A child’s self-esteem is tied, in large part, to how they are treated, valued and cared for by their parents. If we spend too much time “giving time” to everything else in our lives ahead of our children, we are teaching them that they are less important to us — and therefore the greater world. Moreover, if parents don’t make the time to engage with their children the more apt they are to seek out other role models that may or may not have their best interests in mind.

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Private equity real estate funds have stepped up to be a major source of financing for the commercial real estate industry—and a bigger allocation for investors. However, fund managers may face a tougher road ahead for fundraising in the near term as capital flows to the sector slow.

Debt strategies have moved from the fringe to a more established and accepted part of the commercial real estate investment universe over the past several years. That shift has generated a significant wave of capital. According to London-based research firm Preqin, global private equity real estate debt funds have raised about $165.6 billion since 2013.

“Over the last three years in particular we’ve seen a massive amount of capital allocated to debt funds,” says Todd Sammann, executive managing director and head of credit strategies at CBRE Global Investors. The vast majority of that capital is targeting double-digit returns and is almost entirely allocated to closed-end funds. “The industry has seen fundraising trail off a little bit in 2019, which is not particularly surprising given the amount of capital that was formed,” says Sammann.

According to Preqin, the volume of capital raised by debt funds appears to have peaked at $33.7 billion in 2017. Fundraising edged lower to $29.4 billion in 2018 and has dropped more sharply in 2019, with fundraising through Nov. 7th totaling $15.6 billion.

That decline comes even as the broader private equity real estate fund market is enjoying robust capital flows. As of Nov. 7th, that global market had raised $138.2 billion year-to-date, which puts it on track to exceed the $146.1 billion raised in 2018 and likely to break the record of $147.5 billion raised in 2008, according to Preqin’s Q3 real estate report.

“There is no doubt that what Preqin is reporting, to a certain extent is true, that the appetite may not be there. But I also think that will rebound,” says Zac Barnett, co-founder of Fund Finance Partners, a debt advisory firm for private equity fund sponsors. “Private equity real estate debt doesn’t seem to be going anywhere. It fills a need, particularly when crossing over to the infrastructure space where there are very few banks that are able to play.”

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How does governance come into play for institutional asset managers. One key area is how leverage is managed, according to Richard Wheelahan, III, and Zac Barnett, the Co-Founders of Fund Finance Partners. Over the past decade Richard has advised fund sponsors and lenders, both as an adviser and as a principal at a $3 billion asset management firm. Zac has worked for twenty years as one of the leading attorneys the fund finance space; during this time he has represented investment banks and fund sponsors on some of the largest, most complex fund financings in the industry. The full interview with CorpGov is below:

CorpGov: In Asset Management, what is the role of corporate governance?

Messrs. Wheelahan and Barnett: All funds have governance standards which the asset management team must abide by.  Registered funds, like BDCs and REITs, are subject to the same corporate governance standards that public operating companies are, even though they aren’t operating companies in the traditional sense.  Private fund requirements are primarily negotiated by the fund sponsor with large investors and are usually also imposed by SEC regulations.

CorpGov: Can you talk about the use of leverage by private equity and other asset class funds, and how they are governed?

Messrs. Wheelahan and Barnett: While leverage is now more common than not, how the fund sponsor goes about obtaining and utilizing it must be permitted by the relevant regulatory limitations and the fund’s governing documents – its agreements with its investors. For Regulated Investment Companies (’40 Act funds), some of which are publicly traded, the limitations on leverage are prescribed by the Investment Company Act of 1940 (although this is subject to change as seen in the past year) as well as the Investment Company’s offering materials. Private funds’ use of leverage is potentially limited – or unlimited – by the private fund’s governing docs.

Whether managing a registered or a private fund, fund sponsors have a fiduciary duty to their investors to obtain the best terms, pricing and structure on any leverage they utilize. Relying on an unbiased intermediary – one which isn’t in the business of lending to funds but is solely engaged to optimize the funds’ borrowing terms to run a competitive process – is a good way to satisfy that fiduciary duty.

CorpGov: What are best practices in corporate governance for fund sponsors?

Messrs. Wheelahan and Barnett: Fund sponsors should be deliberate in their leverage strategy, especially early in the life cycle. Strategic leverage considerations and regulatory limitations should be communicated to the board in the case of a registered fund or considered carefully by the sponsor in consultation with the fund’s larger investors, and a private fund’s governing documents should provide for maximum flexibility.

