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

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

Tax Concerns1

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

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

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

ERISA Concerns2

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

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

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

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

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

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

High Net Worth Individuals

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

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

Challenges Facing Lenders and Funds in a Facility with a Feeder

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

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

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

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

Potential Structures for Feeder Funds in Subscription Facilities

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

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

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

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

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

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

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

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

Conclusion

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

Endnotes

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

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

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

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

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

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

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

The past year was an active year for Fund Financings, with positive growth and strong credit performance through 2015 as an asset class. Capital call subscription credit facilities (each, a “Facility”) continued steady growth and followed the uptick of closed funds and capital raised through Q3 and Q4 2015. Additionally, anecdotal reports from many of the major Facility lenders (each, a “Lender”) and Mayer Brown’s practitioners noted a substantial increase in alternative fund financings, including unsecured Facilities looking to the assets of private equity funds, such as hybrid and NAV Facilities, a trend that seems to be continuing through 2016 (“Alternative Fund Financings”). Additionally, 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 2015 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 2016.

Fundraising and Facility Growth

Fundraising In 2015

Overall, 2015 was a positive year for private equity funds (each, a “Fund”). Fundraising was up slightly from 2014 levels, which were the highest levels seen prior to 2008. Globally, through Q3 2015, Funds raised over $391 billion in investor (each, an “Investor”) capital commitments (“Capital Commitments”), higher than the same period in 2014 with $389 billion of commitments raised.1 Continuing the prior year’s trend of flight to quality, Investor capital was attracted to larger sponsors. During the same periods, fewer Funds were formed, with 760 Funds in 2015 as contrasted to 889 in 2014, resulting in a larger average Fund size. We note that the focus of such fundraising appears to be in the more mature North American and European markets as well as in the buyout, real estate and infrastructure sectors.2 Additionally, anecdotal reports from Mayer Brown practitioners point to Europe in particular having a good early 2016 in terms of Funds and amount of capital raised. Moreover, Investors have expressed continued interest in private equity, and the majority of Investors in 2015 expressed that they were below their target allocation to private equity, which is encouraging for the prospects of new commitments in 2016.3 Given that Facility growth typically follows fundraising activity, this appears to bode well for the coming year.

Facility Growth

Although the Fund Finance market lacks league tables or an overall data and reporting and tracking service, it is clear that the market continued to expand in 2015. In respect of Fund Financings, Mayer Brown represented Lenders and Funds in new money transactions reflecting in excess of $30 billion of Lender commitments, a significant increase from $25 billion in 2014. We believe this growth to be steady, and initial indications are that this will be sustained into 2016. Notably, we are seeing growth not only from the continued penetration of Facilities with Funds and sponsors who have traditionally not utilized them but also from the continued diversification in product offerings in the Facility market (including hybrid, umbrella and unsecured or “second lien” Facilities). We note that the active European market has also been focused on product diversification (perhaps even more so than in the United States), and we have seen growth in respect of unsecured Facilities in that market as well. Such diversification makes Facilities more attractive to a broader spectrum of Funds and increases the utility and lifespan of the product for Funds. Separately, throughout 2015, we have also seen a proliferation of interest in Alternative Fund Financings such as fund-ofhedge-fund financings, management fee lines and facilities based on net asset value (“NAV”) of a Fund’s underlying assets with our representing Lenders and Funds in approximately $5 billion of transactions closed during 2015. We believe that Alternative Fund Financings will be a key driver of growth in the Fund Finance market in 2016 and beyond.

Trends and Developments

Monitoring and Technical Defaults

We are aware of a handful of technical defaults over the course of 2015, arising primarily out of reporting failures in respect of borrowing base calculations and components thereof (including failures to timely report the issuance of Capital Calls). While none of these defaults resulted in losses, some resulted in temporary borrowing base deficiencies requiring cure through prepayments. Facility covenants providing for monitoring of collateral (including prompt delivery of Capital Call notices, notices of transfers, Investor downgrades and similar requirements) could have properly identified such issues. As a result we may, and probably should, see renewed focus by Lenders on Capital Call monitoring procedures and borrower reporting.

Nav And Secondary Fund Facilities

The private equity secondary market continues to grow as Investors review their portfolio allocations and seek to tailor their investments, either to diversify their exposure to particular asset classes or to free up capital for investment in newer Funds. Additionally, various financial institutions have sought to respond to regulatory capital pressures through the sale or adjustment of investment portfolios, which has led to a robust secondary market in the recent past.4

As a result, we have seen continued interest from both Investors and lenders in finding ways to provide either for financing of the acquisition of such assets on the secondary market or financing of Investors’ current portfolios. In a number of cases, the desire for leverage has also been undertaken in order to provide for capital relief. These financings are generally NAV financings, as the borrowing base is comprised of the reported NAV of such private equity investment portfolios as may be adjusted for certain factors. Such financings tend to be bespoke in nature and based upon the particular basket of investments the borrower seeks to finance, requiring significant due diligence by the lending institution and the incorporation of concentration and other limitations in respect of the assets being financed. We believe this type of Facility will continue to grow in popularity as the secondary market remains strong and those acquiring or holding such investment portfolios desire leverage to enhance returns or obtain capital relief.

