The strong credit performance and significant growth of subscription credit facilities (each, a “Subscription Facility”) and the broader Fund Finance market continued into the first half of 2017. In fact, Mayer Brown remains unaware of any Subscription Facility lender (each, a “Lender”) experiencing a loss in connection with any Subscription Facility. Likewise, while we are aware of a handful of exclusion events occurring in 2017, these events were isolated and were largely based on factual issues related to the specific investor (each, an “Investor”) and not the private equity fund (each, a “Fund”). Below we set forth our views on the state of the Fund Finance market as well as current trends likely to be relevant as 2017 comes to a close.

Fundraising in 2017

Investor capital commitments (“Capital Commitments”) raised in Q2 exceeded $100 billion, continuing what Preqin has described as an “unprecedented sustained period of strong fundraising.”1 In fact, Q2 saw traditional buyout Funds have their best Q2 in five years, raising approximately $88 billion – accounting for 73 percent of total capital raised in the quarter.2 Notably, the five largest Funds raised in Q2 were buyout funds, and they accounted for 71 percent of all buyout capital raised and 52 percent of total Q2 fundraising. 3

While buyout Funds comprised the vast majority of capital raised, the trend of larger sponsors attracting the lion’s share of Capital Commitments was consistent across all Fund types, as evidenced by the fact that nearly 63 percent of Capital Commitments were committed to the ten largest Funds closed in Q2.4 Likewise, the average Fund size grew over the first half of 2017 with $543 million as the average size in Q1 and $637 million in Q2.5 As more Investors look to limit their investments to a smaller group of preferred sponsors, sponsors are also diversifying their product offerings. For example, we have seen a number of sponsors leverage their existing Investor relationships by creating Funds focused on sectors in which they have not traditionally participated (i.e., buyout shops creating direct-lending Funds). Mayer Brown’s fund formation team confirms this trend, indicating that a large portion of their work this year has been devoted to assisting sponsors in developing new platforms in the private credit and debt sectors.

Consistent with prior quarters, most of the capital raised in Q2 originated in North America.6 Europe was again the second-largest fundraising market, and notably, the largest Fund that closed in Q2 was a €16 billion Europefocused buyout Fund. 7 Asia continued its steady climb into private equity in Q2, including the closing of a $9 billion Asia-focused Fund. 8 As further explored below, many Investors have indicated increasing interest in Asia making that the second-most-targeted region for future investment after North America and supplanting Europe. This shift is evidenced by the fact that four out of the five largest Funds in the fundraising market are Asia focused, and three specifically target investments in China.9 Capitalizing on this trend, Asia-focused Funds that are in their fundraising periods are seeking $94 billion more in Capital Commitments than Europe-focused Funds.10

Fund Finance Growth and Product Diversification

Although the Fund Finance market lacks league tables or centralized reporting, our experience and anecdotal reports from a variety of market participants strongly suggest that the Subscription Facility market continues it steady and persistent growth and, as of Q2, is more robust than ever. In fact, both the number and size of Subscription Facilities Mayer Brown has documented this year have outpaced last year. Based on anecdotal reports, again from a variety of market participants, most of those polled expect growth and performance of Fund Finance to continue into at least mid-2018.

We also continue to see diversification in Fund Finance product offerings (including hybrid, umbrella and unsecured or “second lien” facilities). In particular, “Alternative Fund Financings” such as fund of hedge fund financings, management fee lines, 1940 Act lines (i.e., credit facilities to Funds that are required to register under the Investment Company Act), and net asset value credit facilities have garnered more interest by Funds and Lenders alike.

In the first half of 2017 alone, Mayer Brown had already documented more and larger “Alternative Fund Financings” (i.e., net asset value facilities, secondary facilities, hybrid facilities and second lien facilities) than all of last year. Our mid year update will be held in New York this year, focused on such types of Alternative Fund Financings. Please join us on September 13 for our Hybrid Facilities and Other Alternative Lending Products Seminar focused on Alternative Fund Financings.11

Trends and Developments

TECHNICAL DEFAULTS

As expected with growth, we have seen an uptick in technical defaults over the course of 2017. A handful of such technical defaults were caused by Funds making capital calls without notifying the Lender as required in the Subscription Facility documentation. We note that Subscription Facility covenants providing for monitoring of collateral (including prompt delivery of capital call notices, notices of transfers, Investor downgrades and similar requirements) have continued to tighten, and more Lenders are preparing monitoring guidelines in order to provide a document compliance roadmap for Funds. Additionally, a number of Lenders have refined their back office processes with the goal of detecting any compliance problems more quickly and getting ahead of any potential issues.

As more Funds enter into Subscription Facilities prior to their final Investor closings, market participants have seen an increased number of defaults resulting from Funds entering into side letters without prior Lender review and consent, contrary to the requirements of the Subscription Facility loan documentation. Working through these issues and unwinding the problematic side letter provisions (including provisions that had spread through the “most favored nation” clauses) prove to be difficult and costly for Funds. Such situations highlight the importance of Funds working with both the Lender and their counsel to confirm the reporting requirements and to devote adequate resources in connection with loan document compliance prior to entering into side letters.

EVOLVING EXCLUSION EVENTS

While the market has traditionally been cognizant of jurisdictional risks such as sovereign immunity concerns, the globalization of the product and investor base have also presented new concerns in light of cross-border economic policies such as currency controls. It was widely discussed at the Asia-Pacific Symposium (discussed in further detail below) that in some instances, Chinese Investors have been prohibited from moving cash outside of the country, in light of currency controls recently implemented by the Chinese government. To mitigate the risk that this leads to their inability to fulfill their contractual obligation to fund a capital commitment, Lenders should consider whether their current exclusion events cover off such a risk, and if not, could consider adding exclusion events tailored to currency controls and similar legal impediments to funding.

ILPA RECOMMENDATIONS

Since our last market review, there has been much discussion in the press regarding the ways Funds and sponsors can utilize Subscription Facilities, and the disclosure provided to Investors regarding Fund performance in light of the use of leverage – specifically how using Subscription Facilities can distort a Fund’s internal rate of return (“IRR”), one of the key financial metrics used in the Funds industry to judge overall performance.

The resulting discussion has been robust, with a number of interested parties expressing their views as to the use of such leverage. Perhaps most importantly, the Institutional Limited Partners Association (“ILPA”), which is the industry organization for institutional Investors in private equity, issued “Subscription Lines of Credit and Alignment of Interests – Considerations and Best Practices for Limited and General Partners” in June.12 The ILPA guidelines focused mostly on Funds properly disclosing the key terms and conditions of any Subscription Facility to Investors. To that end, ILPA included a sample due diligence questionnaire Investors might consider having a Fund answer prior to investing.13 The guidelines also recommended that Funds also report IRR net of any Subscription Facility indebtedness and suggested that quarterly Investor reports include outstanding Subscription Facility usage, the amount of time that Subscription Facility draws are outstanding and fees and costs relating to Subscription Facilities. While these guidelines remain a work in progress and Fund Finance market participants are currently working with ILPA to refine them, we do think a standardized approach to disclosure would be a positive development for Funds, Investors and Lenders.

Industry Conferences

MAYER BROWN CHICAGO MID -YEAR REVIEW

We hope you can join us at September’s Mayer Brown Mid-Year Review to be held in Chicago on September 20.14

In last year’s Mid-Year Review in Chicago one of the more interesting discussions revolved around a “race to the bottom” arising from Lenders and counsel new to the market, which often unknowingly take underwriting and loan documentation risks. One Lender cited an example where they were asked to join a syndicated deal for a top-tier fund where agent’s counsel failed to flag unfavorable side letter provisions (including cease-funding rights) and the loan documentation did not contain numerous market-standard exclusion events. The topic garnered so much interest that we plan to address the topic again at our September review in Chicago.

