Mayer Brown announced today that Bryan Barreras has joined the firm’s New York office as a partner in the global Banking & Finance and Fund Finance practices.
Read full story here
Mayer Brown announced today that Bryan Barreras has joined the firm’s New York office as a partner in the global Banking & Finance and Fund Finance practices.
Read full story here
As the subscription credit facility market continues to experience steady growth, lenders seek to expand their lending capabilities beyond traditional subscription credit facilities to commingled private equity investment vehicles (“Funds”). One way lenders have accomplished this is by lending to Funds that have a single dedicated investor in the Fund (each, a “Fund of One”). By way of background, a subscription credit facility (a “Facility”) is a loan or line of credit made by a bank or other credit institution (a “Creditor”) to a Fund that is secured by (i) the unfunded commitments (the “Capital Commitments”) of the investors to fund capital contributions (“Capital Contributions”) to the Fund when called from time to time by the Fund (or its general partner, managing member or manager (a “Manager”)), (ii) the rights of the Fund or its Manager to make a call (each, a “Capital Call”) upon the Capital Commitments of the investors and the right to enforce payment of the same and (iii) the account into which investors fund Capital Contributions in response to a Capital Call.1
A Fund of One has one investor (which is typically a well-established institutional investor) (the “Investor”). The respective rights and obligations of the Investor and the Manager are primarily contained in the limited liability company agreement, the limited partnership agreement or an investment management agreement of the Fund of One (the “Governing Agreement”). A Fund of One may also have an equity interest from an additional party (typically an affiliate of the sponsor and Manager of the Fund of One), but the additional party’s equity interest is often small compared to the equity investment of the Investor. A number of institutional Investors have shifted towards investing in Funds of Ones for a number of reasons, including: (i) a Fund of One offers greater control of all aspects of the investment process (such as investment decisions and reporting), (ii) Funds of One usually have reduced management fees, (iii) the investment mandate can be customtailored for the Investor and (iv) the Investor is protected from co-investor default risk.2 Many institutional investors, including state pension plans, foreign pension plans and sovereign wealth funds, have been known to use a Fund of One as an investment vehicle. Although a Manager will control the Fund of One and have primary responsibility for conducting the operations and making investment decisions for the Fund of One, the level of involvement and control by an Investor in a Fund of One can vary. The level of involvement of the Investor is generally shaped by the specific investment policies and experience of the Investor’s personnel in the type of investments intended to be made by the Fund of One, the relative negotiating power of the Investor and the Manager and, in some cases with respect to certain foreign investors, the desire to avoid having effective practical control over the Fund of One in order to be eligible to achieve desirable US federal income tax treatment on the investment.
This article addresses issues and documentation considerations for Facilities to a Fund of One
Governing Agreement Issues
Not all potential Fund of One borrowers have a Governing Agreement that is able to support a Facility. To be suitable for a Facility, the Governing Agreement should, among other things, expressly authorize the Manager to obtain a Facility on behalf of the Fund of One and provide as collateral the right to call upon the unfunded Capital Commitments of the Investor. For purposes of this article, we assume that the Capital Commitment of the Investor is an equity commitment and the Investor is fully obligated to fund upon a validly issued Capital Call from the Manager or the Creditor pursuant to a pledge of the Manager’s rights. Three common concerns regarding the Governing Agreement of a Fund of One in particular are: (1) the consent rights of the Investor with respect to borrowings and the operating budget, (2) limitations on the right to pledge the Capital Commitment of the Investor and (3) enforcement rights against the Investor if the Investor fails to fund its Capital Commitment.
Consent rights afforded to an Investor under the Governing Agreement for a Fund of One may be quite broad. For example, the Investor may have consent rights for each investment with respect to each borrowing and/or the budget. This is unlike a commingled Fund with a large number of Investors, in which the mandate to the Manager with respect to investments is often broad in nature, and consent is not generally required prior to each investment. Furthermore, the Investor in a Fund of One may have a consent right regarding all borrowings of the Fund of One (or a consent right for all borrowings above a particular threshold amount) and/or the right to approve the Fund of One’s operating budget. In a commingled Fund, by contrast, there is typically a provision in the Governing Agreement permitting borrowings and giving authorization to the Manager to set the Fund’s operating budget. If the Investor has a consent right with respect to individual borrowings and the operating budget, the Creditor may consider making it explicit in an Investor Letter (as described in “Facility Documentation Considerations” below) that the Investor consents to the Facility and agrees to fund Capital Contributions to the Creditor during an event of default under the Facility.
There may also be limitations in the Governing Agreement regarding the amount of the Investor’s Capital Commitment that can be pledged to the Creditor as collateral for the Facility. For example, if an Investor has a Capital Commitment of $100 million, the Governing Agreement for the Fund of One may provide that only 80 percent ($80 million) of the Investor’s Capital Commitment may be pledged to the Creditor. In this case, the Creditor would only consider $80 million as part of the borrowing base for the Facility, not the total $100 million Capital Commitment. In addition, there may be issues with tracking (whether or not capital that has been called is part of the Capital Commitment that may be pledged to the Creditor). One solution is to provide in the Governing Agreement or subscription documents, as applicable, that the Investor has two Capital Commitments: one Capital Commitment that may be pledged to a Creditor and one that may not be pledged. In addition, the Creditor may require that the reporting of Capital Calls clearly sets forth the Capital Contributions that have been called and what portion is part of the Capital Commitment that has been pledged to the Creditor.
Finally, Funds of One differ from commingled Funds in their treatment of defaulting Investors. In a typical Governing Agreement for a commingled Fund, there are often draconian enforcement rights with respect to Investors that fail to fund Capital Contributions when due, including a forced sale of the defaulting Investor’s interest in the Fund at a discount of up to 50 percent as well as loss of distribution rights and other rights such as participating in future investments of the Fund and voting. In a Fund of One, however, there are typically narrower enforcement rights under the Governing Agreement (often limited to default interest and the right of the Manager to pursue ligation against the Investor), and the Manager does not have the ability to call on other Investors to make up the defaulting Investor’s shortfall. In addition, it is unlikely that the Manager’s Capital Commitment would be sufficient to make up the shortfall caused by the defaulting Investor. The Creditor may consider seeking additional credit support from the Manager, a sponsor of the Manager or a parent entity of the Investor to address the limited enforcement rights in the Governing Agreement.
Facility Documentation Considerations
While a Facility for a Fund of One is generally similar to a Facility for a commingled Fund in terms of closing documentation, a Facility for a Fund of One may require a few specific changes in order to give the Creditor comfort from an underwriting perspective.
First, the Creditor may require an investor letter (the “Investor Letter”) from the Investor in a Fund of One in connection with the Facility. An Investor Letter is an acknowledgement made by an Investor in favor of a Creditor in which the Investor makes representations, acknowledgements and covenants relating to the pledge to the Creditor of the right to receive and enforce the Facility collateral. It is also not uncommon for the Creditor to require an investor opinion (an “Investor Opinion”) from legal counsel of the Investor stating various legal conclusions with respect to the Investor, such as the valid existence and good standing of the Investor and the corporate power and authority to execute the Investor Letter. Although there is a market trend away from requiring an Investor Letter and an Investor Opinion for Facilities generally, it is still common for a Creditor to require this additional documentation in a Facility for a Fund of One where the Creditor is relying on the Capital Commitment of a single Investor for repayment.