Hedging Mechanics

The inclusion of hedging and swap collateralization mechanics (“Hedging Mechanics”) in Facilities was a significant trend in 2015. Hedging Mechanics offer a means for borrowers to secure hedging and swap obligations under existing Facilities, rather than posting cash or other collateral. Typical Hedging Mechanics allow borrowers to request that hedging or swap agreements entered into with Lenders (“Hedging Agreements”) be allocated a portion of the borrowing base (a “Trade Allocation”) for purposes of collateralizing such Hedging Agreements. The borrower’s obligations under an applicable Hedging Agreement are then deemed a part of the borrower’s obligations under a Facility, reducing the borrowing base and the borrower’s availability by the amount of the Trade Allocation. In the event the termination value of an applicable Hedging Agreement moves against the borrower, the borrower may be permitted to request that an additional Trade Allocation be made for such Hedging Agreement.

A number of other Hedging Mechanic components may require consideration on both a business and a legal level. For example, while Hedging Agreements secured by a Trade Allocation are typically pari passu with the Facility obligations (in each case up to the full amount of the Trade Allocation), Lenders will need to determine where amounts owing pursuant to obligations exceeding a Trade Allocation will fall in the payment waterfall. Additionally, Lenders and borrowers should also consider the impact that existing Trade Allocations should have on a Lender’s ability to assign its interest under the Facility. From a legal perspective, counsel must consider the impact of certain regulatory requirements applicable to Hedging Agreements (e.g., the Commodity Exchange Act). The foregoing provides only a brief overview of some of the key components of Hedging Mechanics, and other aspects should be considered on a deal-by-deal basis. Given the increase in the popularity of Hedging Mechanics in Facilities, we expect to see continued development and innovation in this area during the 2016 year.

Bail-In Provisions

In 2015, the European Union adopted the EU Bank Recovery and Resolution Directive (“BRRD”) with the aim to curtail future taxpayer-funded bail-outs of banks. The BRRD provides that, among other things, unsecured liabilities of a failing EU bank or other covered market participants governed by certain EU member states (a “Covered Institution”) may be written down or canceled in order to recapitalize the Covered Institution. According to the Loan Market Association (“LMA”),5 the powers to write down and cancel liabilities extend to commitments the Covered Institution has to fund loans under a credit facility and could result in the cancellation of a Covered Institution’s ongoing commitment in a Facility and excuse from making its pro rata share of a loan).6 The BRRD also provides that any contract that a Covered Institution enters into, including those that are governed by the law of non-European jurisdictions (such as New York law), must include a provision providing notice of the bail-in requirements and an acknowledgement by the other contract participants that the Covered Institution’s obligations can be written down or cancelled via the BRRD (the “Contractual Recognition Provision”). These new rules take effect as early as January 1, 2016 for some European jurisdictions; and the LMA has further taken the position that transactions pre-dating such date should add the Contractual Recognition Provision if (a) a Covered Institution joins the facility (including as an increasing or assignee Lender), (b) the document is materially amended, or (c) new liabilities arise under the facility document.7 In response to these new requirements, the main US loan trading organization, the Loan Syndications and Trading Association (“LSTA”) has adopted form bail-in provisions including a suggested Contractual Recognition Provision and amendments to the LSTA standard “Defaulting Lender” provisions to pick up the possibility of the application of such write-down and cancellation powers. While these provisions are not technically needed unless a Covered Institution is a party to the Facility, in an effort to freely and quickly syndicate (both before and after a default), we have seen Lenders request these provisions in deals going forward and believe they will become standard in all syndicated credit facilities in 2016.

Management Fees and Overcalls

Last year we saw the proliferation of provisions in Fund partnership agreements that prohibited making overcalls8 to pay management fees. From an Investor’s perspective, the rationale of not paying another Investor’s management fee seems reasonable. However, this creates issues for Facility Lenders as the use of proceeds section of most Facilities permits borrowings to pay management fees. By creating such an overcall limitation, if the Fund uses the Facility to front management fees, a Lender could theoretically face a situation where any Capital Contribution default (including a default made by Investors not included in the borrowing base) would result in a dollar-for-dollar loss. Lenders have largely responded to the rise of this provision by either prohibiting the use of Facility proceeds to front management fees or creating other limits in respect of such borrowings to limit exposure to such risks such as periodic cleandown or other requirements.

Confidential Investors

In 2015, we saw more Funds agree to confidentiality provisions with Investors that prevented them from disclosing the identity of such Investor to Lender. The presence of a confidential Investor creates a number of issues for a Facility, even if such Investor is not included in the borrowing base. Lenders may face challenges with respect to confidential Investors given the often-required “know your customer” and “anti-money laundering” checks, particularly where such Investors make up a significant portion of a borrower’s commitments. However, such issues relate not only to Investor due diligence, but also Capital Call mechanics. In particular, the need to make pro rata Capital Calls on all Investors as required under the Fund partnership agreement would not be possible if such Investor’s identity was unknown. This would pose issues in respect of an exercise of remedies by a Lender. While Lenders vary on the solutions they may find acceptable with respect to Investor due diligence issues, there are a number of methods that are being used to address the issue of making pro rata Capital Calls including the insertion of various provisions in side letters permitting such a call or the potential structuring of such Investor’s commitments through a feeder fund so that a call upon the actual Investors of the Fund would only require a call upon the feeder fund through which such confidential Investors invest, in order to satisfy the pro rata Capital Call requirement.