FUND FINANCE ASSOCIATION ASIA-PACIFIC SYMPOSIUM

The 1st Asia-Pacific Fund Finance Symposium (the “Asia-Pacific Symposium”) was held in Hong Kong in mid-June. The Symposium brought together over 350 bankers, lawyers, Lenders and Fund sponsors for the first time to discuss the Asian private equity market generally as well as the market for Subscription Facilities and Alternative Fund Finance products. A number of themes were raised during the Asia-Pacific Symposium and a brief summary is set forth below.

INCREASED APPETITE

One of the themes of the Asia-Pacific Symposium was the increased interest and appetite of Asia-sponsored Funds for Subscription Facilities. In particular, while the market in America and Europe is viewed as mature and a number of Asia-focused Funds with U.S. or European sponsors have Subscription Facilities, most Funds with Asian sponsors do not yet take advantage of such leverage at the Fund level. Additionally, many facilities with Asian sponsors tend to be fairly bespoke given the newness of the product in the market and the complexities regarding investor bases for such Funds.

Preqin provided an interesting presentation at the Asia-Pacific Symposium which expanded on this theme, noting a strong start to fundraising in the Asian market, with 95 percent of Investors in private equity seeking to maintain or increase allocations to Asia and 86 percent wishing to invest equal or greater Capital Commitments in Asia in 2017 versus 2016.15 Additionally, preliminary data show the IRRs for Asia-focused Funds exceeding those of European Funds for vintage years since 2010.16 As the market for Subscription Facilities generally follows fundraising, it is not a leap to suggest that Asia is a burgeoning market.

It was also noted at the Asia-Pacific Symposium that the recent press relating to Subscription Facilities has not led to a negative impact on lending activity, but rather hasled to discussions and interest from sponsors and Investors in better understanding the product and perhaps using such leverage.

SEPARATE MARKETS

Another point that was emphasized by Preqin was the diversity of various markets within Asia. Asia-focused Funds continued to delve mainly in private equity buyout and infrastructure, with smaller concentrations of Capital Commitments being raised for venture capital, private debt, real estate and natural resources.17 However, it was also noted that allocations among these areas varied widely depending upon country focus as the areas of focus for China-focused Funds varied from that of Australia-Asia Funds and Japanese markets.

INVESTOR MATTERS

The impact of special purpose Investor vehicles, which are often used by Asian Investors, was debated. Such vehicles, often used to make a single investment, can muddy Lenders’ assessment that a credit link exists whereby parent entities with otherwise demonstrable creditworthiness are in fact backstopping the vehicle’s obligations to Fund Capital Commitments. With respect to such Investors, the availability of financial information and Investor privacy were also raised as barriers to Lenders’ ability to properly assess credit risk and create a diverse borrowing base. On the other hand, it was noted that the ability to assess creditworthiness of Investors in the Asian market may be a particular advantage for Asian banks that have established deep relationships with such Investors and can assess such risks more readily.

Additionally, the Asian Investor profile is changing as private wealth increases. The proliferation of high net worth Investors and family offices can be challenging to Lenders to the extent they make up a significant proportion of the borrowing base for a Subscription Facility. While this challenge is not a new one for Lenders, and is often mitigated by the use of concentration limits, this also seems to be increasingly impactful for Funds with Asian sponsors in particular (as opposed to Funds investing in Asia with U.S. or European managers, as the mix of Investors in such Funds tends to be different).

Another overarching theme was that larger economic forces may be brought to bear on Funds and Investors in the Asian market. The flight of capital from China in 2015 and 2016 drove foreign exchange reserves down by 25 percent, and China responded by slowing capital outflows and tightening controls on moving cash out of China since late 2016.18 Recent news reports indicate that such controls have already impacted some of China’s most prolific overseas Investors in making overseas Investments.

Additionally, the segregation of separate feeder or parallel Funds for Investors who could be impacted could be a solution for Lenders with respect to Subscription Facilities, such that those Investors’ Capital Commitments would not be financed by a Subscription Facility. Additionally, it was noted that Chinese banks’ increased role in the market for Subscription Facilities could make them uniquely suited to finance such Investor risk, in that structures to permit payment in local currency in China might be arranged, to the extent such controls would otherwise prevent funding to a Lender outside of China to repay a Subscription Facility.

Conclusion

2017 continues the generally steady growth in the Fund Finance market. Large sponsors diversifying their platforms into debt funds and credit funds will likely give rise to an uptick in the number of fund financings during the near term. The germination taking place in Asia should eventually lead to significant cultivation over the long term. So long as market participants remain vigilant with respect to underwriting, diligence and structure we project that that overall health of the market for Subscription Facilities and Alternative Fund Financings will be well sustained for several years to come.

Endnotes

1 Preqin Quarterly Update Private Equity and Venture Capital, Q2 2017, p.2.

2 Preqin at p.3.

3 Preqin at p.3.

4 Preqin at p.2.

5 Please note that the fundraising related to the Soft Bank Vision Fund, which is targeting a $100 billion close, and has raised $93 billion year to date, skews these averages.

6 Preqin at p.4.

7 Preqin at p.4.

8 Preqin at p.4.

9 Preqin at p.5.

10 Preqin at p.5.

11 Please register for this year’s Mayer Brown Hybrid Facilities and Other Alternative Lending Products Seminar at https://connect.mayerbrown.com/133/630/ compose-email/internal-invitation-event-170913-nycseminar-fundfin-hybrid.asp?sid=blankform

12 https://ilpa.org/wp-content/uploads/2017/06/ILPASubscription-Lines-of-Credit-and-Alignment-ofInterests-June-2017.pdf.

13 For more proposed sample answers to these due diligence questions, see Model Responses to ILPA’s Subscription Credit Facility Due Diligence Questionnaire.

14 Please register for this year’s Mayer Brown Mid-Year Review at https://connect.mayerbrown.com/email_handler.aspx?sid=blankform&redirect=https%3a%2f%2fconn ect.mayerbrown.com%2f56%2f316%2flandingpages%2fblank-rsvp-business_draft.asp.

15 Preqin Private Capital in Asia Pacific, Insight into this Diverse Market, Ling Yan Teo, Manager, Asian Fund Managers, http://www.fundfinanceassociation. com/wp-content/uploads/2017/06/Asia-PacificPreqin-Slides.pdf.

16 Preqin Private Capital at p.3.

17 Preqin Private Capital at p.5.

18 China Gives up its Global Role for a Stronger Yuan, Nathaniel Taplin, Wall Street Journal, Aug. 7, 2017 https://www.wsj.com/articles/ china-gives-up-global-role-for-a-strongeryuan-1502106508.

The market for subscription-backed credit facilities, also known as “capital call” or “capital commitment” facilities (“Subscription Facilities”), continues to grow rapidly, expanding into a broader range of Funds,1 with constantly evolving features and mechanics. As the Subscription Facility market continues to grow, the functionality of Subscription Facilities has also grown beyond its roots of bridging capital calls. Funds are now realizing a variety of benefits beyond bridging capital calls, several of which are briefly discussed below.

Bridging Capital Calls and Other Financings

Traditionally, the primary function of Subscription Facilities has been to bridge capital calls and other types of permanent financing, creating a number of benefits including the following.