A second issue for a Creditor to consider is the proper advance rate against the Capital Commitment of the Investor. In a Facility in which there are numerous Investors, the Creditor will often advance against different percentages of each Investor’s Capital Commitment depending on the creditworthiness of each Investor based on the Creditor’s underwriting of each Investor (for example, the Creditor may advance 90 percent against well-established institutional Investors and 70 percent against other designated Investors). For a Fund of One, the analysis may be similar and the advance rate for that single Investor may depend on what the Creditor would normally advance against that particular Investor in the case of a Facility to a commingled Fund. However, an important consideration for the Creditor is how much overall exposure the Creditor has to that particular Investor across the Creditor’s other Facilities, such as exposure to that Investor in Facilities to commingled Funds in which that Investor has also invested.
Alternatively, the Creditor may decide to advance a lower percentage against the Investor’s Capital Commitment than it would otherwise in case of a Facility to a commingled Fund because the Creditor does not have certain benefits related to a Facility for a commingled Fund. Most notably, the Creditor is relying on the Capital Commitment of a single Investor in a Fund of One and does not benefit from the reduced risk that comes with diversification from relying on the Capital Commitments of numerous Investors in a commingled Fund. In a commingled Fund, a Creditor typically advances loans against the Capital Commitments of only well-established institutional Investors and certain other Investors in the Fund, although the Creditor takes as collateral the Capital Commitments of all Investors in the Fund. In a Fund of One, the Creditor does not have such additional collateral from other Investors aside from the sponsor Capital Commitment, which is often just a fraction of the Investor Capital Commitment, and that is likely insufficient to cover any shortfall.
Events that would remove an Investor from the borrowing base (“Exclusion Events”) in a Facility to a Fund of One will often be similar to what would be found in a typical Facility. Such Exclusion Events generally include the Investor filing for bankruptcy, judgments against the Investor over a certain threshold amount, failure to make a Capital Contribution within a certain time period, transfer of the Investor’s interest in the Fund of One and default under the Governing Agreement or other subscription documents. However, the Exclusion Events in a Facility to a Fund of One may be more stringent in a few respects, including with respect to a cure or grace period. If any credit support is provided by a parent of the Investor (as discussed more fully below), the Exclusion Events typically extend to the parent of the Investor as well. Also, if the Investor executes additional documentation supporting its obligations to fund Capital Commitments in the form of an Investor Letter (as discussed above) and the Investor violates the term of that Investor Letter, there may be an Exclusion Event relating to that breach. If there is an Exclusion Event and there are amounts outstanding under the Facility, then the Investor’s removal from the borrowing base is likely to result in a mandatory prepayment event under the Facility.
Another difference between a Facility to a commingled Fund and a Facility to a Fund of One involves Creditor consent for an Investor to transfer its interest in the commingled Fund or the Fund of One, as applicable. In a Facility to a commingled Fund, the Creditor may be more comfortable permitting an Investor to transfer its interest (subject to any necessary prepayment under the Facility) because the Creditor’s collateral includes the Capital Commitments of many other Investors. However, for a Fund of One, because the Creditor’s underwriting of the Facility is strongly tied to its underwriting of the single Investor, a transfer by that Investor may likely require additional credit approval. Therefore, it is typical that a Facility to a Fund of One prohibits the Investor from transferring its interest in the Fund of One without the prior consent of the Creditor. In addition, even if the Creditor ultimately permits the Investor to transfer its interest (for example, to an affiliate of the Investor), the Creditor may require the original Investor to provide credit support for the new Investor.
For a Facility to a Fund of One, the Creditor may also require some form of credit support or other credit enhancement from the Investor, a parent of the Investor and/or the sponsor of the Fund of One. When the credit support is from a parent of the Investor, it is typically in the form of a comfort letter, guaranty or keepwell agreement. Delivery of one of these documents will often enable a Creditor to include a less creditworthy Investor or special-purpose vehicle in the borrowing base. If the credit support is from the Manager or a sponsor of the Fund of One (or principals of the sponsor) or from the Investor itself, such credit support will often be negotiated and a cap may be placed on the guarantor’s obligations with respect to the Facility.
Given the utility of these Facilities for Funds in terms of providing liquidity and facilitating investments, the number of Funds seeking a Facility continues to rise as does the demand for Facilities for a Fund of One. With attention to the nuances in the Governing Agreement and related subscription documentation, loans to Funds of One can be made with closing documentation similar to what is required in a Facility to a commingled Fund together with an Investor Letter, Investor Opinion and perhaps a comfort letter or other form of credit support or credit enhancement. Please contact the authors with questions regarding these transactions and the various methods for establishing a Facility in connection with a Fund of One.
1 For more background on these terms and related terms used in this article, see “Beginner’s Glossary to Fund Finance” in the Fund Finance Market Review, Spring 2016, on page 178.
2 See “Separate Accounts vs. Commingled Funds: Similarities and Differences in the Context of Credit Facilities” in the Fund Finance Market Review, Summer 2013, on page 35.
A management fee credit facility (a “Management Fee Facility”) is a loan made by a bank or other financial institution (a “Lender”) to the management company or investment advisor (collectively, a “Management Company”) that is typically the sponsor (or affiliated therewith) (a “Sponsor”) of a private equity fund (a “Fund”). The Lender under a Management Fee Facility is typically secured by, among other things, a pledge from the general partner (the “General Partner”) or Management Company of its rights to receive management fees under the Fund’s limited partnership agreement (a “Partnership Agreement”) or other applicable management or investment advisory agreement. The Fund itself may have a subscription credit facility (a “Subscription Facility”), also known as a “capital call facility,” for which the collateral package is the commitments of the limited partners in the Fund (the “Investors”) to make capital contributions when called by the General Partner.1 A Lender under a Subscription Facility typically requires a covenant that restricts payments by a Fund in respect of other debt or obligations owed to affiliates of the Fund (including, without limitation, to its General Partner or the related Management Company in respect of fees) following the occurrence and during the continuance of an event of default, any potential event of default and/or other mandatory prepayment events thereunder, essentially subordinating such payments to the obligations owing to the Lender under the Subscription Facility (a “Subordination Provision”). A Subordination Provision may be problematic for the General Partner or Management Company because the Lender under a Management Fee Facility will be reluctant to permit the subordination of the payment streams needed to make payments owed to such Lender to payments owed to a Lender under a Subscription Facility. This article will discuss the potential tension between a Management Fee Facility and a Subscription Facility in the context of a Subordination Provision and suggest a few possible solutions that would allow the Fund, General Partner/Management Company and Lender(s) to permit the two different facilities to coexist and benefit each party in interest.