Sovereign Wealth Funds and the Energy Sector

It is estimated that sovereign wealth funds (“SWFs”)9 currently hold investments exceeding $7 trillion (more than all of the world’s hedge funds and private equity funds combined) and have significant uncalled commitments to private equity funds.10 Most SWFs are energy dependent (the Institute of International Finance suggests that almost 60% of their assets are within the energy sector), and thus, the recent market volatility and drop in oil prices has strained their liquidity. In 2015, many SWFs liquidated assets to counteract the poor portfolio performance. From a subscription finance perspective, SWFs have traditionally been difficult to underwrite as very few publicly disclose financials or issue any annual report. With that said, in the last few years we have seen Lenders become increasingly comfortable lending against SWFs at reduced advance rates or subject to certain concentration limits. While this approach logically makes sense given the historical performance of the subscription facility space, in light of the energy crisis, we suspect Lenders will take a harder look at advancing against SWFs in 2016.

As the commodities market values continue to slide, we have also seen a number of market participants seek additional collateral to secure new and existing asset-level facilities in the energy sector, including traditional Facility collateral. While such efforts have differed in their scope and structure, including whether such collateral was provided on a secured or unsecured basis, this trend may continue to the extent commodities markets remain volatile.

Conclusion

As noted above, 2015 was a year of steady growth in the Facility market accented by both penetration into new Funds as well as product diversification of both Facilities and Alternative Fund Financings. We are cautiously optimistic that such trends will continue in the near future through 2016, and while the recent volatility in the greater financial markets provides a number of uncertainties, especially in the energy sector and with respect to Investors who are focused on such returns, we believe that such uncertainties also provide opportunities for savvy Investors and Lenders in providing necessary financing.

Endnotes

1 Preqin Quarterly Update Private Equity Q3, 2015, p. 6.

2 Preqin at p. 6.

3 Preqin at p. 8.

4 Preqin. Private Equity Spotlight November 2015, p. 3.

5 The LMA is the leading industry organization for loan trading in Europe.

6 In addition to writing down or canceling lender commitments, other liabilities of a Covered Institution can be compromised by the BRRD, including (a) indemnities typically given by the Covered Institution to the administrative agent; (b) requirements of the Covered Institution to share or turn over recoveries made from the borrower; (c) confidentiality duties; (d) requirement of the Covered Institution to obtain borrower or administrative agent consent prior to transferring its interest; (e) restrictions on a creditor’s actions typically found in intercreditor documentation; (f) administrative obligations, such as notifications of tax status or requirements to make other notifications or to supply or forward information; and (g) potential noncontractual liability under loan market documentation such as potential claims in negligence or misrepresentation. See The LMA Recommended Form of Bail-in Clause and Users Guide, Dec. 22, 2015, http://www.lma.eu.com/documents. aspx?c=170.

7 See Id.

8 “Overcalls” are capital calls on non-defaulting Investors to resolve a shortfall caused by an Investor that defaults on its obligation.

9 Sovereign wealth funds are special purpose investment funds sponsored by governments and/or sovereigns that typically hold, manage, or administer assets of their sponsor.

10 See Simon Clark, Mia Lamar & Bradley Hope, “The Trouble With Sovereign-Wealth Funds,” Wall Street Journal, December 22, 2015.

Over the last ten years, there has been a steady trend transition from defined benefit plans to defined contribution plans. As further evidence of this trend, as recently as the end of the fourth quarter of 2013, defined contribution plan (“DC”) assets amounted to $5.9 trillion, compared to just $3.0 trillion in assets for private-sector defined benefit (“DB”) plans.1 At the same time, DC plan fiduciaries are seeking to achieve the historically higher returns of DB plans by venturing into alternative investments (real estate, private equity and hedge funds). In the face of the large amounts of capital now being funded to DC plans and the desire by DC plan fiduciaries to improve returns, fund sponsors have been actively courting such DC plans and establishing investment vehicles tailored to the needs of such DC plans (such investment vehicles are referred to herein generally as “DC Funds”).

Access to a line of credit offers a number of benefits to both DC plan fiduciaries and DC Fund sponsors. A credit facility can help DC plan fiduciaries and DC Funds manage the daily liquidity required by DC plan participants and fiduciaries, as well as provide bridge capital to fund DC Fund investments. While alternative investments (real estate, private equity and hedge funds) are typically illiquid, the higher rates of return offered by such investments may offset the risks to DC plans and fiduciaries caused by such illiquidity, particularly when a credit facility can mitigate much of the illiquidity concerns.

This Legal Update provides background on a number of issues for DC Fund sponsors and for lenders (each, a “Lender”) in connection with a credit facility to a DC Fund (such credit facilities referred to herein generally as “Facilities”). It also proposes structural solutions for certain of those issues.

Facility Size and Uses

Compared to credit facilities provided to typical private equity funds or private equity real estate funds, Facilities for DC Funds tend to be rather small in relation to the total size of the DC Fund. While Facilities may vary, they are often 10-20% of the total DC Fund size. While there is potential for Facilities to grow in size relative to DC Fund size as Lenders get more comfortable lending to DC Funds and DC Funds continue to find new ways to take advantage of the liquidity provided by a Facility, limitations on collateral (discussed below) and the DC Fund’s need for liquidity may prevent such Facilities from reaching the relative size of credit facilities traditionally sought by other types of private equity funds or real estate funds.

Historically, DC Funds have relied upon Facilities primarily for standby funding to match redemption requests of DC plan participants to the timing of redemption windows of the DC Fund’s underlying investments. Accordingly, such Facilities have generally been used infrequently, and have not typically maintained long-term outstanding balances beyond redemption windows of the DC Fund’s underlying investments. For DC Funds that have longer track records and historically reliable streams of participant cash in-flows, Facilities could potentially be used to fund investments in advance of capital contributions from DC plan participants. Fiduciary concerns related to increased leverage and potential losses for DC plan participants, however, may prevent the use of Facilities as a means to further leverage investments.