First, Subscription Facilities offer Funds fast access to capital, allowing Funds to move quickly with respect to time-sensitive investments. In the governing documentation of typical Funds, investors must be given at least 10-15 business days notice prior to funding a capital call. In contrast, the terms of most Subscription Facilities permit Funds to receive borrowings with as little as one business day notice, avoiding the long lead time required in calling capital from investors. The faster access to capital afforded by a Subscription Facility may give Funds a competitive advantage over rivals, especially with respect to quickly developing opportunities. Additionally, by having a Subscription Facility available, Funds may be able to avoid making anticipatory capital calls for investments that are ultimately not consummated resulting in an administrative burden of returning the capital to the investors.

Second, Subscription Facilities provide a means for Funds to “smooth” capital calls made to investors in terms of size and frequency. Without a Subscription Facility in place, Funds may need to make frequent capital calls in small amounts in order to provide for working capital and similar expenses, including payment of management fees. With a Subscription Facility in place, Funds are able to borrow for these smaller capital needs and subsequently call larger amounts of capital at more regular intervals to repay such borrowed amounts. By utilizing the Subscription Facility to “smooth out” capital calls, Funds and investors are relieved of the administrative burden caused by small and frequent capital calls, meaning cost savings for both Funds and investors.

Finally, Subscription Facilities offer a means for Funds to bridge permanent asset-level financing. In a scenario where a Fund is unable to secure asset-level financing prior to the consummation of an investment, the Fund may be able to rely on the Subscription Facility to bridge the gap. Proof of access to capital via the Subscription Facility may be a means for the Fund (as a bidder) to show the seller of an asset that it has access to funds for purposes of finalizing the transaction prior to the Fund being able to secure commitments from asset-level lenders. This bridging function gives Funds a stronger bargaining position when negotiating asset-level financing with lenders, since the Fund’s hand is not forced by the ticking clock of the impending investment closing. Additionally, incurring debt under the Subscription Facility may be a cheaper alternative to the asset-level financing available, with less burdensome reporting requirements, in which case the Fund may be incentivized to leave Subscription Facility debt outstanding for a longer period of time.

Access to Letters of Credit and Alternative Currencies

Another benefit of Subscription Facilities is providing Funds access to letters of credit and alternative currencies. Access to letters of credit can provide a valuable financial instrument to Funds, particularly in the development phase of projects. Additionally, as Funds expand globally, the ready access to alternative currencies often provided in Subscription Facilities can be an advantage for Funds. Such ready access to alternative currencies eliminates the need for Funds to call capital in one currency and convert it to another, improving the speed of capital access, lessening the impact of exchange rate exposure and reducing administrative burden. In the event a Fund needs access to new alternative currencies, typical Subscription Facility mechanics generally permit Funds and lenders to readily add new alternative currencies to the Subscription Facility.

Facilitates “True Up” of Capital

Typical governing documents of Funds require investors “true-up” capital contributions when new investors are admitted to the Fund. These true-up mechanics ensure that capital contributions made by prior investors are rebalanced so that new investors have their pro rata interest in the Fund. Such mechanics typically require contributions from new investors and return of contributions to prior investors, which is burdensome and adds back-office costs for both the Fund and the investors. By utilizing a Subscription Facility for the Fund’s capital needs prior to the Fund’s final investor closing, the Fund may be able to eliminate or lessen the need for this true-up requirement. Rather than calling for additional contributions or returning prior contributions each time new investors enter the Fund, the Fund may be able to front the purchase of investments with proceeds of the Subscription Facility until the final investor closing.

Hedging and Swaps

The inclusion of hedging and swap collateralization mechanics into Subscription Facilities offers a means for Funds to secure “foreign exchange forwards” and “foreign exchange swaps” (collectively, “Eligible Swaps”) 2 under the Subscription Facility, rather than posting cash or other collateral with hedge and swap counterparties. These mechanics, in short, permit the Fund to request that Eligible Swaps be allocated a portion of the borrowing base on a pari passu basis for purposes of collateralizing such agreements. In the event the applicable Eligible Swap moves against the Fund, the Fund can typically request that additional collateral be allocated to the borrowing base. These mechanics are extremely valuable to Funds as they avoid either the borrowing expense of posting cash or the drag on return caused by the Fund keeping cash or other liquid collateral on hand.

So too, in light of certain margin regulations scheduled to take effect in many jurisdictions around the globe, most other types of swaps and hedges (hereinafter, “Ineligible Swaps”) will now be required to be collateralized by cash or highly rated securities. For these Ineligible Swaps, Subscription Facilities offer crucial and quick liquidity for Funds needing to post cash to secure such swaps at relatively inexpensive borrowing and carrying costs.

Qualified Borrowers

Subscription Facilities often include an option for Funds to add Qualified Borrowers to the Subscription Facility. Typically, “Qualified Borrowers” are portfolio companies or their holding companies that are controlled by the Fund, do not provide any security or credit support with respect to the Subscription Facility, are only liable for their own borrowings (and not the borrowings of the Fund or any other Qualified Borrower), and are included in the Subscription Facility without the lenders conducting an in-depth review of their financial health. Qualified Borrowers provide Funds the flexibility to incur indebtedness at different levels of their organizational structure, primarily for tax and accounting purposes. This function may be particularly valuable when a Fund wishes to incur debt at the holding company level but is unable or delayed in obtaining its own financing or the Subscription Facility provides a cheaper alternative.

Distributions and Redemptions

Subscription Facilities may enhance the ability of Funds to pay distributions to investors and honor redemptions on behalf of Investors. The liquidity provided by Subscription Facilities allows Funds to make distribution payments to investors prior to the liquidation of such Funds’ investments. This function can smooth distributions for investors and prove particularly valuable in a scenario where a Fund owns appreciating assets that do not generate large cash flows. With respect to open-end Funds, Subscription Facilities can likewise provide liquidity to Funds in honoring redemptions by investors, allowing Funds to avoid liquidation of investments at inopportune times. Effective use of a Subscription Facility for the foregoing distribution and redemption functions may make Subscription Facilities more attractive to investors.

The foregoing provides only a brief overview of some of the advantages of Subscription Facilities. As the features and mechanics of Subscription Facilities continue to grow, the utility of Subscription Facilities to Funds continues to grow. As more Funds realize the benefits associated with Subscription Facilities, we expect greater market penetration and higher utilization of Subscription Facilities.

Endnotes

1 “Fund” is used herein to describe any real estate, private equity, infrastructure, debt and similarly focused investment funds.

2 The term “foreign exchange forward” means a transaction that solely involves the exchange of two different currencies on a specific future date at a fixed rate agreed upon on the inception of the contract covering the exchange. The term “foreign exchange swap” means a transaction that solely involves: (a) an exchange of two different currencies on a specific date at a fixed rate that is agreed upon on the inception of the contract covering the exchange; and (b) a reverse exchange of the two currencies described in subparagraph (a) at a later date and at a fixed rate that is agreed upon on the inception of the contract covering the exchange. See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203 § 721(a), 124 Stat. 1376, 1661 (2010) (codified at Commodity Exch. Act § 1a(24)-(25); 7 U.S.C. § 1a(24)-(25)).

