Subscription credit facilities for private equity funds have become increasingly popular. While many of these facilities are relatively small in absolute dollar terms, they provide flexibility and liquidity that many general partners value. However, lenders providing these facilities often require undertakings from fund borrowers and their investors that can be onerous, particularly if they have not been addressed in the initial fund documents.
Subscription credit facilities typically take the form of a senior secured revolving credit facility secured by the unfunded capital commitments of the fund’s investors. The facilities are subject to a borrowing base determined based on the value of the pledged commitments of investors satisfying specified eligibility requirements, with advance rates based on the credit quality of the relevant investors.
The purpose of subscription credit facilities is usually to provide liquidity for the fund on a faster basis than calling for capital contributions. Under a credit facility, borrowed funds typically can be made available within a day, while under a typical limited partnership agreement, capital calls may take 10 business days or more.
As this might suggest, subscription credit facilities are most commonly used for short-term bridging of capital calls. However, they can also be used for longer term bridging purposes, for example in real estate funds, to bridge the period between acquisition of a property and the incurrence of a “permanent” mortgage or to provide or backstop construction financing or letters of credit during the development phase of a project.
Subscription credit facilities typically involve a pledge by the fund borrower and its general partner or other managing entity of:
- the right in and to the unfunded capital commitments of the investors;
- the right to make capital calls and to enforce the obligations of the investors to contribute capital; and
- the deposit account into which investors are required to fund their contributions.
The fund’s underlying investments are typically not part of the security package, although in some facilities (particularly for funds that are at or near the end of their investment period) such investments do constitute part of the borrowing base.
The lender’s security interest in most of this collateral is easily perfected by filing a UCC financing statement. Perfection of the security interest in the bank account into which the investors have agreed to make their capital contributions is achieved by giving the lender “control” pursuant to a tri-party agreement among the lender, the depository bank and the fund. This element is relatively straightforward, although the financial institution maintaining the account may demand problematic terms that a subscription facility lender would resist, including demands for indemnification by the lender and ability of the depository bank to make claims for fees, expenses and indemnities against the balances on deposit in the account. These issues should be addressed in a timely fashion in order to avoid last minute delays.
Borrowing Base and Advance Rates
Advance rates will depend on a number of factors, including the credit of the various investors, the amount of information available to the lender regarding such credit and the quality of the documentation allowing the lender to exercise its rights to call the capital during an event of default.
Not surprisingly, lenders who provide subscription credit facilities typically give borrowing base credit only for the undrawn commitments of creditworthy investors that meet specified requirements, i.e., “Included Investors”. Investors who are publicly rated BBB+/Baa1 or higher are typically included. Advance rates for rated Included Investors may be higher for investors with higher credit ratings, and typically range between 80% and 100% of the face amount of the unfunded commitment. Unrated investors may also qualify as Included Investors if they provide sufficient information to enable the lender to determine that they satisfy certain credit criteria, which not all investors are willing to provide. Unrated investors will generally be Included Investors only if the lenders consent, and the advance rate for the commitments of unrated investors will similarly typically be subject to lender consent. Whether the standard of lender discretion for approval of and advance rates with respect to unrated Included Investors is “sole discretion”, “reasonable”, “good faith” or other, is subject to negotiation, the outcome of which can make a meaningful difference when it comes time to bring in additional investors.
Lenders often also seek to impose concentration limits limiting the aggregate amount of capital commitment of a single investor or category of investors that may be included in the borrowing base. In addition, lenders may wish to exclude certain types of investors from the borrowing base. Lenders will look carefully at entities that are subject to restrictions on their investment activities, such as ERISA-regulated pension entities. Inclusion of commitments of investors that have the benefit of sovereign immunity, such as governmental plans and sovereign wealth funds, can also be problematic, unless that sovereign immunity has been effectively waived (either expressly by the relevant investor or by applicable statute or case law). That said, lenders will often approve investors that have sovereign immunity or are subject to restrictions as Included Investors if they deliver investor documents addressing these issues (as further discussed below). Also, lenders active in this market are often familiar with the relevant investors and may be willing to give borrowing base credit for their commitments based on prior dealings with them. It can therefore be valuable for borrowers to discuss in detail borrowing base issues with prospective lenders at the commitment or term sheet stage, especially in cases where lenders are likely to question a large percentage of the initial capital commitments to the fund.
Finally, there may be exclusion events the occurrence of which will make an Included Investor a non-included investor. For example, bankruptcy of the relevant entity or default on the payment of a previous capital call will certainly result in an Included Investor becoming non-included, as will failure to maintain the required credit rating or other financial criteria.