These are deliberate decisions, and boards with oversight responsibility should be informed about both the strategy and specific tactical plan to accomplish these fiduciary responsibilities. Unless the fund sponsor has a robust debt capital markets and leveraged finance capability with the bandwidth to run a competitive process, fund sponsors and boards of directors should seriously consider engaging a professional intermediary.

CorpGov: What does your business, Fund Finance Partners, do for fund asset managers and fund sponsors?

Messrs. Wheelahan and Barnett: We believe that next to asset performance, leverage strategies are at the very heart of maximizing returns, and we provide innovative options that are lower-cost and more flexible for funds. As a sponsor’s strategy evolves we can help rethink or change how to efficiently pivot the fund sponsor’s approach to capitalizing these funds and maximizing the performance of the underlying collateral.

These shifts and pivots can trigger fund sponsor obligations in both the governing documents, as well as public disclosures and board involvement for registered funds. An advisory firm like ours which has experience with all types of fund leverage and all types of funds, including registered ones can provide valuable guidance in optimizing the fund’s leverage strategy. We do this while maintaining a constructive, risk-reducing dialogue with corporate governance constituencies.

Fund Finance Partners (“FFP”)is led by a team of finance and asset management professionals which has collectively executed more than 600 unique fund finance transactions. FFP is dedicated to innovation and growth of the market of debt capital solutions to fund sponsors and investors.  For further information go to https://fundfinancepartners.com/

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The Fund Finance market has been on an incredible run. We at FFP, like many of you reading this, want to see that success continue. We believe that the only way the market can maintain its staggering growth rate is to evolve, innovate and modernize its transaction processes.

As many of you know, the core subscription facility product has exploded over the last 10-15 years thanks to the hard work of so many, particularly industry’s leaders. Bankers have appropriately identified the fund sponsors’ need and have expertly refined their product offering to meet those needs. The attorneys have worked long and hard at erecting sound legal structures to ensure the reliability of the unfunded capital commitments and access to them via a proper capital call. This has resulted in profitability for so many deserved market players. However, now is not the time to pat each other on the back; we must re-invest and continue to innovate or else product and market stagnation will begin its eventual creep.

Despite the introduction of many new developments in technology, legal staffing, document review and the like, many if not most of these advancements have yet to penetrate the Fund Finance space. We believe that must and will change. Here at Fund Finance Partners, we have taken steps to help drive efficiency of lender selection, negotiation and legal document review.

By way of example, we’ll use the core Fund Finance product, a subscription financing, as the reference point for some of the streamlining methods we’ve been working on at Fund Finance Partners. Let’s take a quick peek at what we call Fund Finance 2.0 and how we hope to help us get there.

COORDINATION-THE LEFT AND RIGHT HAND

We’ve all seen deals significantly delayed or even crater due to improper coordination and planning on behalf of the fund sponsor. The attorneys and business folks forming the fund (right hand) don’t always keep the finance counsel and universe of lenders (left hand) appraised of various fund structure, Side Letter and LPA provision changes. We’ve seen the irreparable damage that can be caused by not properly identifying troublesome comments from tax, ERISA counsel, investor counsel, etc. during the fund formation process. If not addressed, these comments can, among other things, eviscerate the fund’s borrowing base or prevent access to creditworthy investor uncalled capital. The good news is that 9 times out of 10, these issues can be positively resolved with proper explanation to the party commenting. We at Fund Finance Partners have the experience to spot the potential problems and the blueprint for ensuring that the left hand is always aware of what the right hand is doing.

LEGAL DOCUMENTATION-THIS IS NOT ROCKET SCIENCE

A critical step toward achieving transaction time and cost efficiency is having the legal work accomplished at the appropriate level. Let’s take the document that the investor executes establishing its commitment to the fund (“the Subscription Agreement”) as an example. Traditionally, review of subscription agreements and related fund documentation would be executed by junior, mid-level or even more senior associates. This may have been appropriate 10-15 years ago when the product was less mature due to the differentiation of subscription agreement forms as well as the relative (as compared to present day) inexperience of each the lender and borrower-side counsel. There is no doubt that these documents need to be reviewed to confirm investor name, GP countersignature, LP commitment amounts, ERISA and other investor representation designations, etc. but an attorney certainly needn’t review every line of these documents. That said, we do recommend a senior attorney, perhaps even a partner review the fund’s form of subscription agreement to insure there is nothing out of the ordinary with respect to the proper representations / representations requested, compliance with law, etc.