I. Introduction

As the fund finance market continues to mature, fund-related product offerings are expanding both in number and in customization, attracting a broader array of private equity and real estate funds (“Funds”) and credit providers, and increasing the range of the financing products available to Funds and their Sponsors (“Sponsors”) beyond the traditional subscription credit facility product.1 We have seen growing interest among participants in the Fund finance market in partner or employee loan programs, often also commonly referred to as a shareholder or Sponsor loan program or a co-investment line of credit, depending on the nature and structure of the facility (a “Co-Investment Facility”). At the most fundamental level, a Co-Investment Facility is a line of credit extended by a bank or other financial institution (a “Lender”) to an individual member, principal or key employee of a Fund’s General Partner (“General Partner”), affiliated Management Company (“Management Company”) or Sponsor (collectively, a “Participant”), the proceeds of which are used by the borrower to make direct or indirect investments in Funds managed by their firms or the General Partner or Management Company affiliated with such Funds. Co-Investment Facilities are frequently established on a platform basis, permitting multiple Participants to partake in the benefits of a credit line while streamlining the documentation process. In some cases, a Co-Investment Facility is structured with the Fund’s General Partner, Sponsor-affiliated “special limited partner” or Management Company (collectively, a “Sponsor Vehicle”) as the borrower, with individual employees and principals acting as guarantors of the facility based upon a pre-determined maximum allocation of the overall facility amount. While there are a number of similarities between a Co-Investment Facility extended to a General Partner or Management Company and what is commonly known as a management fee credit facility2, this article will focus primarily on facilities extended to or for the benefit of individuals affiliated with a Fund as part of a broader loan program.

When security is taken, the basic collateral package for a Co-Investment Facility typically consists of a pledge by the Participant of its limited partnership interest in the Fund or the relevant Sponsor Vehicle, including the right to receive distributions from the underlying Fund or Sponsor Vehicle, as applicable. In the case of a Sponsor Vehicle borrower, the collateral, when required, is often comprised of a pledge of any limited partnership interest the Sponsor Vehicle holds in the Fund, the Sponsor Vehicle’s right to receive distributions from the Fund, any management or other fees payable to such Sponsor Vehicle under the Fund’s limited partnership agreement (the “Partnership Agreement”), and potentially any right to receive carried interest payments, as applicable. In either structure, the security package usually also includes a pledge over the deposit account into which Fund distributions and other relevant payments are made (a “Collateral Account”). A control agreement among the borrower, the Lender and the depository bank would be needed to perfect the Lender’s security over the Collateral Account. In some cases, a Co-Investment Facility is secured only by the Collateral Account into which Fund partnership interest distributions or other payments are required to be made, without a security interest being granted in any partnership interest or other contractual rights held by the borrower. We have also seen Co-Investment Facilities completed on an unsecured basis. In such a situation, additional credit support in the form of guarantees from the Sponsor Vehicle or individual principal or employee Participants, as applicable, may be delivered. A negative pledge over each Participant’s or Sponsor Vehicle’s partnership interest in the Fund or other relevant assets is frequently required in unsecured facilities to give the Lender comfort that other creditors will not have a competing secured priority interest over such assets.

In addition, the Lender may also require a pledge of a common restricted cash account into which Co-Investment Facility loan proceeds are funded with respect to all individual Participant borrowers participating in a loan program (a “Common Restricted Account”). It is customary for such a restricted account to be established nominally in the name of the Fund or relevant Sponsor Vehicle, and gives the Lender additional comfort that loan proceeds will be deployed directly by the Participant or Fund to make investments. Use of a Common Restricted Account also may aid in the administration of a loan program by the Sponsor and Fund; the Fund may withdraw loan proceeds from a single account instead of having to aggregate individual wires from the borrowers to make an investment (similarly, this minimizes the number of wires and advances the Lender must send out for a borrowing, which are usually coordinated across Participants in the program).

II. Background and Context

The utility of Co-Investment Facilities in a number of areas makes them increasingly popular. First, a Co-Investment Facility may enhance the ability of Participants to invest alongside other Investors in a Fund, either directly or through a Sponsor Vehicle, by potentially increasing the amount of capital a Participant may commit to a Fund (or Sponsor Vehicle). While for any given employee of a Fund or affiliated vehicle the decision to invest in an employer’s Fund may be discretionary and viewed as an employment benefit, after the economic downturn, Sponsors have faced growing pressure by their outside Investors to make larger investments in the Funds they manage. By leveraging the expected distributions from equity interests held in a Fund or other Sponsor Vehicle, a Co-Investment Facility may permit a Sponsor and its affiliated professionals to increase the total amount of capital committed to the Fund, thereby helping to satisfy calls from Investors that a Sponsor have more “skin in the game.” This in turn further strengthens the alignment of the interests between the third-party Investors and the Fund’s principals. Given the positive effect a Co-Investment Facility can have on aligning the interests of the Investors and Fund management and the recent traction this product has gained in the Fund finance market, we suspect that most Fund managers would find a Co-Investment Facility beneficial on one or more levels.

Second, a Co-Investment Facility may facilitate the funding by Participants of their capital contributions upon a capital demand notice by the General Partner of the Fund (or the relevant Sponsor Vehicle) by minimizing or eliminating the need and time for such Investors to gather personal funds to honor such a capital call. As mentioned above, the cash proceeds of the loan(s) under a Co-Investment Facility are typically deposited into a segregated Common Restricted Account held by the relevant Sponsor Vehicle or Fund, thus avoiding the need for individual Participant borrowers to transfer loan proceeds from their own account to the Fund or Sponsor Vehicle. This permits the Fund or applicable Sponsor Vehicle to more expeditiously deploy capital and avoid having to monitor separate wires from individual affiliated Investors, while also providing additional certainty that a capital call will be satisfied.

Finally, from the perspective of a Lender, advancing an Co-Investment Facility may allow a Lender to deepen its relationship with a Sponsor and better position itself to meet other financing needs of the Fund and its affiliated entities. A better understanding of the Sponsor’s structure and business may in turn lead to opportunities for a Co-Investment Facility Lender to provide other financing services, such as portfolio-company level financings, after-care facilities as the Fund approaches and surpasses its investment period, and potentially private wealth management services for the Sponsor’s principals and employees. A Lender willing to provide a Co-Investment Facility to a Sponsor may have a competitive advantage in winning subscription facility business over other Lenders that are not able to provide liquidity at the top of the Fund’s capital structure. These ancillary benefits are, of course, in addition to the fees and interest income a Lender would earn in providing a Co-Investment Facility.

III. Structure and Loan Documentation

Co-Investment Facilities can be structured as term loans or revolving lines of credit and, consistently in our experience, carry an interest rate higher than prevailing rates for a traditional subscription facility. Such facilities may be extended to the Participants themselves or to a Management Company or other Sponsoraffiliated vehicle through which the Participants will invest. The maximum available amount of a Co-Investment Facility is principally based on a credit assessment of each Participant and the quality of the collateral, if required. The basic loan documentation for a secured Co-Investment Facility will often include the following: (a) a loan agreement that contains all of the terms of the loan, borrowing mechanics, conditions precedent, representations, warranties and covenants, events of default and miscellaneous provisions typically found in a commercial loan agreement; (b) a promissory note; (c) a pledge or security agreement pursuant to which an individual Participant borrower assigns its rights with respect to its limited partnership interest in the Fund or relevant Sponsor Vehicle (or in the case of a Sponsor Vehicle borrower, any limited partnership interest the Sponsor Vehicle holds in the Fund and potential rights to receive management fees and carried interest payments); (d) a pledge over the Collateral Account into which distributions and other payments on account of the assets described in clause (c) are to be paid; (e) a pledge over the Common Restricted Account, if relevant to the particular borrowing structure being employed; (f) guarantees from individual employees or principals if the borrower is a Sponsor Vehicle (or in the case of Participant borrower(s), a guarantee from the relevant Sponsor Vehicle); (g) account control agreement(s) over the Collateral Account and any Common Restricted Account to perfect the Lender’s security interest therein and permit the Lender to block withdrawals from such account(s); (h) Uniform Commercial Code financing statements filed in respect of Article 9 collateral against the applicable debtors; and (i) other customary deliverables such as an officer’s certificate certifying as to the relevant organizational documents, resolutions and incumbency signatures, opinion letters and other diligence deliverables, as appropriate.