Undertakings of Investors
Lenders will also typically require that investors, in addition to satisfying the specified credit standards, make various acknowledgements, representations and covenants for the benefit of lenders in order to qualify as Included Investors, typically in the form of an “investor letter”. Obtaining investor letters can be burdensome and will increase legal costs. Where a financing is anticipated, it is helpful to include in the partnership agreement an undertaking by the investors to execute a consent letter for the benefit of lenders, along with an outline of the acknowledgements and undertakings typically demanded by lenders. In recent years, however, investors have been increasingly reluctant to provide investor letters, and a significant number of fund borrowers have successfully resisted these requirements, particularly where the relevant provisions are included in the fund documentation in a form acceptable to the lenders.
Representations by the investors in favor of the lenders, even if included only in the limited partnership documentation, will give the lenders appropriate comfort and facilitate inclusion in the borrowing base. Lenders will also want to see a covenant from the investors to provide periodic credit information, as well as an acknowledgment of their “absolute and unconditional” obligation to fund their remaining capital contributions (including contributions required as a result of the failure of another investor to fund and contributions necessary to pay outstanding debt after the end of the fund’s investment period), an agreement to fund their capital contributions into a specified deposit account that will be pledged to the lenders, and an acknowledgment of the lender’s right to consent to transfers of investors’ interests in the fund. Similarly, covenants to provide reasonable cooperation to lenders will also help the fund maximize its borrowing potential.
In addition, lenders typically want investors to acknowledge the pledge by the General Partner of its right to call capital and that such right may be exercised by the lenders. Lenders also insist that investors waive any rights of setoff, counterclaim or other defenses they may have to any capital call (including under certain provisions of the Bankruptcy Code), especially capital calls that are made by or on behalf of the lender.
In doing its diligence on the investors, the lender will want to review all side letters and may request additional information about a particular investor and its circumstances. If the lender cannot be satisfied as to the individual investor’s status, it will reserve the right to disallow that investor as an “Included Investor”, so it is in the borrower’s interest to help the lender get the information it needs.
Undertakings of the Fund Borrower
There are important differences between the covenants in subscription credit agreements and those in typical revolving credit agreements. These differences are primarily driven by the nature of the collateral for subscription credit facilities.
To protect their collateral, lenders will generally insist on some limitations on the borrower’s ability to amend its fund documents without lender consent. Borrowers will want these limitations to be as narrow as possible so that they apply only to, e.g., amendments that adversely affect, from the lender’s perspective, investors’ obligations and liabilities relating to capital commitments or the fund’s or general partner’s rights to make capital calls and enforce remedies against investors.
As noted above, lenders also typically seek the right to consent to Included Investors’ transfers of their partnership interests in the fund. While some restrictions on Included Investor transfers are the norm, the more borrower-favorable approach is to provide that an unapproved transfer will result in the exclusion of the relevant investor’s capital commitment from the borrowing base but will not trigger an event of default under the credit agreement.
Lenders often argue for a right to consent even to transfers by non-included investors, or for the right to call an event of default under the credit agreement if a certain number of investors transfer their interests or withdraw from the fund, on the grounds that such transfers or withdrawals are warning signs of a troubled fund. For similar reasons, lenders may seek to include covenants relating to fund investments, such as valuation requirements or portfolio concentration limits, and covenants restricting the incurrence by the fund borrower of indebtedness other than under the subscription facility.
Some lender concern about the performance of a fund borrower is reasonable, in that a bankruptcy of the fund or mass investor defaults could make it difficult for the lender to get repaid. However, because lenders are primarily relying on Included Investors’ capital commitments, rather than on the value of the borrower’s portfolio company investments, and are typically over-secured (as commitments of non-included investors are pledged even though they are not included in the borrowing base calculation), lenders arguably do not need the same level of control over the borrower’s business that they would have with a more typical corporate credit facility. Borrowers should resist overly strict covenants that could restrict liquidity, impose burdensome administrative requirements or force the fund to pass up attractive investment opportunities, and should try to narrow covenants aimed at ensuring the overall health of the fund so that they do not impose more stringent limitations on investments and indebtedness than are imposed by the fund documents.
Other provisions commonly seen in subscription credit facilities include restrictions on management fees and distributions during the continuance of an event of default under the credit agreement, covenants or events of default relating to key person events that could trigger the end of the fund’s investment period and lender rights to consent to the exercise by the fund or general partner of remedies for investor defaults (driven by lender concern that the exercise of certain remedies, such as termination of a defaulting investor’s right to contribute, can be inconsistent with the lender’s interest in the collateral).
Subscription credit facilities have become more and more widespread in the private equity world, as they provide sponsors and general partners with additional funding flexibility and liquidity. On the other hand, some investors may object to certain of the terms required by lenders, such as financial disclosure, restrictions on transfers of limited partnership interests, and waivers of defenses. As a result, it is important for sponsors to set the expectations of all relevant parties in a manner that facilitates the financings without being unrealistic. This is usually best done by providing appropriately measured provisions in the fund documentation from the very first drafts that are provided to prospective investors. To the extent issues arise after the documentation process has begun, the outcome will be more uncertain than if expected lender demands are in the mix from day one.