Management Fees Generally
The ability of any Fund to invest and provide returns to its Investors is necessarily dependent on the guidance of the General Partner or Management Company regarding how the capital of the Fund will be invested. The General Partner and/or Management Company will receive a fee as compensation for discovering and evaluating investment opportunities and conducting other management responsibilities along with providing general back-office support to a Fund (such fees collectively, the “Management Fee”). The Management Fee may be applied by the General Partner or Management Company to pay its operating expenses and the salaries of the employees and investment professionals employed thereby. Payment of the Management Fee is typically either made directly to the General Partner and/ or Management Company by an Investor or it may be paid through the Fund in the form of a capital call pursuant to the subscription agreement that each Investor has with the Fund. The General Partner or Management Company will typically receive payment of the Management Fee from the Investors in the Fund on either a quarterly or semiannual basis.
The Management Fee is usually charged on a per-Investor basis and is often calculated by multiplying a percentage (historically between 1.5 percent and 2 percent per annum) by such Investor’s capital commitment. The Management Fee is appropriately calculated to cover the cost of operating the General Partner or Management Company.
Note that not all payments to the General Partner or Management Company constitute Management Fees. A General Partner or Management Company may also receive a performance payment (often referred to as the “promote” or “carried interest”) as compensation for achieving returns above a certain benchmark (a “Performance Fee”). Once a Fund is able to return the capital of an Investor and a certain percentage of profit on such capital, the General Partner or Management Company may participate in any returns above this preferred or hurdle return. The Performance Fee is generally separate and distinct from the Management Fee and is not typically included as collateral or a payment stream in a Management Fee Facility.
Subscription Facilities and the Subordination Provision
A Subscription Facility is beneficial to a Fund (and thus the General Partner and Management Company) for many different reasons, including its ability to provide bridge financing that allows the Fund to quickly capitalize on an investment opportunity by providing access to capital on a faster basis (sometimes as early as the next day) than would normally be available from Investors under the terms of the Fund’s Partnership Agreement. Typically, each Investor will have up to ten business days to fund its capital commitment following a capital call by the Fund. The mechanics related to calling capital from Investors necessarily require a Fund to delay (or have sufficient advance notice of) any investment and may limit the investment opportunities of a Fund simply due to this timing restriction. A Subscription Facility will eliminate or significantly reduce this delay. The Lender under a Subscription Facility will advance capital to the Fund and rely on the ability of the Fund to call capital from Investors as the source of repayment. The collateral package given to a Lender under a Subscription Facility by the Fund will include the collateral assignment of the right to make capital calls upon Investors to repay the amounts advanced to the Fund under the Subscription Facility.
The loan documentation for the Subscription Facility will often include a Subordination Provision, which will typically extend to the Management Fee. If the Fund were to make a payment of the Management Fee following the occurrence and during the continuance of an event of default, potential default or other mandatory prepayment event under a Subscription Facility, such payment will likely violate the Subordination Provision. Lenders, however, are increasingly willing to include a carve-out to the Subordination Provision that allows for payment of the Management Fee by the Fund despite the existence of an event that triggers the Subordination Provision under the Subscription Facility. The inclusion of this carve-out by Lenders for payment of the Management Fee (but typically not permitting payment of any Performance Fee) while the Subordination Provision is effective has become a market trend because payment of the Management Fee is viewed by Lenders as critical to the Fund’s ability to continue to operate. In contrast, Lenders generally view the Performance Fee as excess compensation that constitutes a share of the profit of the Fund and not as a payment that is necessary for the General Partner or Management Company to continue to function.
Permitting the payment of the Management Fee, even during an event of default, can be viewed as an alignment of interests for all parties that goes beyond keeping the Fund operational. The Lender has a vested interest in permitting the Fund to manage its investments and continue to operate the Fund so as to maximize the potential source of repayment of obligations owed to the Lender under the Subscription Facility. Achieving this result to maximum effect can realistically only be achieved if the General Partner and/or Management Company can continue to pay its employees and keep the Fund functioning. If the General Partner or Management Company is not paid for its services during this critical period, the ability to receive payment on the Fund’s obligations to the Lender under the Subscription Facility or capture potential profits for Investors (and a potential Performance Fee for the General Partner/ Management Company), in each case, could be severely impaired. While recognizing the mutually beneficial aspect of permitting the payment of the Management Fee, a Lender may be hesitant to allow unrestricted payments in respect thereof. In such instances, the Lender may place a cap on the dollar amount the Fund is permitted to pay in respect of the Management Fee on either a quarterly or annual basis or the cap may only be effective during the occurrence and continuance of an event of default under the Subscription Facility.
While the market trend recognizes the benefits of exempting the payment of the Management Fee from the Subordination Provision of a Subscription Facility during times of stress, the Partnership Agreement of the Fund increasingly includes restrictions on paying Management Fees. These so-called “overcall” restrictions prohibit capital calls with respect to Management Fees on non-defaulting Investors to offset the shortfall created when another Investor defaults in its capital commitment to the Fund.2 An overcall restriction becomes problematic for a Lender under a Subscription Facility because the terms of a Subscription Facility will often permit the payment of Management Fees with the proceeds of any borrowing under the Subscription Facility. If the Partnership Agreement of the Fund, however, includes an overcall restriction, the Lender can only rely on the non-defaulting Investors for purposes of repaying the obligations under the Subscription Facility attributable to the payment of the Management Fee.3 Due to this risk, Lenders may consider limiting the payment of Management Fees with the proceeds of any borrowing under the Subscription Facility. Another approach to mitigating a Lender’s exposure to the overcall restriction risk is to require an accelerated repayment period (a “clean-up call”) in respect of any borrowings under a Subscription Facility that are earmarked for payment of the Management Fee.4
Placing caps on Management Fee payments, prohibiting borrowings under a Subscription Facility to pay Management Fees or implementing a clean-up call feature are all solutions that can be successfully used under a Subscription Facility to permit payment of the Management Fee while mitigating the risk exposure of a Lender.
Management Fee Facilities and the Restrictive Agreement Covenant
The Management Fee is typically paid by Investors in the Fund on either a quarterly or semiannual basis, however the General Partner’s or Management Company’s ongoing expenses related to managing the Fund (from managing and evaluating investments to paying employee salaries) must be paid on a more frequent basis. The General Partner or Management Company may use the proceeds of the Management Fee to pay a variety of different costs associated with its business, such as providing general working capital, funding its own capital contribution to a Fund, and facilitating the buy-out of partners and/or mergers and acquisitions. A Management Fee Facility allows the Management Company or Sponsor to receive consistent cash flow that would otherwise be unavailable if relying on the standard Management Fee payment schedule and is typically structured as a revolving loan commitment from the Lender, secured by a pledge by the General Partner or Management Company of its right to receive payment of the Management Fee from one or several Funds.5 Generally, a Lender will only provide a Management Fee Facility to a Management Company or Sponsor that can demonstrate a proven history of receiving Management Fees; it is unlikely that a first-time Sponsor will find a Lender willing to provide financing based on the anticipated and as-of-yet undocumented receipt of Management Fees.