In underwriting and advancing a Co-Investment Facility, a Lender may also require a more robust document package including one or more of the following: (i) personal financial statements from the Participants detailing such individual’s financial condition, copies of bank and brokerage statements and tax returns (which materials may be required to be delivered on an ongoing periodic basis); (ii) a letter agreement executed by the Participant and the Fund or Management Company certifying as to the individual borrower’s employment data; and (iii) if required under the Partnership Agreement of the Fund or other relevant formation documentation of the Sponsor Vehicle, a consent to the pledge by the Participant (or Sponsor Vehicle) of its rights with respect to its partnership interest in the Fund or other Sponsor Vehicle from the General Partner or other relevant entity, and potentially a consent from other Investors in the Fund if required by the Partnership Agreement.

In addition to the loan and other documentation described above, as additional credit support, Lenders may require one or more guarantees in connection with a Co-Investment Facility. Where individual Participants are the borrowers, the Lender may require a guarantee by the Management Company or other Sponsoraffiliated entity of all outstanding amounts under the Co-Investment Facility. Where a Sponsor Vehicle is the borrower, the Lender will often require the individual principals to guarantee up to a pre-determined specified percentage of the obligations of the Sponsor Vehicle under the Co-Investment Facility. In addition, a Co-Investment Facility Lender may require that a minimum balance (typically determined as a percentage of the outstanding loans) be maintained in the Collateral Account or Common Restricted Account to cover a portion of the outstanding loan balance. Some Lenders require that draws on the Co-Investment Facility be used to fund only a specified percentage of the Participant’s or Sponsor Vehicle’s capital contributions as a way of promoting the borrower’s “skin in the game” and ensuring that the borrower’s investment is not fully leveraged.

Other key terms that may be included in Co-Investment Facilities are minimum net asset value tests with respect to the relevant Fund or Sponsor Vehicle or financial covenants specifying that the net asset value not decrease by a specified percentage year-over-year. In situations where the Lender is primarily looking to distributions from the Fund or Sponsor Vehicle as a source of repayment, the Co-Investment Facility may include a mandatory prepayment provision, whereby a specified percentage (often between 50% and 100%) of the proceeds of all distributions, payments and fees paid to the borrower (net of any applicable taxes) must be applied to repay the loan. Co-Investment Facilities usually include cross-defaults to other material debt of the individual borrowers and often to any subscription credit facility to which any related Fund may be a party. Ultimately, the structure and terms of a Co-Investment Facility will be bespoke, and contingent upon the Fund’s structure, underlying formation documentation, financing needs and the credit quality of the relevant debtors.

IV. Diligence Matters

As with most Fund finance products, a Lender must carefully review the Partnership Agreement and other constituent documents to understand how and when payments or distributions with respect to any proposed collateral or loan repayment sources are made, and to assess any attendant risks related to such collateral or sources of payment. The Fund’s constituent documents should also be reviewed for any limitations on the right of the Participant or Sponsor Vehicle, as applicable, to pledge its limited partnership interest in a Fund or right to receive management fees or other payments if such assets are intended collateral. For example, it is not unusual for a Partnership Agreement to prohibit a limited partner from pledging its interest in the Fund to a Lender without first obtaining consent from a specified percentage of Investors and/or the General Partner. Such a restriction would be relevant if the Lender expects to take a security interest in such assets. As noted above, however, we have seen Co-Investment Facilities completed without limited partnership interests as collateral, with credit support instead being provided in the form of any of a guarantee, pledge of Collateral Account and/or Common Restricted Account, negative pledge over partnership interest rights or minimum balance requirements, for example. In addition, to the extent the Fund has entered into a subscription credit facility or other debt obligations, consideration should be given to whether any pledge or other restriction contemplated by the Co-Investment Facility could run afoul of covenants in such other debt instruments. Finally, as with most credit products, a Lender will want to assess the general economic and investment environment relevant to the Fund’s business to stress-test the basic underwriting assumptions used in structuring and pricing a Co-Investment Facility.

V. Conclusion

As the traditional subscription facility market becomes ever more competitive, Lenders that can offer a Sponsor additional value-add financing products at different levels of the capital structure may be better able to differentiate themselves in an increasingly crowded market. Co-Investment Facilities may provide an opportunity for a Lender to expand its lending relationship with a Sponsor while enabling a Sponsor and its principals to have more “skin in the game.” With ample legal and credit due diligence and careful structuring, Lenders may be able to arrange a Co-Investment Facility to provide additional liquidity at the top of the Fund’s capital structure in a way benefiting both the Lender and the Fund.

Please feel free to contact the authors with questions regarding Co-Investment Facilities or the various structuring alternatives and considerations attendant to such facilities.

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 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 OpenEnded 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.

2 Please see Mayer Brown LLP’s article Management Fee Credit Facilities on page 64, for further discussion and analysis of the management fee facility product and key issues when lending against management fee payment streams.

Background/Key Issues

Basel III, a regulatory capital framework for financial institutions, was developed by the Basel Committee on Banking Supervision (the “Basel Committee”) in response to the financial crisis that began in 2008. During the crisis, banks were unable to dig themselves out of financial trouble due to their relative inability to convert assets into cash. In hopes of preventing a reoccurrence of this problem, the Basel Committee created Basel III to better regulate and supervise the financial sector and manage its risk. In so doing, Basel III’s reforms target the financial sector on both micro and macro levels.

The Basel III regulations have been gradually phased in by participating jurisdictions1 and, among myriad effects on the capital markets, have impacted the types of subscription credit facilities lenders are putting in place. A subscription credit facility is an extension of credit by a lender to a private equity fund (the “Fund”) wherein the lender is granted a security interest in the uncalled commitments of the Fund’s limited partners to make capital contributions when called from time to time by the Fund’s general partner (a “Subscription Facility”). This article will briefly summarize the Basel III regulations as they have been implemented in the United States, examine a resulting increase in the use of uncommitted lines of credit, and consider certain issues in the context of uncommitted lines of credit.

Basel III Regulations

While a full analysis and description of the U.S. implementation of Basel III (as thereby implemented, “U.S. Basel III”) is beyond the scope of this article, it is worth understanding the general structure of this regulatory framework, which in the United States applies to banks, bank holding companies (except small bank holding companies with less than $500 million in assets), certain savings associations and savings and loan holding companies (each, a “Bank”). The overall purposes of the U.S. Basel III regulations are to: (i) improve the financial sector’s ability to absorb losses during periods of financial and economic stress; (ii) strengthen risk management and governance; and (iii) build greater transparency and disclosures in the financial sector.2 There are a few key components of the U.S. Basel III framework that can be linked to the recent increase in the use of uncommitted lines of credit: a liquidity coverage ratio, a capital conservation buffer, and a leverage ratio.