Structuring / Security Issues

BORROWER STRUCTURES

DC Funds rely on a number of different legal structures and pooling vehicles, including separate managed accounts, collective investment trusts and insurance company separate accounts. A description and summary of these structures and vehicles is beyond the scope of the Legal Update, but it is important to recognize that each of these structures and vehicles carries distinct legal consequences that shape a Facility’s structure. It is important for Lenders to fully understand the relationship between DC Funds and the actual borrower under the Facility. Some structures used by DC Funds do not utilize a separate legal entity for the borrower, rather the borrower consists solely as a specific set of assets or funds within a larger legal entity. It is important to consult with legal counsel not only to ensure that Lenders have sufficient legal recourse with respect to a Facility’s borrower, but also to protect corporate formalities of the DC Fund related to distinct pools of assets belonging to one or more related legal entities.

SECURITY AND COLLATERAL

While a subscription-backed credit facility looks to a fund’s investors for repayment and as the ultimate collateral, the participantfunded nature of DC Funds is not compatible with such an approach.2 Instead, Lenders can rely upon a variety of security packages tied to a DC Fund’s investments for collateral. Collateral packages for Facilities typically fall into three categories: illiquid investments, liquid investments and distributions proceeds. A pledge of illiquid investments, such as interests in private equity funds, real estate funds or hedge funds may be complicated by transfer restrictions applicable to such interests. Moreover, any such pledge may also require additional consents from third-party entities. An indirect pledge of such interests could be structured with a pledge of the equity of an aggregating vehicle that holds such underlying investments. Careful review of the underlying investment documentation must then be undertaken to ensure that the indirect pledge does not breach any transfer restrictions or require any third-party consents.

In addition to illiquid investments, DC Funds typically hold certain liquid investments in the form of cash/cash equivalents or other liquid securities. DC Funds rely upon such liquid investments to support liquidity requirements of DC plan participants and to aggregate cash in-flows pending new investments. Liquid investments are unlikely to be subject to transfer restrictions or consent requirements and, to the extent such liquid investments are held in one or more securities accounts with the Lender, perfecting rights in the collateral is usually straightforward.

Lastly, the collateral package could include a pledge of distribution proceeds from a DC Fund’s underlying investments, along with one or more account(s) held with the Lender into which such proceeds are deposited. Again, careful review should be undertaken to ensure that such a pledge does not breach any of the underlying investment documentation.

Of course, given the creditworthiness of the borrower, the reliability of DC plan contributions, the value of the underlying DC Fund investments and the multiple sources of repayment, a Lender may also be comfortable offering a Facility on an unsecured basis.

ERISA CONCERNS 3

Facilities for DC Funds may present different ERISA4 concerns as compared to credit facilities for more traditional private equity funds or real estate funds. Unlike other fund-financing products where ERISA issues are focused on seeking comfort that loan parties will not be deemed to hold “plan assets,”5 DC Funds, by their nature, may hold “plan assets” and accordingly are subject to ERISA, including ERISA’s prohibition on party-ininterest transactions. In a Facility, the primary concern under ERISA arises with respect to any relationships between the Lender, the DC Fund itself and/or the underlying DC plans taking part in DC Funds, due to the fact that such relationships may give rise to prohibited transaction excise tax penalties for the Lender.

Conclusion

While to date Facilities for DC Funds have been relatively rare, as more fund sponsors seek to establish DC Funds, the opportunity is ripe for new market participants. With a careful review of the legal structure of a DC Fund, including with respect to the borrowing entity for the Facility, and attention to the collateral package, a Facility can be structured to provide important and often vital liquidity to a DC Fund while still satisfying the Lender’s credit criteria. Please contact any of the authors with questions regarding DC Funds and the various structures for effectively establishing Facilities for such entities.

Endnotes

1 Investment Company Institute, “The US Retirement Market, Fourth Quarter, 2013.” Table 1.

2 For a more detailed description of the subscription facility market and features of the subscription credit facility product in general, please see “Summer 2013 Market Review,” Fund Finance Market Review, Mayer Brown, Summer 2013, on page 19.

3 For a general description of ERISA issues related to lending to real estate, private equity and other investment funds, please see “Subscription Credit Facilities: Certain ERISA Considerations,” Fund Finance Market Review, Mayer Brown, Summer 2013, on page 38.

4 Employee Retirement Income Security Act of 1974, as amended, and the rules and regulations promulgated thereunder by any US governmental authority, as from time to time in effect.

5 “Plan Assets” has the meaning given in 29 C.F.R. §2510.3-101, et seq., as modified by Section 3(42) of ERISA.

A subscription credit facility, also frequently referred to as a capital call facility (a “Subscription Facility”), is a loan made by a bank or other credit institution (a “Lender”) to a private equity fund (a “Fund”).1 What distinguishes a Subscription Facility from other secured lending arrangements is the collateral package, which is comprised not of the underlying investment assets of the Fund but, instead, of the unfunded capital commitments (“Capital Commitments”) of the limited partners of the Fund (the “Investors”) to make capital contributions (“Capital Contributions”) when called from time to time by the Fund’s general partner (the “General Partner”).