A Management Fee Facility will often include covenants that are designed to give the Lender comfort that the payment stream of each Management Fee securing the facility will continue to be paid to the General Partner or Management Company for the duration of the Management Fee Facility. These covenants may take the form of a requirement that (i) the General Partner or Management Company receive a minimum amount of income from the Management Fees, (ii) a certain ratio of the Management Fees received to the aggregate commitments of the Investors in each Fund that are paying the Management Fee is maintained or (iii) the Fund maintain a minimum net asset level. A negative covenant with respect to entering into “restrictive agreements” is another common restriction found in a Management Fee Facility. This type of covenant, which is analogous to a negative pledge, restricts the General Partner or Management Company from entering into, or permitting to exist, any agreement or other arrangement that prohibits, restricts or imposes any condition upon the ability of any Fund to pay Management Fees to the General Partner or Management Company (a “Restrictive Agreement Covenant”). If the General Partner and/or Management Company agree to include a Subordination Provision under a Subscription Facility for a Fund from which the Management Fees are part of the collateral package granted to the Lender under a Management Fee Facility, the General Partner/Management Company would most likely breach the Restrictive Agreement Covenant in such instance.
Addressing the Subordination Provision/ Restrictive Agreement Covenant Conflict
The conflict between the Subordination Provision that is often included in a Subscription Facility and the Restrictive Agreement Covenant included in a Management Fee Facility presents challenges to both Management Companies/Sponsors and Lenders in attempting to accommodate both facilities. A Lender may be willing to provide a blanket carve-out to the Restrictive Agreement Covenant for any Subscription Facility that may include a Subordination Provision, recognizing that the ability of the Fund to secure financing under a Subscription Facility contributes to the success (and the continued payment of Management Fees) of a Fund. A Lender may also be willing to grandfather on a case-by-case basis existing Subscription Facilities that include a Subordination Provision for any Fund that will contribute Management Fees to the borrowing base for a Management Fee Facility following diligence related to such Subscription Facility and similarly evaluate any new Subscription Facilities for eligibility under a Management Fee Facility. In the instance where the Lender under a Fund’s Subscription Facility is also the Lender under the Management Fee Facility for such Fund’s General Partner/Management Company, the Lender may include a blanket carve-out from the Restrictive Agreement Covenant with respect to the Management Fees that are subject to a Subordination Provision in the Subscription Facility for such Fund due to the Lender’s familiarity with the overall structure of the Subscription Facility and its Investors.
A Management Fee Facility can also be structured in a manner that will (i) reduce the Lender’s exposure to Management Fees that may be subject to a Subordination Provision or (ii) otherwise reduce the Lender’s reliance on Management Fees to secure repayment from the General Partner or Management Company. The former may be accomplished by simply providing a reduced advance rate for any Management Fees subject to a Subordination Provision under a Subscription Facility. The latter may be achieved by diversifying the payment streams that secure a Management Fee Facility. In this diversification scenario, the Lender may elect to expand the collateral package under the Management Fee Facility by receiving a pledge from the General Partner/Management Company that also includes the Performance Fee discussed above, payments with respect to co-investments or other payment streams in addition to the Management Fee. In some cases, the Lender may actually receive a guaranty by one or more of the principals in the General Partner/Management Company or even the Sponsor as another form of support. Each of these approaches provides the General Partner/Management Company and the Lender flexibility to structure a Management Fee Facility that both acknowledges and accommodates Subordination Provisions.
The tension between a Subordination Provision and a Restrictive Agreement Covenant, if properly addressed, should not prevent a Management Company/Sponsor from obtaining financing for a Fund under a Subscription Facility while also permitting it to receive regular cash flow by leveraging Management Fees paid by Investors in such Fund or other income streams. Experienced legal counsel can help both the Management Company/Sponsor and the Lender navigate these issues and suggest structures and proposals that will support borrowing capacity for the Management Company/Sponsor under a Management Fee Facility while ensuring the Lender will also be properly secured.
1 For a detailed update on current trends and developments in the subscription credit facility market and fund finance market, please see Mayer Brown’s Fund Finance Market Review Spring 2016, beginning on page 167.
2 The non-defaulting Investor will likely object to paying the management fees owed by a defaulting Investor, and overcall limitations are increasingly included in the Fund’s Partnership Agreement. Further discussion of overcall limitations in respect of management fees can be found in the “Spring 2016 Market Review” in Mayer Brown’s Fund Finance Market Review Spring 2016, on page 167.
3 Note that, typically, the Partnership Agreement of a Fund will make each Investor obligated to repay any amounts owing under a Subscription Facility by the Fund up to the total capital commitment of such Investor; an overcall restriction may negate this if the amounts owing under the Subscription Facility are in respect of the payment of the Management Fee that is attributable to a defaulting investor.
4 Borrowings under a Subscription Facility are not generally required to be repaid (barring the occurrence of an event of default or other triggering event) prior to maturity of the loan. A clean-up call feature may require that any borrowings that are made in order to pay the Management Fee be repaid within 90 days.
5 For a detailed description and examination of management fee credit facilities, please see “Management Fee Credit Facilities” in Mayer Brown’s Fund Finance Market Review Winter 2013, on page 64.
Real estate, buyout, infrastructure, debt, secondary, energy and other closed-end funds (each, a “Fund”) frequently seek to obtain the benefits of a subscription credit facility (a “Subscription Facility”). However, to the extent that uncalled capital commitments may not be available to support a Subscription Facility (for example, following expiration of the applicable investment or commitment period, a Fund’s organizational documentation does not contemplate a Subscription Facility) or a Subscription Facility already exists, alternative fundlevel financing solutions may be available to Funds based on the inherent value of their investment portfolios (each, an “Investment”). As Fund finance continues to grow in popularity, banks (each a “Lender”) have been working with their private equity and hedge fund clients in particular to assist them with unlocking the value of their Investments. The appetite for liquidity among these Funds dictates facilities that share similar characteristics, although hedge fund financing includes unique issues to address in this expanding market.
One solution for providing liquidity to a Fund is to structure borrowing availability based on the net asset value (“NAV”) of a Fund’s Investments. Although lending against a Fund’s Investments is a far different credit underwrite than a traditional Subscription Facility, we have seen a steady increase in NAV-based credit facilities (a “NAV Facility”), particularly in the context of Funds which invest in other Funds (“PE Secondary Funds”). In a typical structure, the PE Secondary Fund arranges for a credit facility to be provided to a subsidiary of the Fund (the “Vehicle”) as the borrower that is established for purposes of holding/ acquiring Investments on behalf of the PE Secondary Fund, and such Vehicle is restricted from having any indebtedness other than the NAV Facility. As security for this type of NAV Facility, 100 percent of such Vehicle’s equity is pledged in favor of the Lender (along with its bank accounts receiving both capital contributions from the parent Fund(s) and distributions from the Investments). Additionally, in many transactions, guarantees from the PE Secondary Fund are provided in support of such Vehicle’s obligations under the NAV Facility and/or support the payment of any unfunded commitments relating to the Investments. Certain contractual rights may also be provided to permit the Lender to require or direct the disposition of Investments held by the Vehicle after a default of the NAV Facility. This general structure is often used to secure a NAV Facility, such that a PE Secondary Fund is able to pledge the equity of the entity holding the Investments as collateral. We note that as with any NAVbased credit facility, due diligence with respect to the Investments may be required to confirm that transfer restrictions1 in the underlying subscription documents and partnership agreements relating to such private equity Investments would not be violated by the pledge of such equity, and if necessary, appropriate consents to such pledges can be obtained. Hedge funds investing in other hedge funds (each, a “Hedge Fund of Funds” or “Master Funds”) are increasingly seeking to utilize a similar structure to obtain the benefit of Fund-level financing for purposes of portfolio management (access to liquidity without the necessity of exiting illiquid positions in an untimely manner), facilitating redemptions and/or to enhance returns through leverage. Recently we have noted an uptick in Lenders providing financings for Hedge Funds of Funds based primarily on the NAV of its Investment portfolio, i.e., the limited partnership interests in other funds (hereinafter, a “Secondary Facility”). In this article, we set out the basic structure and likely issues that may be presented in the context of a Secondary Facility for Hedge Fund of Funds.