LIQUIDITY COVERAGE RATIO

The first key feature is the liquidity coverage ratio (the “LCR”):3 to ensure that Banks have sufficient capital reserves to withstand any severe short-term disruption to liquidity, U.S. Basel III requires Banks to maintain “an adequate stock of unencumbered high-quality liquid assets (“HQLA”)” that can be easily converted to cash to meet liquidity needs for a 30-day stress scenario. The goal is for a Bank to be able to meet 100% of its total net cash outflows during the 30-day stress period. Implementing a global minimum standard for bank liquidity and “reaffirming that a bank’s stock of liquid assets are usable in times of stress” should strengthen the financial sector’s ability to finance a recovery in the event of another financial and economic crisis.4

U.S. agencies jointly issued a final rule in September 2014 that mandates 100% compliance with the minimum LCR standards set out by the final rule, which are more stringent than those under the international Basel III framework, by January 2017.5 The final rule applies to large internationally active U.S. banking organizations and any consolidated bank or saving association subsidiary of one of those companies that, at the bank level, has total consolidated assets of $10 billion or more.6

CAPITAL CONSERVATION BUFFER

Another key component of the U.S. Basel III framework is the requirement of a capital conservation buffer: in addition to the requirement that Banks maintain a minimum of 4.5% of common equity tier 1 capital, Banks must retain an additional buffer of 2.5% of common equity.7 Together, the two requirements entail that Banks retain a total of 7% of common equity tier 1 capital. Should a Bank fall below the 7% level, additional constraints will be imposed on the Bank’s discretionary distributions. Banks therefore have an incentive to keep more capital on hand, rather than lend it out, to ensure they meet this requirement.

If supervising authorities determine that the credit risk exposure of a Bank is approaching a level of systematic risk (i.e., when judging whether credit growth in relation to measures such as GDP is excessive and could lead to increased system-wide risk), then in order to combat any risk of failure of such credit exposure, a countercyclical buffer requirement ranging in size from 0% to 2.5% of risk-weighted assets may also be imposed. This is treated as an extension of the capital conservation buffer and would remain in effect until the system-wide risk lessens.8

LEVERAGE RATIO

U.S. Basel III also implements a “non-risk-based” leverage ratio (which includes off-balance sheet exposure) for large internationally active U.S. banking organizations that serves as a backstop to the risk-based capital requirements mentioned above.9 This capital reserve is extra insurance in the event that, despite the new risk-based capital adequacy requirements, the Bank’s exposures turn south and the Bank must rely on its own reserves to avoid systemic collapse. A leverage ratio requirement will prevent the financial sector from building up too much leverage; the leverage ratio is meant to prevent excessive leverage and therefore avoid deleveraging processes that can weaken the financial sector.10

Impact on Credit Facility Markets

The key features of the U.S. Basel III regulations discussed above serve to require Banks to keep more cash on hand in the aggregate. Accordingly, it is expected to be more expensive and/or less profitable for Banks to lend money under the U.S. Basel III regulatory regime. In the context of Subscription Facilities, this expense or loss of profit may be (i) retained by the Bank as a loss of profit, (ii) passed along to the Fund in the form of a higher interest rate margin/spread or, in connection with any existing Subscription Facility, increased costs, or (iii) as discussed further below, mitigated through the use of uncommitted credit facilities.

Subscription Facilities have traditionally been structured as committed lines of credit, in which a Bank commits (subject to satisfaction of certain defined conditions precedent) to lend up to a certain amount to a Fund over the life of the facility. For balance-sheet purposes, this effectively involves setting aside capital reserves for the benefit of the Fund; such capital reserves cannot be used for any other purpose before repayment in full of all principal and interest thereon by the Fund or termination of the Bank’s commitment per the terms of the credit agreement. Committed facilities thereby limit the amount of capital available to a Bank to satisfy the U.S. Basel III liquidity and capital adequacy requirements.11

Due to this increased cost, Banks have increasingly considered offering uncommitted lines of credit in an effort to satisfy borrower credit demand, including reducing the passedalong costs associated with committed facilities, while mitigating the impact of these facilities under the liquidity and capital adequacy requirements of U.S. Basel III. In general, an “Uncommitted Line” is a line of credit offered by a Bank to a Fund that does not obligate a Bank to advance loans. Rather, the Bank agrees to make loans available to the Fund in the Bank’s sole discretion. Accordingly, under an Uncommitted Line, a Bank may always refuse to advance a loan, notwithstanding the timely submittal by the Fund of a notice of borrowing, the satisfaction of any conditions precedent or the Fund’s continued compliance with all obligations under the credit documentation. While all Uncommitted Lines maintain the ability of the Bank to make or withhold loans in its sole discretion, Uncommitted Lines can vary in how they address certain issues, including maturity or termination dates and events of default.

Differences between Committed Facilities and Uncommitted Lines

Since a Bank under an Uncommitted Line does not have an ongoing obligation to lend, such a facility may not have a fixed date and may instead be open-ended. Given the Bank’s discretion to refuse a request for a loan under an Uncommitted Line, the Bank has sole control over the tenor of new loans under such a facility. With respect to repayment tenor, some Uncommitted Lines are demandable, allowing a Bank to require repayment at any time upon demand of the Fund (a “Fully Demandable Uncommitted Line”). We have also seen Uncommitted Lines contain maturity dates or termination dates that function to end a Fund’s ability to request additional loans and to fix a date for repayment. Similar to committed facilities, the termination of Uncommitted Lines may be linked not just to a specific date, but also to the occurrence of certain events (e.g., the termination of the Fund’s commitment period). Some Uncommitted Lines are both fully demandable and also have a fixed maturity or termination date.

While the representations, warranties, covenants and obligations of a Fund are generally similar between a committed facility and an Uncommitted Line, there is often divergence with respect to how each handles defaults and other termination events. For instance, in Fully Demandable Uncommitted Lines, Banks may be willing to do away with fixed events of default such as those typically found in a committed facility, instead relying on reporting requirements to learn of any non-compliance and making a real-time decision on when to demand repayment of the Uncommitted Line at such time. Other Uncommitted Lines take an alternative approach and retain events of default typical in a committed facility. Such Uncommitted Lines may tie termination and repayment to both such events of default and demand. Of course, some Uncommitted Lines are structured similarly to committed facilities, and once loans are made thereunder, they are subject to a maturity date or acceleration only upon the occurrence of an event of default.

Other Considerations of an Uncommitted Line

There are a number of other potential considerations that Funds and Banks may weigh when deciding whether to implement an Uncommitted Line.

First, Uncommitted Lines may not offer the same assurances to capital that committed facilities offer. A Fund that has a binding commitment to make an investment may suffer negative economic consequences if it does not have capital available when required for purposes of such investment. Banks offering Uncommitted Lines may therefore have to reassure Funds that, despite the uncommitted nature of an Uncommitted Line, they nonetheless will provide capital as and when the Fund needs it. As Uncommitted Lines have become more prevalent, more and more Funds have grown comfortable that such Uncommitted Lines can provide reliable access to capital.

A second consideration relates to fees a Fund may have to pay a Bank in connection with a facility. Funds understandably may have concerns about paying a large upfront fee. Unlike in a committed facility, where a Fund may pay an upfront fee to secure a Bank’s commitment to fund, a Bank under an Uncommitted Line could refuse to make loans, even after receiving an upfront fee. Banks and Funds have found a number of fee structures under Uncommitted Lines to mitigate this risk, including spreading such fees across the term of the facility or providing for funding fees, payable in connection with each funded loan, rather than upfront or facility fees.

Third, an Uncommitted Line can be difficult for a Bank to syndicate. Having multiple Banks, each with sole discretion as to funding its share of any requested loan, provides another potential source of uncertainty for Funds. Additionally, in connection with Fully Demandable Uncommitted Lines predicated on the Bank having sole discretion over whether to demand repayment of the line, the presence of two or more Banks, even when acting through an agent, could result in inter-lender issues where one Bank demands repayment and the other Bank chooses not to. There are also concerns if each Bank has discretion with respect to which limited partners to include in the borrowing base.

