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.