Secondary Facilities for Hedge Funds of Funds are a highly specialized type of NAV facility and can take multiple formats, including that of a straightforward credit facility, a note purchase agreement or a pre-paid forward sale under an ISDA master agreement used in over-the-counter derivatives transactions. Regardless of form, these facilities contain common components. Traditionally, availability under a Secondary Facility is limited to an amount equal to the “Eligible NAV” of the “Eligible Investments,” multiplied by an advance rate. The “Eligible NAV” typically equals the NAV of the Eligible Investments, less any concentration limit excesses deemed appropriate by the Lender under the circumstances. “Eligible Investments” will typically be a subset of Investments that are not subject to certain exclusion events or other limitations as described in further detail below.
While a common approach to collateralizing NAV Facilities for PE Secondary Funds is for a Lender to obtain an equity pledge of the Vehicle in order to address potential transfer restrictions applicable to the Investments, in the context of Secondary Facilities for a Hedge Fund of Funds, the applicable Master Fund segregates the Investments serving as collateral into a “securities account” under Article 8 of the UCC which is subject to a control agreement executed by a securities intermediary (“Securities Intermediary”) in favor of the Lender. By segregating these assets into a separate securities account, the Securities Intermediary becomes the legal owner of each hedge fund Investment in which the Master Fund invests by executing the applicable subscription documents of the underlying hedge fund Investment (while the beneficial ownership of such Investment remains with the Master Fund). This structure thereby enables the Master Fund borrower to pledge its “security entitlement” (described below) in the underlying hedge fund assets in the securities account to the Lender while the direct owner of such Investment remains unchanged without violating certain transfer restrictions which may otherwise be applicable (similar to the PE Secondary Fund structure described above). However, the right to foreclose on any applicable Investments will remain subject to any applicable transfer restrictions, so the Lender’s primary remedy is redemption (where the Lender instructs the Securities Intermediary to redeem the hedge fund interests credited to the securities account pursuant to the terms of the control agreement). And although such redemption also remains subject to any timing constraints set forth in the hedge fund subscription documents, transfer restrictions should not preclude a practical realization on the underlying collateral.
It should also be noted that feeder funds (each, a “Feeder Fund”) can obtain similar financing by establishing a securities account with respect to its Investment in the Master Fund (thereby enabling the Investment in the Master Fund to serve as the “Eligible Investment” for the Secondary Facility). In this scenario, the portfolio requirements established by the Lender in order to determine the suitability of the collateral supporting the Secondary Facility (described below) are typically tied to the Master Fund’s portfolio of underlying investments.
In many cases Borrowers that enter into Secondary Facilities will have a mature portfolio of Investments, so a Lender may assess at the outset which Investments should be included as “Eligible Investments” for the NAV of the Secondary Facility (otherwise Lenders may look to the investment guidelines provided for in the Master Fund Private Placement Memorandum to establish eligibility criteria for the proposed Secondary Facility). Regardless, Lenders will ordinarily be sensitive to the composition of such portfolio of Eligible Investments, and as a result, will set forth requirements with respect to diversification of the portfolio, investment strategy and minimum liquidity. Common diversification requirements include the following: limitations on the NAV of the largest Investments, sponsor diversification, minimum number of Investments, limitations on the particular types of Investments involved (infrastructure vs. buyout, growth, venture and special situation funds, etc.), geographical limitations and strategy diversification (long vs. short equity Investments, arbitrage and global macro, etc.) and particular investments underlying the limited partnership interests. Nonetheless, it is a typical requirement that there be no change in the investment policy of the Hedge Fund of Funds, sponsor or other creditworthy entity guaranteeing the Secondary Facility without Lender consent.
Exclusion events related to Eligible Investments are also established at the outset of a Secondary Facility and can include: the existence of liens, bankruptcy or insolvency events of the Investment issuer or sponsor, failure by the Master Fund to pay capital contribution obligations as they become due, a write-off or a material write-down by the Master Fund of an Investment, redemption gates or other matters impacting the general partner of an underlying Fund (such as general partner “bad boy” acts or replacement of the general partner). Appropriate exclusion events and diversification requirements are key elements for any Lender providing a NAV-based credit facility as Investments failing to satisfy these criteria will not be included in the borrowing base (while these requirements must also be balanced with the need of the Master Fund to retain appropriate flexibility for purposes of maximizing portfolio value). In any event, ongoing portfolio monitoring and reporting requirements will be imposed on the applicable borrower throughout the term of the Secondary Facility as further described below.
Advance Rate and Financial Covenants
In connection with Secondary Facilities for Hedge Funds of Funds, Lenders establish an “Advance Rate” with respect to the NAV of the Eligible Investments to be acquired and/or refinanced with the proceeds of the Secondary Facility, as may be adjusted to reflect a “haircut” specified by the applicable Lender. Such a “haircut” (or discount) methodology is Lender specific and will often be set forth on an appendix to the initial term sheet for the Secondary Facility and is concerned with addressing risks and exposure the applicable Lender has with respect to the Investment portfolio (including specific Eligible Investments) securing the Secondary Facility (incorporating above-mentioned factors such as the diversification of the Eligible Investments and the Investment style/strategy of the particular borrower and/or Fund of Funds). Considering these “haircuts” are Lender specific, it is not uncommon for a Secondary Facility for Hedge Fund of Funds to be structured as a bilateral lending arrangement (and not syndicated due to difficulties associated with attempting to synchronize these proprietary formulas in the context of a multi-lender credit facility as discussed below). In order to give Lenders assurance of the continued performance of a borrower and/or related guarantor on its obligations under a Secondary Facility, such facilities are often structured by setting forth a maximum “Loan-to-Value” ratio of the outstanding facility amount to the NAV of the Eligible Investments included in the securities account. Loan-to-Value calculations are commonly determined by taking the lowest of (a) the aggregate NAV of Eligible Investments as calculated by the sponsor of the underlying Investment in the most recently provided valuation; (b) the borrower and/or related Hedge Fund of Funds’ valuation in good faith and in accordance with its investment policy or applicable governing documents; and (c) acquisition costs minus NAV adjustments attributable to (i) distributions with respect to such Investments, (ii) other customary to exclusion events or write-downs and/or (iii) any portion of NAV of eligible investments in excess of concentration limits. Such Loan-to-Value calculations may also take into consideration cash distributions maintained in the collateral account
Another common and important financial covenant to ensure performance of the Secondary Facility focuses on share drop percentage thresholds on a monthly, quarterly and yearly basis. For each such calculation it is important to specify at the outset whether NAV will be pegged on the closing date of the Secondary Facility (or whether the NAV value can increase over the life of the borrower and/ or Hedge Fund of Funds), and whether impacts to NAV resulting from third-party redemptions will be included in such calculations. Other financial covenants include limitations on debt or liens incurred by the applicable borrower and that all Investments are made through the account held by a securities intermediary and pledged to the Lender as security, as described in further detail below. A change of the securities intermediary or a change of control of the Investment manager can also lead to a default of the Secondary Facility. Finally, Lenders may require prohibitions on Investments other than the Investments in the initial portfolio and investments relating to the initial portfolio Investments.