Conclusion

Based on our experience in documenting Uncommitted Lines and our view of the market, we expect there to be continued appetite in the market for Uncommitted Lines. While we expect that there will always be demand for committed facilities, particularly for larger Funds seeking larger multi-lender facilities, U.S. Basel III’s requirements may encourage Banks, especially banks with less access to liquid capital, to offer additional Uncommitted Lines. Given that an Uncommitted Line, in practice, will provide reliable access to capital, and that the pricing may be favorable to Funds, Fund appetite, particularly for those Funds that share a strong relationship with the Bank, should remain consistent for Uncommitted Lines.

Endnotes

1 For an overview of the phase-in timelines for the various Basel III requirements, see Bank for International Settlements, “Basel III Phase-In Arrangements,” available at http://www.bis.org/bcbs/basel3/basel3_phase_in_ arrangements.pdf. As discussed further in this article, the United States has set its own timetable for the implementation of these requirements.

2 See Bank for International Settlements, “Basel III: International Regulatory Framework for Banks,” available at http://www.bis.org/bcbs/basel3.htm.

3 For more detail on the Basel III framework, see “Leverage and Liquidity Requirements under Basel III,” the Mayer Brown Fund Finance Market Review Summer 2014, on page 111.

4 Mervyn King, Chairman of the Group of Central Bank Governors and Heads of Supervision, quoted at http:// www.bis.org/publ/bcbs238.htm.

5 See OCC, “Description: Final Rule,” available at https:// www.occ.gov/news-issuances/bulletins/2014/ bulletin-2014-51.html.

6 See U.S. Department of the Treasury, “Description: Final Rule” (October 2014), available at https://www.occ.gov/ news-issuances/bulletins/2014/bulletin-2014-51.html; Law360, “Basel III Is Not the End of Regulatory Overhaul”, available at https://www.law360.com/ articles/460903/basel-iii-is-not-the-end-ofregulatory-overhaul.

7 The capital conservation buffer was first put into place at 0.625% in January 2016 and will reach 2.5% effective as of January 2019.

8 See Federal Reserve System, “Regulatory Capital Rules: The Federal Reserve Board’s Framework for Implementing the U.S. Basel III Countercyclical Capital Buffer,” available at https://www.federalreserve.gov/ newsevents/press/bcreg/bcreg20160908b1.pdf.

9 The U.S. agencies’ final rule required certain public disclosures by banks to regulators connected to the leverage ratio to be made beginning in the first fiscal quarter of 2015. Full implementation of the minimum leverage ratio requirement is not due until January 1, 2018. See Federal Reserve System, FDIC, OCC, “Joint Press Release: Agencies Adopt Supplementary Leverage Ratio Final Rule,” available at https://www.federalreserve.gov/newsevents/press/ bcreg/20140903b.htm.

10 See Department of the Treasury, Federal Reserve System, FDIC, “Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Minimum Regulatory Capital Ratios, Capital Adequacy, Transition Provisions, and Prompt Corrective Action,” available at https://www.occ.gov/news-issuances/newsreleases/2012/nr-ia-2012-88a.pdf.

11 See “Capital Commitment Subscription Facilities and the Proposed Liquidity Coverage Ratio,” the Mayer Brown Fund Finance Market Review Winter 2013, on page 75.

Fund financings experienced positive growth and strong credit performance as an asset class through the end of 2016. Capital call subscription credit facilities (each, a “Subscription Facility”) sustained their steady growth as the product continues to diversify into various fund industries and follows the performance of capital raising in 2016. Investor capital call (each, a “Capital Call”) funding performance continued its near-zero delinquency status, and we remain unaware of any Subscription Facility lender suffering any losses on any particular transaction. Below we set forth our views on the state of the Subscription Facility market and current trends likely to be relevant in 2017, as well as the market for secondary facilities and other fund financings (“Alternative Financings”). In addition to such trends, this Market Review touches on recent updates with respect to public pension funds as well as the latest legal issues affecting fund financings.

Fundraising and Subscription Facility Growth

Fundraising in 2016 and view to 2017

In our last Market Update, published in the Fall of 2016, we predicted a positive fundraising trend for private equity funds through 2016 (each, a “Fund”). Despite the volatility and uncertainty seen in each of the US and UK political spheres, our optimism proved to be correct for the balance of 2016. Globally, Funds raised over $347 billion in investor (each, an “Investor”) capital commitments (“Capital Commitments”), which surpassed 2015 when $329 billion of commitments were raised.1 Flight to quality (or at least familiarity) continued in that larger sponsors continued to attract a more-concentrated share of commitments. Notably, the 10 largest Funds accounted for 26% of all fundraising and 12% fewer Funds closed in 2016 than in 2015, resulting in an average fund size of $471mm—an all-time high.2

As the low interest rate environment persists, the interest in Funds appears to be high, and it seems that such activity will continue into 2017. Returns for Funds in 2016 continue to average in the mid-teen range3 for all asset classes—which makes such investments popular for institutional investors. In particular, public pension funds generally experienced lackluster returns in 2016 (a gross 1.7% on assets)4 as did endowments (as described below). With options for higher returns limited, we believe that Investors seeking higher yields will continue the trend of increasing their exposure and allocations to private equity asset class.

Secondary Funds

A significant area of growth in the Fund Finance area continues to be the financing of Secondary Funds (Funds that primarily purchase private equity LP interests on the secondary market). These Secondary Funds provide liquidity and other benefits for both Investors and sponsors, especially at the end of a Fund’s life cycle. Sponsors find the use of Secondary Funds attractive as it can allow them to restructure or recapitalize their Funds. Secondary Funds can also be attractive to Investors looking to realize investments at a price certain or rebalance or reallocate their asset class exposure and investment priorities.

In 2016, there was continued and significant demand for assets to be purchased by Secondary Funds, given large fundraises by such Funds closing last year. 5 The competition resulting from such demand has also resulted in higher than expected asset value.6 One private equity secondary advisor, Greenhill, has estimated that pricing increased for such transactions as a result, with pricing at 89% of net asset value on average.7 Notwithstanding the robust demand, secondary purchases were reportedly down in 2016 by about 10% (as measured by net asset value).8

The financing of Secondary Funds follows both fundraising in respect of traditional Facilities as well as Alternative Financings focused on both the acquisition of a portfolio of investments and potentially dividend recapitalizations for the end stage of fund life. Given the significant amount of dry powder that remains, we are optimistic with respect to additional volume and performance for both acquisition activity and Alternative Financings in 2017.

Subscription Facility Growth

Although the Fund Finance market lacks league tables or an overall data reporting and tracking service, our experience is that, in 2016 and so far in 2017, the Subscription Facility market is continuing its steady upward trajectory as Funds seek to take advantage of the numerous benefits Subscription Facilities provide.9 Following this trend, Mayer Brown saw an increase in both the number of fund finance transactions and the aggregate new-money lender commitments in 2016, with new-money commitments across the Firm’s Fund Finance platform exceeding $36 billion – a new record for the Firm. Moreover, diversification with respect to such financings continue, in both product offerings (such as hybrid, umbrella and unsecured or “second lien” facilities) as well as geographic scope. We have also seen that the Subscription Facility market is rapidly gaining traction outside of the US and the UK with Asian, Canadian and Latin American lenders heavily investing in strengthening their own Fund Finance platforms.

Additionally, Alternative Fund Financings, such as fund of hedge fund financings, management fee lines and facilities based on the net asset value of a Fund’s underlying assets, have garnered more interest, with Mayer Brown representing Lenders and Funds in approximately $8 billion of such transactions that closed in 2016.

