Lenders are rushing to close a potential fund finance loophole in response to Société Générale’s dispute with Abraaj Group investors.
When a bank agrees to provide a subscription credit line to a private equity fund, it creates a security over the general partner’s right to call capital from its investors. This enables the creditor to approach the limited partner directly for its commitment in the event of a default from the fund.
Lenders will often look to ‘perfect the security’ by having GPs notify investors that a security has been created. GPs typically serve these notices in their quarterly update, potentially leaving a three-month window in which LPs could be released from their commitment or fund documents altered.
As SocGen fights to retrieve commitments from some LPs in Abraaj Private Equity Fund VI, which suspended operations and released investors from commitments in February, the way lenders seek to protect rights of recourse is changing.
“Banks are now more likely to require general partners to issue a notice of security at the time a subscription credit line is agreed and the security is actually issued,” Jeremy Cross, partner at fund finance lawyer Cadwalader, Wickersham & Taft, told Private Equity International.
A fund finance specialist at an international investment bank told PEI on condition of anonymity that his firm was one of many increasing their early notice adoption. The lender is also considering a clause that would enable it to call in the loan should a GP face allegations of mismanagement of funds from a regulator or a significant number of LPs.
“The stub period between when a facility is put in place and when the quarterly report is issued can potentially leave lenders open to risk,” said Gavin Rees, head of global funds banking in Europe at Silicon Valley Bank, which has more than $19 billion in loan commitments to private equity and venture capital firms.
“It’s now becoming the norm to provide a notification [of security] at the time a facility is closing and ask the borrower to go through the minor inconvenience to send a separate notice ahead of the next quarterly report.”
Abraaj was thrust into the spotlight last February after reports that limited partners in its $1 billion Global Healthcare Fund had hired auditors to trace capital that was to be invested in medical projects in India, Pakistan, Kenya and Nigeria. The firm is being dismantled, with names like Colony Capital and Actis in the frame for various parts of the business.
SocGen had appointed receivers as of November to issue drawdown notices to LPs in APEF VI for their pro rata share of the amounts outstanding under the facility, according to documents prepared by joint provisional liquidators Deloitte and PwC seen by PEI. APEF VI is understood to have already used a capital call facility from the French bank to acquire KFC Turkey prior to its suspension.
The released LPs are disputing the validity and enforceability of these claims. It is unclear whether a notice of security had been issued.
Société Générale and Deloitte declined to comment for this story.
Early notifications are by no means a new concept – the degree of use depends on factors such as experience of manager and maturity of the fund. It is now being used more consistently across the board, Rees noted.
Where’s my money?
SocGen faces the challenge of retrieving its capital from dissenting LPs. As APEF VI completed one investment before it ceased operations, LPs could in theory sell their positions, with buyers potentially being asked to pay the outstanding commitment. If the LPs disputing SocGen’s drawdown notice are unwilling to sell their positions, one option may be to do so by force. If the lender does not, for whatever reason, have the right or desire to sell, it can seek to pursue the matter in court.
A protracted legal process is not likely to appeal to any parties, given the potential for extensive legal fees and reputational risk to LPs who might seem difficult to work with or appear less creditworthy.
A number of LPs – mostly Abraaj-related entities – had already defaulted on a capital call facility held with British bank Barclays before the JPLs were brought in, as PEI reported in October. The defaulted proportion of this facility was to be paid using management fees raised from a drawdown notice issued by the JPLs to LPs in Abraaj’s LatAm, Turkey, Pakistan and Africa funds.
Subscription credit lines have traditionally been viewed as low risk for lenders. The Abraaj dispute is often cited as one of, if not the only, cases of such a loan going wrong and could set a precedent for any future unpaid facilities.
The consequences could be far-reaching. One lender at PEI’s CFOs & COOs Forum New York in January last year estimated that there was about $400 billion in outstanding subscription lines of credit, with 60 percent in the US.
Industry adoption of the post-Abraaj approach to these loans could be widespread, according to the fund finance specialist.
“Many others are taking the same route,” the lender noted. “People who don’t will be in the minority.”