As the Subscription Facility market continues to grow and mature,2 Lenders willing to include the widest range of Investors within the borrowing availability (the “Borrowing Base”) may enjoy a competitive advantage against Lenders that have a relatively more narrow set of Investors they will advance against, all things being equal. One way to potentially expand the borrowing capacity under a Subscription Facility is for a Lender to advance against more of the governmental Investors in the Fund and, in particular, governmental Investors that are public retirement systems (each a “System”).3

Historically, full Borrowing Base credit (typically a 90% advance rate) is given to Investors that are Systems with (a) a senior unsecured debt rating (or its equivalent) of BBB+ or better by Standard & Poor’s Financial Services LLC or Baa1 or better by Moody’s Investors Service, Inc., and (b) a minimum funding ratio4 above a specified threshold (typically 90% if the Investor’s rating is BBB+/Baa1 (or equivalent) and no minimum for Investors with higher credit ratings). These rating and funding ratio criteria are often referred to as the “Applicable Requirement” in a Subscription Facility. Where it can be established that a state, county, municipality or other governmental subdivision is ultimately responsible for the obligations of a System, a Lender can reasonably look past the System’s own credit profile and, instead, to the credit rating and quality of the responsible governmental entity in determining if the Applicable Requirement has been satisfied, or whether the System Investor otherwise merits inclusion in the Borrowing Base, perhaps at a lower advance rate (typically 60–65% of the unfunded Capital Commitment). Thus, establishing a credit linkage between a System and a creditworthy responsible governmental entity may provide a way for a Lender to get comfortable advancing against the unfunded Capital Commitment of a System Investor that would otherwise not satisfy the Applicable Requirement on its own. Below we outline a few alternate approaches and factors that a Lender may use to assess whether an adequate credit linkage exists between a System and a responsible governmental entity.

Overview of Public Retirement Systems

Systems are created and administered under the laws of a state (the “Plan Sponsor”) to provide pension and other retirement benefits to employees of governmental units such as states, cities and counties. Systems typically hold substantial reserves available for investment in a diverse array of financial products and often rely on significant investment returns to supplement the participating employee and employer contributions used to fund retirement benefits for the System’s participants.

A System can be organized to provide benefits for employees of a single governmental unit or employees of multiple governmental units. A single-employer system is a System that provides benefits for employees of only one governmental entity, often the Plan Sponsor. Some common examples of a single-employer System are those that provide benefits to retired state judges or state legislators. In such a System, the relevant state would be the only employer of the individuals covered by the System. A multi-employer system is a System that covers the employees of more than one governmental entity.5 An example of a multiemployer System is a System that provides retirement benefits to a state’s public safety personnel. Such a System may cover employees of many different governmental entities, such as state university police departments, county sheriffs’ departments and city fire departments.

The retirement benefits offered by a System may be structured in a variety of ways. Here, we will focus on Systems that are organized as defined-benefits Systems, where the employees covered by the System will contribute a statutorily determined percentage of their income during the term of their employment in return for a defined level of benefits during their retirement. Many states have constitutional protections safeguarding the pension benefits accrued by public employees during their careers.6 These constitutional provisions can prevent Plan Sponsors from reducing the level of benefits promised to public workers, causing Plan Sponsors to focus on ways to increase the System’s assets rather than reduce pension liabilities to ensure the financial health of the System.

Credit Linkage to Plan Sponsors

By demonstrating that a creditworthy governmental entity is ultimately responsible for the funding obligations of a System, a credit linkage analysis provides valuable underwriting information and may facilitate inclusion of a System in the Borrowing Base. Because the statutory regimes used to govern Systems are varied and often complex, a credit linkage review calls for a thorough analysis by counsel of multiple sources of state and local law, including state constitutions, statutes, ordinances and case law, as well as statements and financial reports issued by both the Plan Sponsor and the System. There are a number of ways that a Lender can attempt to link the credit rating of a System and its Plan Sponsor, some of which are quite direct while others are more attenuated. It is important to note, however, that the degree of connectivity between a System and its Plan Sponsor required to establish a sufficient credit linkage to permit inclusion of a System Investor’s unfunded Capital Commitments in the Borrowing Base will differ based on the preferences of the relevant Lender. We will focus on two of the more popular methods used to demonstrate such a credit link in more detail below.

PLAN SPONSOR’S ASSUMPTION OF LIABILITY OF SYSTEM’S INVESTMENT OBLIGATIONS

Perhaps the most straightforward way to establish a credit linkage is to research and locate a source of law that expressly provides that the Plan Sponsor is responsible for the liabilities of the System. In the best case scenario, such a law would expressly designate all of the System’s liabilities as direct obligations of the Plan Sponsor. In such a situation, a Lender can take comfort that the rated Plan Sponsor is ultimately responsible for funding the investment-related obligations of the System. The laws in this area, however, are seldom so clear, and a careful legal analysis will need to be undertaken to assess the extent to which the Plan Sponsor actually assumes the System’s liabilities. For example, the laws may provide that the Plan Sponsor assumes operational and administrative liabilities of the System but be silent as to investment liabilities or benefit obligations. This type of limited assumption of liability would likely not include the assumption of the System’s obligation to fund Capital Contributions to a Fund. Thus, a Lender may not be comfortable advancing against a System Investor in reliance on such a limited assumption of liability and may need to undertake a different analysis to establish whether an adequate credit link exists to include such an Investor in the Borrowing Base.

