See ERISA § 408(b)(17)(B)(ii) and Code § 4975(f)(10).