These Alternative Fund Financings have been a driver of growth in the Fund Finance market and are emerging as a permanent fixture of the market with such additional opportunities for leverage being increasingly appealing to general partners. One recent poll of general partners in Funds found that Alternative Financings of interest include general partner facilities, hybrid facilities and asset recourse facilities with 45%, 29% and 26% respectively, of general partners polled saying they would consider using them in the future.10

Trends and Developments

Monitoring and Technical Defaults

We are not aware of any technical defaults over the course of 2016, which seems to follow more rigorous monitoring of collateral by lending institutions (including prompt delivery of capital call notices, notices of transfers, Investor downgrades and similar requirements). As reported in our prior issue, a number of lenders have provided their customers with monitoring guidelines or templates to assist with their back-office processes, which have likely contributed to this result.

Complexity of Fund Structures

We have seen Funds be more willing to adjust their Fund structures to admit Investors with specific needs, including those related to tax, jurisdictional and similar concerns. This has resulted in a proliferation of parallel funds, funds-of-one, sidecar vehicles, and rather complex Fund structures over the last year.

For example, while so-called “cascading pledge” structures have been somewhat common for years in Subscription Financings, we are now seeing structures where capital contributions must “cascade” through five or six layers of fund entities before hitting the borrower’s collateral account. Lenders have adjusted accordingly and are actively developing solutions to streamline documentation and overcome a multitude of new obstacles presented by these structures.

Pension Fund Update

Much has been made with respect to the funded status of public pensions, due to recent reports regarding investment losses and underfunding of various plans. In particular, recent reports relating to both the State of Connecticut and the Dallas Police and Fire Pension Fund have highlighted funding level declines. In the case of Dallas Police and Fire, this decline has occurred due to mounting real estate and other investment losses over the past few years, leaving the fund with only 45% of the assets necessary to meet future benefits, requiring substantial additional contributions to be requested from the city of Dallas11 and additional withdrawals as retirees opted to accelerate retirement. With respect to the Connecticut State Employee Retirement System, recent valuations coupled with state budget proposals would provide that it has only enough assets to cover 35% of its long-term liabilities,12 and new proposals for taxation have been raised to close state budget shortfalls associated with payment of pension costs.13

However, for the most part, good news prevailed in 2016, which marked the third year where the average funded status of public pensions made gains, with the average status of public pension funds being 76.2% at the end of 2016.14 Additionally, such gains were made while 40% of the funds lowered their assumed rate of return and many reduced their investment return assumptions15 to be more realistic in light of the overall investment environment. Regardless, in a typical Subscription Facility, public pensions are only included in the borrowing base to the extent that they have an investment grade rating and/or 90%+ funding status, so a significant drop in a pension’s funding status versus its liabilities would likely cause a mandatory prepayment of a Subscription Facility (to the extent such an investor were to be necessary to support outstanding borrowings)

Additionally, continued lender attention has been seen with respect to the issues of pay-toplay and other common side letter provisions which often have withdrawal or other consequences for Investors in Funds, and ultimately with respect to Facilities as well. In particular, federal prosecutors have recently targeted a former pension executive of the New York Common Retirement Fund in a probe of possible misconduct.16 The allegations stem from possible bribery including trips and other possible compensation by contacts at an outside brokerage providing services to the pension fund. While such allegations remain unproven, they continue to show the importance of obtaining assurances to the extent possible in side letters containing cease funding or other requirements, in order to require funding by a pension fund to a lender who has relied on commitments.

Endowment Updates

Another traditional investor in Funds, endowments, struggled in 2016. The largest US endowments, in particular, have seen belowaverage and in some cases negative investment results in 2016, with the worst average annual return (-2.6%) since the financial crisis.17 Most of these returns have followed the capital markets and, therefore, reflect asset allocations for such endowments that were more heavily weighted on exposure to such markets rather than private equity.18

In fact, disappointing overall returns have caused many endowments to shift strategy. In a public move, the largest US endowment, Harvard University, with $34.5 billion of assets under management, has recently announced that it is revisiting its traditional approach of relying on a large internal team.19 Instead, it seeks to eliminate a large number of its in-house investment staff, and the remaining investment staff would become more “generalist” covering multiple aspects of the portfolio rather than specialists on a particular asset class or strategy. 20

We think that such shifts in strategy may also lead to growth of endowment interest in Funds managed by outside managers and perhaps increase allocations by endowments in private equity in 2017.

Hague Convention and Impact on Alternative Financings

One development of particular note for Alternative Financings is the upcoming effectiveness of the Convention on the Law Applicable to Certain Rights in Respect of Securities Held with an Intermediary, commonly known as the “HSC,” which was promulgated by the Hague Convention on International Private Law. This conflicts of laws regime is important in respect of multi-jurisdictional transactions and applies to securities held through an “intermediary” and generally relates to perfection and priority of a security interest in a security entitlement of securities accounts. Given securities accounts can often serve as the primary collateral account for Financings, and in respect of Alternative Financings such as hedge fund of fund financings, the primary collateral is a securities entitlement with respect to a hedge fund of fund’s accounts; the HCS and its applicability to indirect holdings systems can cause issues of concern for Lenders relating to perfection of security interests.21 Such issues should be carefully navigated by Lenders using experienced counsel with respect to both the intersection of the HSC, the Uniform Commercial Code and Alternative Financings.

2017 Outlook

As noted above, 2017 continues the generally steady growth in the Subscription Facility market. We, like Investors that are currently in the market, remain optimistic that such trends will continue through the remainder of 2017 and that the recent market changes in the United States, United Kingdom and Europe will continue to provide opportunities for Investors as well as Funds seeking financing and institutions providing such financing.

Endnotes

1 Preqin Private Equity & Venture Capital Spotlight, January 2017, p.11.

2 Id.

3 Preqin at p.10.

4 Public Pension Funds Lower Fees, Improve Funding Ratios in 2016, Meghan Kilroy, Pensions and Investments Online, January 17, 2017.

5 Greenhill Secondary Market Trends & Outlook, January 2017.

6 Id.

7 Id.

8 Id.

9 For more information on the benefits of Subscription Facilities, please see our article The Advantages of Subscription Credit Facilities, page 240.

10 Investec Fund Finance GP Trends 2016.

11 Dallas Mayor Sues to Stop Police, Fire Pension Exits, Heather Gillers, November 21, 2016, Wall Street Journal.

12 Future Payment Scheme Takes a Heavy Present Toll on State Pension Fund, Keith M. Phaneuf, January 5, 2017, Connecticut Mirror.

13 Connecticut Governor Seeks to Shift Teacher Pension Costs to Towns, Cities, Joseph De Avila, February 3, 2017, Wall Street Journal.

14 Kilroy at p.1.

15 Kilroy at p.1.

16 New York Pension Scandal Prompts Firing of Second Employee, Justin Baer, February 1, 2017, Wall Street Journal.

17 Large Endowments Struggled with Returns in Fiscal 2016, Christine Williamson, February 6, 2017, Pension and Investments Online.

18 Id.

19 Harvard Decides to go Different Way on Investing, James Comtois, February 6, 2017, Pension and Investments Online.

20 Id.

21 For more information on this topic and assistance navigating these changes, please see the recent article by Mayer Brown partner Barbara M. Goodstein, Hague Securities Convention Comes Into Effect, New York Law Journal, February 1, 2017. http://www. newyorklawjournal.com/id=1202778150394/HagueSecurities-Convention-Comes-Into-Effect?mcode=12026 14952687&curindex=0&curpage=1