Lenders should also be aware of the prominent role a Securities Intermediary plays with respect to the custody of, and reporting requirements associated with, the Investments serving as collateral for the Secondary Facility. As previously mentioned, assets such as limited partnership interests, limited liability company interests, shares of closely-held corporations and life insurance policies are commonly subject to broad transfer restrictions which impact grants of security interests over such collateral. To secure the obligations to a creditor under a Secondary Facility, a Hedge Fund of Funds commonly pledges an investment account, managed by a Securities Intermediary as collateral.2 A security interest in such account is typically perfected through a control agreement executed by the Securities Intermediary, and in contrast to a direct pledge of a Fund of Fund’s rights in the underlying Funds (which may be viewed as breaching such transfer restrictions), the rights at issue under the control agreement are directly traceable to a Securities Intermediary and are viewed under the Uniform Commercial Code as a “security entitlement” (which is both a package of personal rights against a securities intermediary and a property interest in the assets held by the Securities Intermediary). And in addition to other remedies available under the loan documentation, the creditor’s avenue of enforcement of its security interest in the Investments pledged as collateral may be through redemption, whereby the creditor instructs the Securities Intermediary to redeem the Hedge Fund of Funds’ interests from the underlying Funds which have been credited to the securities account, which the Securities Intermediary will be obligated to request pursuant to the relevant control agreement.
Lenders typically require reporting with respect to the Investments pledged as collateral, including monthly reporting of the Investments maintained by the Securities Intermediary and redemption information. Lenders may also seek from the applicable borrower month-to-date estimated NAV, monthly estimated NAV and monthly official NAV reporting with respect to each Investment pledged as collateral. Furthermore, periodic reporting relating to a Hedge Fund of Funds’ balance sheet showing aggregate assets, liabilities and net assets, as well as ongoing reporting requirements such as a management letter, audited financial statements, schedules of Investments (detailing all of the Hedge Fund of Funds’ Investments) and other financial assets may be requested by the applicable Lender. Other reporting requirements may involve disclosure of any changes to liquidity, currency or other significant terms of the Hedge Fund of Funds’ Investments, or even relate to the Securities Intermediary and involve weekly reporting of aggregate assets and detailed positions at the Securities Intermediary, as well as access to the positions electronically or via email reports with required consent for any movements of cash or securities into and out of the account. And to the extent the information provided by the Securities Intermediary to the Master Fund (which may include weekly reporting of aggregate assets and monthly fair market value information (net of liabilities) and similar information) is consistent with the reporting requirements of the applicable Lender, this may simplify implementation of a Secondary Facility.
One of the primary challenges in a Secondary Facility is the Lender’s comfort around the calculation of the NAV of Investments, as Hedge Funds of Funds are often invested in illiquid positions with no readily available mark. To further complicate such issue, in a multi-Lender facility, each Lender will have different ways of calculating the advance rate applicable to a given portfolio of Investments and thus issues might arise as to which Lender decides what the value of the collateral is and/or what NAV of the Investments shall be for purposes of covenant compliance under the Secondary Facility. Additionally, in the context of Secondary Facilities provided to a Feeder Fund, issues may arise as to whether the Feeder Fund can have more beneficial rights than other limited partners invested in the Master Fund. For instance, a Lender may request that the Feeder Fund acting as borrower be able to redeem its interest in the Master Fund notwithstanding any other gates imposed on redemption (and applicable to the remaining limited partners), and despite the fact that such Master Fund will always be subject to the redemption provisions of the underlying Investments. Nevertheless, the Lender will argue that it should be entitled to more favorable provisions on the basis that it is a debt provider, instead of equity. And while a detailed examination of these issues is beyond the scope of this article, we note that Lenders and Master Funds alike have successfully navigated around these issues in connection with establishing Secondary Facilities.
While the underwriting process of Secondary Facilities is materially different from that of Subscription Facilities and other Fund financing alternatives, when structured properly, Secondary Facilities can offer an attractive risk-adjusted return for a Lender while providing Funds and Hedge Funds of Funds needed liquidity and flexibility. As more Funds and particularly Hedge Funds of Funds seek to maximize the value of their underlying Investments, we expect additional growth in the market for Secondary Facilities.
1 In many circumstances, General Partner consent may be required to address indirect transfer limitations contained in the underlying Investment documentation. We note that General Partners will generally provide consents to such pledges, and the foregoing are more easily obtained than a lien on the Investment itself.
2 The Master Fund also typically provides a security interest in the financial assets pledged as collateral, and a Uniform Commercial Code financing statement is filed in connection therewith.
Fund Financings continued positive growth and strong credit performance as an asset class through Q2 2016. Capital call subscription credit facilities (each, a “Facility”) continued their steady growth and followed the uptick of closed funds and capital raised through Q2 2016. Investor capital call (each, a “Capital Call”) funding performance continued its near-zero delinquency status, and we were not aware of any Facility events of default in 2016 that resulted in losses. Below we set forth our views on the state of the Facility market and current trends likely to be relevant in the latter half of 2016. In addition to such trends, this Market Review touches on Brexit and its impact on the Fund Finance markets, developments in Irish regulated funds, developments relating to the introduction of Cayman limited liability companies, and hedging constraints and Facility attractiveness.
Fundraising and Facility Growth
Fundraising in 2016
So far, 2016 has continued a positive trend for private equity funds (each, a “Fund”). Globally, through Q2 2016, Funds raised over $182 billion in investor (each, an “Investor”) capital commitments (“Capital Commitments”), markedly higher than the same period in 2015 where $137 billion of commitments were raised.1 Larger sponsors continued to attract a large share of commitments—notably the five largest Funds raised almost half of the commitments in Q2, four of which were focused in buyout, with the fifth and largest Fund being a secondary fund. In addition to buyout, venture capital funds were also popular with investors, and a larger number of venture capital funds closed in Q2 than any other type of fund. Going forward into the latter half of 2016, one could make the case that investor interest appears to be shifting away from private equity and venture capital, towards other areas including growth funds, funds of funds and secondary funds, which are being targeted by larger proportions of investors.2
Even with the unexpected Brexit vote and the ensuing political uncertainty, investor interest has been fairly steady through Q2. While the North American market continues to dominate, with 45 percent of the capital raising targeted there in Q2, European-focused Funds continue to be second with approximately 25 percent of the capital of Investors in the market being focused on investments there.3 About the same number of Investors are seeking global allocations as compared to the same period in 2015. That said, it appears that going forward, Investors may be doubling down on Europe. More than a majority of Investors (56 percent) are looking to make new commitments in Europe in the next 12 months, which is a notable increase in European interest from this time last year and tops current Investor interest in any other region, including North America (at only 48 percent).4 Such reports seem to bode well for Facility growth, including in the European market.