PL AN SPONSOR’S RESPONSIBILITY FOR FUNDING THE SYSTEM

When clear statutory or case law evidence does not exist to establish credit linkage, another method that can be used involves conducting an analysis of the sources of the System’s assets to ascertain the extent to which the Plan Sponsor is responsible for providing funds to the System vis-à-vis other participating employers. If the System primarily receives its funding (i.e., its assets) from the Plan Sponsor, it may be reasonable for a Lender to consider the credit worthiness of the Plan Sponsor as a primary factor in deciding whether or not it will advance against a System Investor. The purpose of this funding analysis is to determine the percentage of a System’s assets that is coming from the Plan Sponsor in relation to other sources, thus illustrating for each entity its level of responsibility for funding a System’s liabilities.

A System is often funded primarily by the three following sources: (i) employee contributions deducted from each participating employee’s salary, (ii) employer contributions required to be made under the law and (iii) investment gains earned through investment of the System’s reserves.7 According to data gathered in 2010 by the US Census Bureau, from 1995–2010, 68 percent of public pension fund receipts came from investment earnings, 11 percent came from employee contributions and about 21 percent came from employer contributions.8 Employer contributions are the only System assets that are funded directly from the coffers of Plan Sponsors; as such, the key task in conducting a funding responsibility analysis is to review applicable laws to determine the required annual employer contributions for each participating employer.

Once the amount each participating employer is required to contribute annually to a System has been determined, the next step in a funding analysis is to establish the percentage of employer contributions coming into the System that has historically come from each participating employer (including the Plan Sponsor) by reviewing the System’s financial, actuarial and other information. This information will help a Lender assess the degree to which the Plan Sponsor has been responsible for providing funds to the System that, when extrapolated, may give the Lender enough comfort that the Plan Sponsor will provide adequate assets to the System to fund Capital Contributions going forward so as to enable the Lender to include the System Investor in the Borrowing Base.

With respect to a single-employer System, the sole employer (i.e., the Plan Sponsor) would be the only governmental unit responsible for providing funds to the System, making a credit linkage easier to establish. When analyzing a multi-employer system, however, it can become significantly more challenging to establish a credit linkage between the System and its Plan Sponsor.

In some cases, the Plan Sponsor of a multiemployer System assumes responsibility for funding the employer contributions of some or all of the other participating employers. For example, the Illinois Teachers’ Retirement System is a multi-employer System consisting of approximately 1,000 governmental units, where approximately 95 percent of the employer-provided funding for the Illinois Teachers’ Retirement System is the responsibility of the State of Illinois.9

More typically, with respect to multi-employer Systems, each governmental unit participating as an employer in the System is only responsible for making a required employer contribution for its own employees. In this scenario, a funding analysis requires locating and reviewing the financial, actuarial and other information related to the System to determine the extent to which the Plan Sponsor is responsible for funding the System relative to other participating employers in order to establish the extent to which the Plan Sponsor is supporting the System.

An additional layer of complexity is added when a Lender is considering advancing against a public pension fund that holds assets of multiple Systems. This situation can arise when a state that sponsors multiple Systems seeks out ways to reduce the administrative burden of operating multiple Systems by creating, for example, a common pension fund that collects, pools and invests moneys received from several different Systems (a “Common Fund”).10 When such a Common Fund is established to facilitate investment activities, the funds of each System may be invested jointly, while the gains and losses of the Common Fund are allocated among each System on a pro rata basis. In this scenario, again, a funding analysis calls for locating and reviewing the financial, actuarial and other information related to the Common Fund and each System participating in the Common Fund to determine the extent the Plan Sponsor is responsible for funding the assets of each System and, ultimately, the Common Fund relative to other participating employers.

ADDITIONAL CONSIDERATIONS

In deciding whether to advance against a System, in addition to a credit linkage analysis, there are other potential factors that a Lender may wish to consider and discuss with its counsel. For example, a Plan Sponsor of a System may have enacted a statutory regime that helps ensure that sufficient funds will be made available to the System for it to meet its liabilities.11 In such a case, a Lender may become more confident in the overall creditworthiness of the System and may become comfortable advancing against a System (perhaps at a lower advance rate and/or with tight concentration limits) despite the lack of credit linkage to the Plan Sponsor.

Lenders should also be aware of a Plan Sponsor’s ability to adjust the accrued liabilities of the System. As mentioned above, in many instances, System benefits are protected by state constitutional provisions. Certain states, such as Arizona, Illinois, Michigan and New Jersey, have pending cases relating to recently enacted pension reforms touching on this issue. These cases may have implications for the ability of Plan Sponsors in those states to limit their benefit liabilities as a means of managing the fiscal health of a System. As such, Lenders participating in the Subscription Facility market will want to consult with counsel familiar with these issues as they look to advance funds against Capital Commitments made by Investors that are Systems. Finally, it is important to note that, when a Lender is advancing against a governmental entity, it should consider the extent to which the entity may be able to use sovereign immunity defenses to impede enforcement of its contractual obligations in federal and/or state court.12

Conclusion

As the Subscription Facility market becomes increasingly competitive, a Lender’s ability to provide Borrowing Base credit for a greater number of a Fund’s Investors is one way for a Lender to distinguish itself from its competition. By analyzing the legal regime and publicly available financial and other information about a System and its sources of funding, a Lender may be able to establish sufficient credit linkage between a System Investor and a more creditworthy Plan Sponsor, facilitating inclusion of such an Investor in the Borrowing Base.

Endnotes

1 For a more detailed description of the subscription facility market and features of the subscription credit facility product in general, please see Mayer Brown’s Fund Finance Markets Legal Update “Summer 2013 Market Review.” on page 19.