COMMUNICATION-THERE IS PLENTY OF PIE

As mentioned above, a huge reason of the market’s success can be traced back to industry leaders particularly on the lender-side of the aisle. The most successful market participants have worked collegially with other lenders to make sure that their fund sponsor clients (and potential clients) needs are being met; whether or not they are taking part in the transaction. However, there remain all too many instances where short-term self-preservation instincts can play a role in client service and fund sponsors suffer as result. We’ve all seen or heard of fund sponsor’s being coerced into a product that is not right for them or left on the sidelines instead of being directed to a capital source that can fulfill its specific needs. FFP has the non-partisan platform, lender comparison checklists and product knowledge to ensure fund sponsors are connected with the proper lending source leaving them with a positive experience, increased faith in our markets and a willingness to enter into more fund finance transactions, thus growing the pie.

Pension funds are taking aim at private equity firms for exploiting a financial sleight of hand that can make even mediocre investments look brilliant.

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Introduction

Private equity and other investment funds have traditionally utilized portfolio company-level financing to finance acquisitions. These types of financings have focused on the portfolio company for both the debt underwriting and collateral package. The categories of these loans include asset-based loans (“ABL”), cash flow financings and real property mortgages, among other traditional lending products.

In our practice, we are seeing increased and opportunistic use of fund-level debt as an alternative or complement to secured financing at the portfolio company level. Fund-level debt can include net asset value (“NAV”) credit facilities, subscription credit facilities and facilities combining characteristics of both NAV and subscription credit facilities (“hybrid facilities”). This article focuses on the relative benefits of using fund-level credit facilities to finance acquisitions of portfolio companies and/or assets thereof as compared to traditional acquisition finance.

Overview of NAV, Subscription and Hybrid Credit Facilities

NAV credit facilities are fund-level facilities that look to investments of the fund as the primary source of repayment. Although a lender may consider the strength of a fund in its underwriting process (e.g., compare the credit evaluation for providing financing to a successful $1 billion Fund VI versus an untested $50 million Fund I), the assets of the fund are typically the primary basis for a lender’s underwriting and, in the case of a secured facility, the sole collateral. In a secured NAV facility, the lender can obtain liens on, among other things, (a) the equity interests in portfolio companies (or holding companies that ultimately own the portfolio companies), (b) distributions and liquidation proceeds from the portfolio companies or other investments, (c) in the case of debt funds, loans extended by the debt fund to its borrowers and (d) fund-level collection accounts. In other cases, borrowers with creditworthy assets are able to access credit based on borrowing base formulas but without granting liens on their assets.

Loan availability under an NAV credit facility is typically limited to a sum equal to (a) an agreed advance rate for a given category of assets (potentially subject to concentration limitations for each category) multiplied by (b) the NAV of certain agreed “Eligible Investments.” NAV credit facilities are often subject to unique covenants and other terms in financing agreements (e.g., the requirement to maintain a minimum NAV or loan-to-value ratio, or rights with respect to asset replacement).

Whereas NAV credit facilities look downward to the underlying portfolio investments or other assets of the fund and their value as collateral and/or source for repayment, subscription credit facilities look upward to the unfunded capital commitments of the investors in the fund.

Subscription (also known as “capital call” or “capital commitment”) credit facilities are now well known and utilized by private equity funds of all stripes. For years, such credit facilities have offered funds with numerous benefits including: (a) quick access to capital to bridge timing gaps in and “smooth out” the timing and receipt of capital calls from investors; (b) flexibility and nimbleness to rapidly access and deploy capital to take advantage of time-sensitive and opportunistic investments; (c) the means to borrow smaller amounts as needed and later call capital in larger amounts to reduce administrative burdens, maximize efficiency and bolster positive investor relations; (d) access to letters of credit and the ability to borrow in multiple currencies; (e) the ability to secure hedges, swaps and other derivatives transactions and (f) the means to bridge capital needs in connection with an asset-level financing.1

Hybrid credit facilities are a blend of NAV credit facilities and subscription credit facilities. Collateral for hybrid credit facilities is negotiated on a deal-by-deal basis, but it can provide lenders with recourse to the underlying investment assets that typically support an NAV credit facility, as well as the uncalled capital commitments of investors that typically support a subscription credit facility.2 For hybrid credit facilities with a blended borrowing base, the proportion of the borrowing base made up of capital commitments versus NAV assets often changes over time; as capital commitments are called and those funds are deployed to make investments, the value of those investments builds up the borrowing base through the NAV asset prong. The blended borrowing base of the hybrid credit facility helps fulfill the financing needs of the fund at multiple stages in its life cycle and obviates the need to refinance as capital commitments are called.

