Welcome to a special joint issue of Collateral and Alternative Insight. This time, last year, we reported on the swelling use of subscription credit lines by managers of private equity funds. There is no sign of the trend abating. According to recent estimates, the global fund finance market is around $500 billion, whilst the UK market is in the region of £150 billion.
Although the terms and structures often reflect the bargaining strength of borrowers in today's market, there are nonetheless a variety of risks and issues that confront GPs and which need to be tackled in negotiating these facilities.
Here are eight top tips for managers when negotiating fund finance structures with lenders.
1. Plan ahead
It may seem self-evident, but the sponsor must ensure that the underlying documentation contains appropriate provisions to accommodate borrowings. At a minimum:
- The fund's limited partnership agreement (LPA) should authorise the manager to secure the right to call undrawn capital commitments and the bank account into which capital contributions are paid.
- If a management line is contemplated, the manager should ensure during the fundraising period that the management agreement (and possibly the LPA, too) permit security over the right to receive management fees.
- Similarly, if a GP-led financing could conceivably be pursued down the line, the LPA should be drafted so as to permit the GP to secure its limited partnership interest .
2. Think of your LPs
The rapid growth of fund finance in the last few years has sometimes unsettled LPs or resulted in them receiving multiple requests from the GP at any one time. Once fund finance is under consideration, the manager should liaise with fund counsel at an early stage to ensure that third party investors are furnished with detailed disclosure on the potential financing, its impact on them and the funds in which they are investing.
Understandably, LPs would like adequate time and information to properly evaluate the transaction. The GP's advisers should be deployed promptly in this regard, and the GP's own team should be ready and available to deal with any investor queries.
Similarly, once the facility has been agreed, as a matter of good investor relations, the formal notice to investors should be led by the GP and its advisers, rather than by the lender.
3. Think about third parties
Don't underestimate the need to involve other parties from the outset and throughout the process. If, for example, a fund administrator provides directors for a fund entity, it and they will expect to review and fully understand the effect of the finance documents before preparing and signing the requisite board resolutions and certificates approving the deal.
Likewise, if security is required over deposit accounts held with third party banks, a condition precedent to closing for the lender will be that the bank formally acknowledges that the security is in place. The larger clearing banks tend to have their own in-house form of notice and acknowledgment, so don't assume they will accept the lender's own form. Similarly, the fund (through its advisers) should ensure that an authorised signatory from the account bank is lined up to sign the security acknowledgment. All other elements to the financing may be in place, but without this signature no money will be advanced!
4. Consider the borrowing base
This could be an article, in itself. The key credit aspect of a subscription line facility is the borrowing base, which provides the source of repayment to the lender. Under a borrowing base, outstanding loans (as well as exposure from letters of credit and hedging) may not exceed an aggregate amount for all investors equal to the product for each investor of the uncalled capital of such investor multiplied by an advance rate based on such investor's creditworthiness.
The lender may remove eligible investors from the borrowing base on the occurrence of default-type events that denote a decline in its creditworthiness. But exclusion for material adverse change or loss of net worth should apply only to non-rated investors, on the assumption that material adverse change or loss of net worth in a rated investor would be reflected in a ratings downgrade.
In addition, lenders may wish to exclude certain categories of investors from the borrowing base. Lenders will look carefully at entities that benefit from sovereign immunity, such as governmental plans and sovereign wealth funds, unless that sovereign immunity has been effectively waived (either expressly by the relevant investor or by applicable law). However, lenders active in this market are often familiar with these investors and may be willing to give them borrowing base credit based on an existing good relationship or prior dealings. It is therefore useful for prospective lenders and borrowers to discuss borrowing base issues at the term sheet stage, especially in cases where lenders are likely to query some percentage of the initial capital commitments to the fund.
5. Be wary of negative covenants
From the fund's perspective, restrictions against additional security that apply only to the lender's collateral are optimal (and typical). If the lender insists on broader constraints covering other fund assets, the fund will need to permit, at the very least, cash collateral for third party letters of credit and hedging, and security over portfolio assets that also secure obligations of portfolio companies. In addition to permitting the types of debt associated with these exceptions, GPs should make sure that ordinary course obligations to make acquisitions or other investments are not prohibited by the financial indebtedness covenant.
6. Temper the undertakings
Subscription facilities commonly contain a comprehensive set of undertakings, but they should be tempered by appropriate qualifications and carve-outs, to ensure that the manager can operate the fund in the manner expected by its investors. In particular, the GP should pay attention to undertakings relating to investors. For example, a lender may want an undertaking from the borrower that no representation or warranty by an investor in its investor documents is untrue and/or misleading. Any such undertaking should be resisted as this is not within the fund's control. In these circumstances, a compromise which is often workable is to state that to the knowledge of the fund parties, they are not aware of any material breaches of the representations given by the investors to the fund. Moreover, the lender should take comfort from KYC procedures that the manager would have taken in respect of each investor.
7. Avoid subordinating your management fees
Whether it's providing a management working capital facility or a subscription line, a lender will want to understand how fees are calculated and paid. Many lenders seek to limit the payment by the funds of management fees during an event of default under the facility if there is outstanding debt – understandably so, because the lender wants to be repaid before any further monies leave the fund in the form of distributions or fees. However, unlike distributions to investors, management fees are paid in consideration for services rendered by the manager; the GP should resist subordinating them to a loan. Moreover, it is in the interests of both the lender and the fund to permit payment of management fees to "keep the lights on", call investor commitments and maintain the day-to-day operations of the fund.
8. Limit rights to amend fund documents
In fund finance, the lender's security interests and source of repayment are closely tied to the fund's organisational documents, so it will be especially sensitive about the terms of the LPA, subscription agreements and side letters. Many lenders demand consent rights over amendments and waivers in these agreements (and sometimes even the PPM), as well as over any new investor side letters and subscription agreements. This allows them to determine whether adverse provisions would trigger an MFN obligation which benefits investors that are already in the borrowing base.
As a starting point, the GP should limit lender consent rights to changes that would materially adversely affect the lender, including adjustments to borrowing limits and changes to capital calls and commitments. Even with this limitation, the lender may require an extensive pre-clearance procedure to determine whether the proposed waiver or amendment would have such an adverse effect. A better approach is for the GP to make the initial determination of 'adverse effect', which opens a window for the lender to pre-approve such adverse amendments. If the GP cannot avoid lender pre-clearance, it should try and shorten the review periods as much as possible.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.