2 For a discussion of key competitive and other trends in the Subscription Facility market, please see Mayer Brown’s Fund Finance Markets Legal Update “Winter 2013 Market Review.” on page 59.

3 For the sake of simplicity, we use the term “System” as encompassing both the legal entity established to administer pension benefits and the related retirement/ pension fund that holds assets in trust to pay liabilities.

4 In a Subscription Facility, a governmental plan Investor’s “funding ratio” is typically defined as the percentage obtained by dividing (i) the actuarial present value of the assets of the Investor by (ii) the actuarial present value of the plan’s total benefit liabilities.

5 The Plan Sponsor of a System does not necessarily have to be an employer of employees covered by the System. For example the Public School Teachers’ Pension and Retirement Fund of Chicago was created and is governed under the laws of the State of Illinois, but does not cover employees of the State of Illinois. For illustrative purposes, this article focuses on Systems that have Plan Sponsors participating as employers in the System.

6 For example, Article 13, Section 5 of the Illinois Constitution provides that membership in a pension system of any governmental unit in the state is “an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.”

7 See “Public Pension Funding 101: Key Terms and Concepts,” Benefits Magazine, April 2013, pages 28-33, page 30.

8 NRTA and National Institute on Retirement Security, NRTA Pension Education Toolkit, Pension Contribution Requirements, 2011, Page 2.

9 Official Statement for $750,000,000 State of Illinois General Obligation Bonds, Series of May 2014, dated April 25, 2014, Page 66.

10 The Common Pension Funds established by the State of New of Jersey Department of the Treasury, Division of Investments are examples of Common Funds. The Division of Investments uses the Common Pension Funds to invest and manage the collective assets of seven different Systems: the Police & Firemen’s Pension Fund, the Judicial Retirement System, the Police & Firemen’s Retirement System, the Prison Officers Pension Fund, the Public Employees’ Retirement System, the State Police Retirement System and the Teachers’ Pension and Annuity Fund.

11 The laws and regulations related to the funding of the Missouri Education Pension Trust (the “MEPT”) serve as an interesting example of such a regime. The State of Missouri has established the MEPT to invest the assets of the School Retirement System of Missouri and the Public Education Employee Retirement System of Missouri. The State of Missouri does not guarantee the liabilities of the MEPT or assume responsibility for making employer contributions on its behalf, yet in recent years the employer contributions have been very high and often exceed the annual required contribution (determined in accordance with Governmental Accounting Standards Board accounting standards). This high rate of contribution may be due to the fact that if any employer fails to transmit the full amount of its actuarially required employee and employer contributions to MEPT, that employer will be responsible for twice the amount owed, and MEPT is empowered to bring suit against the responsible party to collect the funds, thus incentivizing the participating employers to stay current on their contributions. See Mo. Rev. Stat. § 169.030.2, Mo. Code. Regs. Ann. tit. 16 §10-2.010(6), Mo. Rev. Stat. § 169.620 and Mo. Code. Regs. Ann. tit. 16 §10-6.020(6).

12 For a more thorough analysis on sovereign immunity concerns related to Subscription Facilities, see Mayer Brown’s November 2012 Legal Update “Sovereign Immunity Analysis In Subscription Credit Facilities.”

On December 10, 2013, the federal financial agencies (the “Agencies”) approved joint final regulations (the “Final Regulation”) implementing section 619 of the Dodd-Frank Act, commonly referred to as the Volcker Rule. Section 619 added a new section 13 to the Bank Holding Company Act of 1956 (the “BHCA”), which generally prohibits any banking entity from engaging in proprietary trading and acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with, a hedge fund or a private equity fund. Banks and other lending institutions (“Lenders”) commonly provide loan facilities to private equity funds (“Funds”) that are secured by, or otherwise look to repayment from, the uncalled capital commitments of the Fund’s limited partner investors (each a “Subscription Facility” or a “Facility”). In the typical Facility, the Lender does not directly sponsor, invest in or manage its Fund borrower, but rather only provides extensions of credit.1 Lenders frequently inquire to ensure their Facilities are in compliance with the Final Regulation. This Legal Update clarifies why most Facility structures will not run afoul of the Final Regulation’s prohibition against acquiring or retaining an ownership interest in a covered fund and what parameters a Lender should maintain to ensure continuing compliance.2

Covered Funds as Subscription Facility Borrowers

In order to be subject to the Volcker Rule, a Fund must be a “covered fund,” as defined under the Final Regulation. A “covered fund” includes any issuer that relies solely on the section 3(c)(1) or 3(c)(7) exceptions from the definition of “investment company” under the Investment Company Act of 1940 (the “1940 Act”). It also includes any “commodity pool” under the Commodity Exchange Act that shares characteristics of an entity excluded from the 1940 Act under section 3(c)(1) or 3(c) (7). With respect to US banking entities only, a covered fund would also include any non-US fund owned or sponsored by the US entity itself or an affiliate if the fund would rely on section 3(c)(1) or 3(c)(7) if it were subject to US securities laws.3 A majority of Fund borrowers in Facilities, in our experience, will be covered funds, as they frequently rely on section 3(c)(1) or 3(c)(7).

Subscription Facility Loans, not Ownership Interests

To the extent that an entity is a covered fund and is not covered by an exclusion, a Lender that is a banking entity under the Volcker Rule is generally prohibited from acquiring or retaining any “ownership interest” in the covered fund.