Relative Benefits of Fund-Level Financing

Funds and lenders alike can enjoy benefits of fund-level financing, particularly to facilitate acquisitions, including:

• Decreased transaction costs due to having only one credit facility per fund (rather than multiple asset-level or portfolio company-level credit facilities), resulting in lower overall costs and low to no commitment or broken deal costs.

• Timing benefits due to not having to arrange, structure, coordinate and close multiple asset-level or portfolio company-level credit facilities contemporaneously with, or in order to, facilitate acquisitions.

• The ability to focus fund financial and personnel resources on acquisitions, without the need to run a simultaneous process to secure assetlevel or portfolio company-level financing.

• Lower relative cost of debt and increased fund profitability, for reasons including (a) lenders’ greater comfort in the fund’s overall performance, as opposed to performance on an asset-level or portfolio company-level basis; (b) multiple income streams from multiple portfolio companies and assets to support repayment; (c) reputational risk of non-repayment; (d) decreased diligence costs and (e) better pricing on fund-level debt secured across a diversified pool of collateral, compared to stand-alone portfolio company-level debt.

• Multiple high-quality sources of repayment supporting a single-credit facility.

• Potentially increased deal flow for lenders who are positioned to provide financing for the fund through its investment cycle across various platforms.

• A single, top-level credit facility lends to high levels of cooperation between funds and their lenders, increasing transparency into a fund’s ultimate business goals and strategy and promoting partnerships.

• Lenders at the fund-level facility have a larger hold percentage of the fund’s overall debt, with greater diversity of assets.

• Potential pricing breaks and beneficial borrowing base adjustments depending on the assets and concentrations thereof comprising the borrowing base.

Though beyond the scope of this article, we recognize that fund-level financing is not an ideal fit for every fund and situation. Potential challenges to be addressed include: (a) accounting and tax issues, e.g., how to allocate expenses at the asset or portfolio company level or otherwise as desired, and international tax implications for funds that have diverse investments in multiple jurisdictions; (b) the risk of insolvency at the portfolio company level (although this risk is likely limited for well-diversified and properly structured funds)3 and (c) unique portfolio goals and challenges, e.g., whether advance rates and eligibility criteria offered by lenders will permit funds to achieve preferred leverage levels and returns.

We have addressed these issues in a variety of ways for a diverse array of funds and can suggest solutions based on individual fund characteristics and transaction dynamics. In many cases, these concerns can be mitigated or resolved by consulting experienced counsel early on in the fund formation and/or financing processes, or with other creative approaches (e.g., placing what would otherwise be mezzanine or juniorlevel debt in a senior position at the portfolio company level, which may be obtained at a much lower all-in rate than usual given its then senior position in the capital structure).

Depending on the type, goals and characteristics of the fund, it is possible to employ each of the aforementioned types of financing and to call on uncalled capital commitments, as well as underlying assets and investments, to fulfill varying capital and liquidity needs throughout the entire life cycle of a fund.

Market Trajectory and Conclusion

Given the relative benefits of fund-level credit facilities over traditional asset-level and portfolio company-level financing, as well as the overlap in collateral and sources of repayment, we see funds enjoying numerous benefits in obtaining fund-level facilities on a standalone basis, and/or as a jumping-off point to financing at multiple levels of the capital structure over the life of the fund. As a fund’s capital demands, needs and goals evolve, fund-level facilities can provide unique advantages in terms of flexibility. As funds continue to mature and lenders shift their underwriting focus from individual investments to the strengths of funds themselves, we expect funds will utilize (and lenders will offer) additional fund-level facilities and financing options.

Endnotes

1 For more information on subscription credit facilities, see https://www.mayerbrown.com/files/ Publication/96e93616-8f87-407c-ac3c-c0d151b512b3/ Presentation/PublicationAttachment/b3947934-6123- 45f9-9c2f-ce336d07be75/Subscription-Credit.pdf.

2 For more information on hybrid credit facilities, see Hybrid Credit Facilities, on page 263.

3 This risk can be further mitigated by negotiating a cross-default provision to only certain investments. Funds can also negotiate the ability to substitute non-performing assets for better-performing assets in the borrowing base.