Subscription line (or capital call) facilities are becoming increasingly popular with private equity funds and lenders alike. Over the last year, we have seen numerous funds arrange capital call financing, typically senior secured revolving credit facilities, for the first time.
For funds, the facilities are a relatively inexpensive source of liquidity and provide a quicker source of finance than the time required to call capital from investors. For lenders, the loans are backed by substantial collateral in the form of unfunded investor capital commitments, risk of non-payment default is historically low, and there is an opportunity for the lender to develop a relationship with the private equity sponsor.
Lenders have historically imposed fairly tight facility terms with various restrictions and obligations imposed on the fund. As the lending market becomes more competitive, many fund borrowers have the opportunity, and negotiating power, to agree more flexible covenants.
It is therefore an opportune time to look at some of the critical considerations for funds.
1) Agree a borrowing base mechanic that works for the fund.
It is key that the facility is of a size which is fit for purpose for the fund. This is ultimately a factor of the borrowing base calculation – typically an amount representing the unfunded capital commitments of eligible investors at an advance rate.
However, some lenders may agree to focus less on the creditworthiness of specific investors. An alternative formulation tests whether unfunded capital commitments (with some exceptions) constitute an agreed percentage in excess of the fund’s debt.
Lenders may also be flexible in setting criteria with respect to specific elements of the tests – for example advance rate levels, eligible investor criteria or the scope of events that will cause eligible investors to be excluded from the borrowing base.
Some lenders may also be willing to assess the borrowing base by reference to the net asset value of the fund’s underlying investments rather than undrawn investor commitments. This is particularly useful for funds approaching the end of their investment period.
Fund borrowers now have an opportunity to explore up front with potential lenders which alternatives provide the most flexibility.
2) Flexible structures and the treatment of co-investors.
A fund may wish to set up an employee co-investment vehicle to invest in the structure. Historically, lenders have generally taken security from all fund investment vehicles. However, as co-invests are often immaterial in the context of the fund as a whole, many lenders are now willing to forego co-invest security.
3) Using funds for wider purposes.
The fund may wish to use its facility for a wider range of purposes than bridging capital calls. Many lenders now permit other uses. Flexibility may be given to use proceeds to meet the obligations of an investee company, to bridge co-investments, to provide liquidity to managers or general partners, to repay debt previously incurred for investments, or for other general working capital.
4) Concerns with over-regulation and whether the finance covenants override the fund’s limited partnership agreement (LPA) terms.
As the fund’s LPA, and related fund documents, contain the operative provisions of the fund, it is important for a fund that the facility agreement does not impose a material number of additional restrictions in excess of those in the fund documents. Otherwise, the fund could default its facility (and lose access to liquidity) in circumstances where it is fully operational and compliant with its fund documents.
Examples of over-regulation by lenders include:
Imposing caps on the percentage of investor commitments which are subject to insolvency, or in default of their obligations to advance commitments, or which may be transferred to a new investor; prohibiting changes of general partner or manager; limiting flexibility to raise secured debt in relation to an investment; and imposing events of default relating to key person events (where, under the fund documents, the same event does not cause the partnership to terminate).
However, the tide is turning. In the current market, many lenders are prepared to accommodate fund borrower concerns with over-regulation.
(5) Flow of information and the dangers of micro-managing.
Lenders typically require a fund to provide a wide range of information. This includes yearly and quarterly financial statements, and often extends to other information such as side letters, detail of breaches of fund documents, notice of capital calls, notice of amendments to fund documents, details of changes in the financial condition of investors, and any other information that the lender considers material.
Lenders may, however, be prepared to accept limits to the obligations to avoid causing too great an administrative burden (for example, accepting a schedule detailing capital drawdowns rather than provision of individual capital call notices).
A fund is also typically required to notify investors of the existence of security. To avoid additional administration, lenders may agree to notification of investors at the same time that financial statements are provided.
Fund borrowers now have an opportunity to voice concerns with information obligations – many lenders are willing to listen.
It is a good time for funds to raise subscription line facilities. The fund finance market is growing and many lenders are increasingly flexible on terms. Fund borrowers have an opportunity to achieve better financing terms, and to find financing that meets their specific financing needs without over-regulating their operations.
Thomas Smith is a London-based associate in the finance department at Debevoise & Plimpton.