While it may seem inherent on its face that a debt facility like a Facility is not an “ownership interest” in even the most expansive interpretation, the Final Regulation does define “ownership interest” broadly to mean any equity, partnership or “other similar interest.” The Final Regulation provides that “other similar interest” includes an interest that (i) has the right to participate in the selection or removal of a general partner, director, investment manager or similar entity (excluding certain creditor’s rights); (ii) has the right to receive a share of the fund’s income, gains or profits; (iii) has the right to receive underlying assets of the fund after all other interests have been redeemed or paid in full (excluding certain creditor’s rights); (iv) has the right to receive excess spreads under certain circumstances; (v) has exposure to certain losses on underlying assets; (vi) receives income on a pass-through basis; or (vii) has a synthetic right to receive rights in the foregoing. Accordingly, while a debt interest generally would not be considered an ownership interest, to the extent that a debt security or other interest in a covered fund exhibits any of the foregoing characteristics, it would be considered an ownership interest. The “other similar interest” component makes the definition of “ownership interest” broad and requires specific application to the facts of a given transaction.

The good news for Lenders is that debt interests held in a classic Facility, absent some atypical degree of control over the Fund or pricing mechanic, are unlikely to be considered an “ownership interest” because the loan documents for a Facility generally do not provide the Lender with any of the rights described in subclauses (i)–(vii) above. The Agencies additionally provided explicit clarifying guidance on this: An “ownership interest” generally does not include “typical extensions of credit the terms of which provide for payment of stated principal and interest calculated at a fixed rate or at a floating rate based on an index or interbank rate.”4 Thus, the Lender in a Facility does not directly have an equity stake in the Fund or any rights that amount to an ownership interest under the Volcker Rule.

Default Remedies and Collateral Foreclosures

While certain events may give rise to an event of default under a Facility and provide the Lender with the ability to accelerate the debt and enforce remedies against the Fund, including the ability to charge step-up default interest, such enforcement rights are in line with typical extensions of credit and are not akin to “an ownership interest” for Volcker purposes. The Agencies expressly carved out such rights in the commentary: “the Agencies believe[d] that a loan that provides for step-up in interest rate margin when a covered fund has fallen below or breached a NAV or other negotiated covenant would not generally be an ownership interest.”5 Similarly, rights to participate in the selection or removal of the fund’s management are expressly subject to a creditor’s right to exercise remedies upon the occurrence of an event of default as well.6

Even where a Lender obtains an ownership interest in a Fund by the exercise of remedies during a default (a circumstance potentially relevant to Lenders under hybrid structures that also take a security interest in the underlying assets or in the insolvency of a fund of funds borrower), the rulemakers provided an exception. This exception for ownership interests acquired in the ordinary course of collecting a “debt previously contracted” (“DPC”) means that a Lender, as a secured party, that has covered fund ownership interests as collateral securing a Facility may foreclose on its security interest and thereby take possession and dispose of such ownership interests without violating the Volcker Rule. The Final Regulation expressly sanctions the ownership and sale of the covered fund ownership interest in such a DPC context, provided that the Lender acquiring an ownership interest in a covered fund “divests the financial instrument as soon as practicable, and in no event may the banking entity retain such instrument for longer than such period permitted by [its primary regulator],” typically within approximately two years, subject to possible extensions.7

Facility Limitations

We do advise Lenders to be conscious of the definition of “other similar interest” and curtail their creativity to structures that will not run afoul of the Final Regulation. For example, any sort of warrant or other equity kicker, equity conversion feature, step-up in spread based on Fund performance or the like would all require a hard look under the Final Regulation.

Conclusion

We think it is highly unlikely that a Facility Lender, absent unusual control or profit-sharing mechanics in respect of a Fund borrower, could be deemed to hold an ownership interest in such covered fund under the Final Regulation solely as result of the typical Facility lending relationship.

Endnotes

1 If the Lender is the sponsor, investment advisor or investment manager of the Fund, significant additional compliance obligations are implicated which are beyond the scope of this Legal Update. Similarly, if the Fund borrower is itself sponsored or advised by a banking entity subject to the Final Regulation, additional analysis is required by the Lender.

2 For an in-depth review of the Volcker Rule, please see Mayer Brown’s Legal Update, “Final Regulation Implementing the Volcker Rule.”

3 A fund that is not an “investment company” in the first place or that is able to rely on an exception or exemption under the 1940 Act other than section 3(c)(1) or 3(c)(7) generally is not a covered fund. For example, a real estate fund that invests solely in real property rather than in securities is not an investment company, while a real estate fund that invests in a mix of real property and real estate-related securities may be able to rely on section 3(c)(5)(C) of the 1940 Act. In either case, the fund would not be a covered fund. In addition, even if an entity relies on section 3(c)(1) or 3(c)(7) of the 1940 Act, the entity is not a covered fund if it falls within a Volcker Rule exclusion. The Final Regulation expressly excludes from the definition of a “covered fund” various types of entities, including, among others, certain “foreign public funds” that are analogous to US-registered investment companies, foreign pension and retirement funds, and qualifying loan securitizations and asset-backed commercial paper conduits. If a fund is not an investment company in the first place or is covered by a Volcker Rule exclusion, a banking entity may not only invest in or sponsor the fund without needing to comply with a Volcker Rule exemption but it may also engage in covered transactions with the entity without regard for the so-called Super 23A prohibition.

4 Final Regulation Preamble at 5706.

5 Final Regulation Preamble at 5707.

6 Final Regulation Preamble at 5706. 7 Final Regulation Preamble at 5782.