Although the Fund Finance market lacks league tables or an overall data reporting and tracking service, our experience is that so far in 2016 the subscription facility market is continuing its steady trajectory, and we are seeing continued diversification in product offerings in the Facility market (including hybrid, umbrella and unsecured or “second lien” facilities). In particular, 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 $7 billion of such transactions closed so far in 2016 versus $5 billion for all of 2015. These Alternative Fund Financings have been a key driver of growth in the Fund Finance market to date in 2016 and this category of fund financings is emerging as a permanent fixture of the market. Anecdotally, we are seeing a number of new entrants into this space both on the Lender side and Fund side, and the focus on levering up investment portfolios has increased volume among secondary funds and funds of funds as well as by non-traditional market participants such as family offices and insurance companies.
Trends and Developments
Monitoring and Technical Defaults
We are only aware of a couple of technical defaults over the course of 2016, which is in sharp contrast to 2015 where many of these defaults were caused by reporting failures in respect of borrowing base calculations and components thereof (including failures to timely report the issuance of capital calls). Facility covenants providing for monitoring of collateral (including prompt delivery of capital call notices, notices of transfers, Investor downgrades and similar requirements) have tightened, and a number of lenders have provided their customers with monitoring guidelines or templates to assist with their back office processes.
Also, there have been recent reports in the news capturing the attention of those in the fund world surrounding allegations raised with respect to funds, placement agents and fund sponsors. In one instance, it has been reported that a prominent hedge fund manager with more than $1.3 billion in assets under management, is considering unwinding its main hedge fund and buying out a $20 million investment by a New York City correction officers’ union after allegations surfaced, and an FBI-related raid, about possible bribery relating to this investment.5 Additionally, Andrew a former employee of a prominent private equity advisory group and placement agent, pleaded guilty in July to charges of defrauding Investors and creating a Ponzi-like investment scheme involving many familiar names in the fund world, including various nonprofit foundations.6 Such reports have increased lender attention upon the issues of pay to play 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. Therefore the importance of due diligence on subscription agreements, side letters and Investors continues as a timely lender focus.
Brexit Impact on Facilities
The recent referendum in the United Kingdom to exit the European Union took place on June 23, 2016 (the exit, commonly known as “Brexit”). The vote did not in and of itself trigger Brexit, which will require the formal activation by the European Union under Article 50 of the Treaty on European Union, and given that the process, once triggered will last a minimum of two years, the aftermath has created speculation on the impact on the loan market and the fund market during this time.
While this impact on fundraising and deal volume continues to materialize, as far as documentation is concerned, we understand that the Loan Market Association (the “LMA”), the leading industry group for the UK syndicated loan markets, is setting up a working group which will consider and advise on changes to its documentation on an ongoing basis as the situation matures. The below outlines some general thoughts on documentation changes that may transpire, but we note that as an initial matter, while various aspects of the UK and European economy will be affected, the structure and documentation relating to many lending deals should be relatively unaffected by Brexit, although cross-border secured deals would be affected more than most.
In particular, the loss of the passport if the United Kingdom triggers Article 50 and begins the procedures to exit the European Union would be the largest area of impact, but would not affect UK domestic lending – and much cross-border lending work would not require a passport. Therefore, the lending market may continue much as it did before, recognizing that the details may change. Also, one particular area of difficulty post Brexit (if the United Kingdom no longer has a passport) may occur in lending to jurisdictions such as Italy and France and where there is security held by a UK security trustee if that security needs to be held by EU passported entities.
CHOICE OF GOVERNING LAW/JURISDICTION
No change is anticipated to decisions made by lenders and borrowers regarding the choice to use English law, as the United Kingdom is well established as a commercial jurisdiction of choice due to its recognition of freedom of contract, and it is expected that English law will still be upheld by other EU member states through the EU regulation commonly referred to as Rome 1 which would be applicable regardless of Brexit.7 This regulation requires EU courts to recognize and uphold the parties’ choice of governing law, and would cover, by way of example, the choice of a French borrower to agree to be bound by a US law credit agreement. This is expected to apply regardless of where the counterparties are located, and would, subject to only a few exceptions, require an EU court to uphold the parties’ right to choose to be bound by a particular legal regime. While UK courts would not be bound after Brexit to Rome 1, it is expected that UK courts would introduce similar laws due to the commercial need for the same, and it is also thought that old UK laws had similar effect in any case.
Submission to jurisdiction is less clear, as the United Kingdom will no longer benefit from the rules commonly referred to as the Brussels Regulation8 that are part of a network of EU regulations and international treaties on the recognition and enforcement of foreign judgments. Post Brexit, the United Kingdom would not benefit from mutual recognition under the Brussels regulation, but there is however, good reason to believe that reciprocal recognition of judgments would continue after Brexit, including alternatives to arrive at the same (or similar) position through treaties such as the Lugano Convention and the Hague Convention that similarly provide for recognition and enforcement of foreign judgments (although the latter relates to exclusive jurisdiction clauses only) and also common law. We are of the view that significant changes to current practice or drafting are unlikely in this regard, other than more thought being given to using exclusive jurisdiction clauses, rather than non-exclusive or one-sided jurisdiction clauses. We also note that these treaties and Brexit would not affect the recognition of US judgments so the position vis–à–vis US credit agreements would be unlikely to change.
REFERENCES TO THE EU/EU LAWS
For contracts entered into before the referendum and still in force after Brexit, the assumption is that the English courts will take a pragmatic approach to interpreting preBrexit contracts when it comes to references to the EU/EU legislation and perhaps introduce English legislation to provide continuity. Also, for transactions that are currently being documented, terms ought to be checked to see if there are any sensible changes that could be made at this time to also include references to applicable UK laws and regulations as an option, including review of VAT concepts and restrictions currently in place requiring a borrower to use the audit services of a particular auditor or group of auditors9 (which would require compliance at least until Brexit has been completed and possibly beyond if the United Kingdom itself were to introduce such concepts), as well as generic references to the European Union as either a body or a location which may be used in the documentation, including setting the scope of where account debtors could be located or the places in which Cash Equivalent Investments could be made.
BRRD ARTICLE 55 (BAIL-IN)
The addition of the Bail-in requirements was the subject of our prior Market Review and while such language would still need to be inserted until Brexit has occurred, it should be considered that the United Kingdom could become subject to the BRRD after Brexit (whether via becoming part of the EEA or otherwise) and/or that the United Kingdom may impose its own form of bail-in requirements, which would also need to be included.
Standard in many LMA-based documents, continued use of clauses in loan agreements providing for the repayment of loans if they are illegal to maintain will be helpful to the extent that cross-border loans to France/Italy will require a passport and loss of that passport would require the lender to terminate the loan (or its participation in the loan). Equally, other remedies to this issue could be considered, such as an enhanced right to transfer commitments to affiliates or the ability to simply designate affiliates of the lenders to make loans in certain of the affected jurisdictions.
MATERIAL ADVERSE CHANGE
There has been much discussion as to whether the standard material adverse change or material adverse effect clauses would be triggered by any of the vote to Brexit, the economic impact of such vote and/or Brexit itself. Lending institutions in general are loathe to use such a clause where a Facility is otherwise in good standing, so it is generally viewed as unlikely to be used, and if the vote or Brexit itself were to cause an economic downturn it would appear that lenders could likely rely on other, more specific triggers.
In the situation of a market MAE such as what is seen in mandate documents or syndication documents, it would be more likely that if Brexit leads, for example, to an inability to syndicate deals, a market MAE could be triggered; however it remains to be seen if this will come to pass. We note that prior to the Brexit vote, a number of sponsors requested a carveout from the MAE clause for Brexit in anticipation of such possibility.
As discussed in our prior Market Reviews, the inclusion of hedging and swap collateralization mechanics in Facilities was a significant trend in 2015, providing the means for borrowers to secure hedging and swap obligations under existing Facilities, rather than posting cash or other collateral. We note that margin regulations for uncleared derivatives adopted by regulators around the globe (“Margin Regulations”), including the US, European, Japanese, Swiss and Canadian regulators, coming into effect in March 2017 may impact this trend and will certainly need to be considered when structuring Facilities. Once the Margin Regulations come into effect, swaps between most market participants will be required to collateralize their obligations under uncleared derivatives with cash or highly rated securities meeting prescribed parameters set out by regulators (“Eligible Collateral”).10 Capital commitments and letters of credit supported by capital commitments will not constitute Eligible Collateral. Generally, the Margin Regulations do not apply to transactions entered into prior to the date on which the regulations come into effect.
A notable exception to these requirements involves foreign exchange forwards and foreign exchange swaps, so depending on the Fund’s intended use of hedging mechanics, such regulations may or may not be impactful11
To the extent the effect of these regulations curtails a popular use of a subscription facility, it is still likely to be good news for the subscription facility market as a whole, as many Funds may need to secure their swap obligations and require liquidity to do so. Therefore, Funds that did not previously use Facilities may find them more attractive as a source of liquidity in order to post cash collateral, and funds that already have Facilities may be more inclined to utilize them to secure such obligations.
Introduction of Cayman Limited Liability Companies12
We understand that the Cayman Islands government and private sector have reacted to significant market demand with the introduction of the Cayman Islands limited liability company (the “LLC”) pursuant to the Limited Liability Companies Law, 2016 (the “LLC Law”). The LLC Law was implemented on 13 July 2016 and it is anticipated that the LLC will be a very helpful additional structuring product, including in investment fund structures, corporate reorganizations and other finance transactions. Similar to a company, the LLC is a body corporate with separate legal personality. It has capacity, in its own name, to sue and be sued, to incur debts and obligations and to acquire and dispose of assets. However, the LLC Law provides a framework and a number of fall-back provisions which make the LLC primarily a creature of contract and enable its members to agree as to what the LLC will do, how it will be administered and managed, how members’ investments and contributions to the LLC will be tracked and how distributions will be allocated. In this respect, the LLC benefits from many features typically associated with a limited partnership and, as with Delaware LLCs, the members of a Cayman LLC will in most instances agree and adopt an LLC agreement which regulates the conduct of business and the affairs of the LLC.
Assuming the LLC agreement does not stipulate otherwise, any capital call rights hardwired into the LLC agreement (or any subscription agreement entered into by the LLC and its members) will fall to the LLC itself in the same way as with a company. This should simplify any security package in a fund finance transaction such that security should only need to be granted by the LLC and not its manager. There is no prescribed form of LLC agreement under the LLC Law so a careful review of the contractually agreed terms should be undertaken on a case-by-case basis. However, the expectation is that this new, flexible vehicle will be utilized in the fund finance space in largely the same way as companies and exempted limited partnerships. As such, Cayman Islands law will recognize and hold enforceable such arrangements in much the same way as current market practice.
Use of Irish Regulated Funds13
We are aware of increased interest and use of Irish regulated funds across a spectrum of fund managers and financing transactions, including UCITS, ICAVs and other AIF vehicles (“Irish Regulated Funds”). Specifically, we have seen the use of Irish Regulated Funds in hedge funds, hedge funds of funds, real estate funds and private equity funds. Interest in such Irish funds is often motivated by the access they grant to EU market Investors. While Irish Regulated Funds are generally free to borrow and provide collateral like other common investment vehicles (including security over investments or unfunded capital commitments), there are limitations on the ability of such Irish Regulated Funds to provide guarantees. As of late, the most popular vehicle could be the relatively new ICAV; the majority of 200 Fund Finance | compendium 2011-2018 fall 2016 market review ICAVs have been utilized for new funds but we have seen an uptick in conversions from Irish plcs as well as migrations from other offshore jurisdictions. All anecdotal evidence points to more conversions throughout 2016 and we are forecasting that most new fund launches are likely to use the ICAV.
As noted above, 2016 continues the generally steady growth in the Facility market. We, like Investors that are currently in the market, remain optimistic that such trends will continue through the remainder of 2016 and that the recent market changes in the United Kingdom and Europe will also provide opportunities for Investors as well as funds seeking financing and institutions providing such financing.
1 Preqin Quarterly Update Private Equity Q2, 2016, p.6.
2 Preqin at p.9
3 Preqin at p.8
4 Preqin at p. 9 5 Hedge Fund Tied to Kickback Probe to Liquidate 2d Fund, New York Post, July 20, 2016.
6 Andrew Caspersen Pleads Guilty to Federal Charges in $40 Million Fraud, New York Times, July 6, 2016.
7 This refers to Regulation (EC) No. 593/2008 of the European Parliament and of the Council of 17 June 2008 on the law applicable to contractual obligations.
8 This refers to the Recast Brussels Regulation or the Brussels 1 Regulation, Regulation (EC) No 1215/2012).
9 This refers to the EU Audit Directive 2014/5/6/EU and Regulation (EU) (537/2014).
10 For example, please see Margin and Capital Requirements for Covered Swap Entities, 80 Fed. Reg. 74,840, 74,910 (codified at Appendix B to the final rule).
11 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)).
12 Our special thanks go to Tina Meigh, Partner at Maples and Calder, for her insights and contributions to this section on Cayman limited liability companies.
13 Our special thanks go to Kathleen Garrett, Partner at Arthur Cox, for her insights and contributions to this section with respect to Irish regulated funds.
Along with subscription credit facilities, other forms of fund financing are becoming more prevalent in the asset management industry. In the hedge fund space, fund-of-funds managers are employing financing structures, and portfolio acquisition facilities and general partner support facilities are growing in use.
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