Following on Mike Mascia’s Closing Remarks delivered to young Fund
Finance professionals at last month’s FFA University 1.0, I
wanted to take things back to the basics for those who are just
starting their careers in fund finance.
“Do they lend above the fund or below the
fund?”
These are the first words that come to mind when I think about
the start of my career in fund finance. Like many young
professionals before me, I walked into my first interview armed
with as much knowledge as I considered feasible to cram into my
brain about an area of finance which, up until the moment I was
asked that foreign question, I had little understanding.
Multiple articles, flowcharts and PowerPoint presentations
later, I began to make advances at installing this new language
into Fund Finance Fiona 1.0. As I continued to embark on the next
steps in my career, the amount of legal and business jargon I
needed to learn grew – but my confidence also grew.
As we welcome this year’s fresh batch of first-year
associates, it seems as appropriate a time as any to take things
back to basics – because there is nothing like teaching that
is as effective to reinforce your own learning. So if this is one
of many articles, flowcharts and PowerPoints you have reviewed, or
that remain on your horizon, know that in time, the foreign will
become the familiar.
So what is fund finance? What is a fund? What is happening
above and below it? What are some key considerations for lenders
when structuring, negotiating and documenting such credit
facilities?
What Is a Fund?
- A vehicle for making investments
- Commonly structured as a limited partnership
- Made up of investors (limited partners) and administered by the
general partner
Investors will subscribe to a fund by signing a
subscription agreement and committing to a certain amount
(the general partner is then able to accept any commitment amount
for the investor up to the total amount offered). A fund may
solicit a single investor (a fund of one or separately
managed account/SMA) or a variety of investors, and
hold multiple closings to bring on additional investors for its
investment purposes. Investors are not required to fund all of
their commitment upfront, but rather, each investor is
contractually bound to fund capital calls from the general
partner on behalf of the fund. The general partner will call
capital by delivering a notice to its investors, and each such
notice (a capital call notice) will state the amount and
purpose of the capital call (e.g., an investment,
follow-on investment or, importantly from the lender’s lens,
the repayment of debt).
Note: investors or limited partners are not involved in
the management of the fund and have limited liability, typically
restricted on the basis of the aggregate value of their capital
commitment.
What Is Fund Finance?
“A revolving credit facility is just like a credit card
for a fund!”
The best starting point to learn something new is to build its
foundation relative to concepts you already know and understand. So
why are we comparing a typical fund finance transaction to a credit
card?
The types of loans we generally deal with in the world of
subscription lending (see below) are revolving credit
facilities. This means that a borrower is able to, during the
life of the loan, borrow, repay and borrow again – similar to
the same way a retail consumer would use a credit card, but with
one caveat: the loans typically have a term of two to three years
(with possibly an extension) and which may include mechanisms for
extension either at the borrower’s option or subject to lender
approval.
What is happening above and below the fund: an intro to
subscription lending, NAV and hybrid facilities.
There are two overarching types of facilities in fund finance
– subscription credit facilities and net asset value (NAV)
facilities. With respect to a subscription credit facility, the
lender looks to the uncalled capital commitments of the investors
of the fund (the amount the investor committed to the fund that
hasn’t been subject to a capital call) and the security package
includes the capital call rights of the general partner (who, as
you may recall, administers the fund and makes capital calls to the
investors by delivering capital call notices) and the account(s)
into which capital calls are funded. NAV facilities, on the other
hand, are secured by the assets or actual investments held by the
fund or the equity interests in the vehicles that hold such
investments.
As demonstrated above, subscription facilities look to the
uncalled capital commitments of the investors (i.e.,
above the fund) and NAV facilities look to the assets of
the fund (i.e., below the fund).
Breaking Down the Role of a Fund Finance
Attorney
For the purposes of this article, we will focus on subscription
lending facilities.
I. Diligence
LPAs – to bank or not to
bank?
Often, before a deal is even
mandated, attorneys will be engaged to diligence the limited
partnership agreement (LPA) of the prospective borrower. The LPA
will set out the obligations of the limited partners, the rights
and role of the general partner, and capital call procedures. The
terms of the LPA can make the difference between a deal that is
bankable and one that’s not! From a lender’s perspective,
the fund must be authorized under its LPA to borrow and pledge
investor capital commitments, state that investors are obligated to
fund capital calls without setoff, counterclaim or defense, and
have typical remedies for investor defaults. Among other things,
lenders are also interested in the ability to overcall
(i.e., to call on other investors to fund capital where
there is a shortfall caused by excuse rights or default by other
investors).
Side letters – mine is
bigger than yours!
As indicated above, investors
subscribe to a fund by signing a subscription agreement. But what
happens if an investor would like to alter its rights and
obligations? Since a subscription agreement is typically a form,
any additional rights or obligations will need to be documented
separately in a side letter. While certain side letter provisions
will be irrelevant in the context of a financing (e.g.,
negotiated management fees), a lender is interested in anything
that will interfere with its ability to get repaid in an event of
default – i.e., anything that limits the ability to
call capital from the limited partners, such as cease funding or
withdrawal rights, overcall limitations, reservation of sovereign
immunity, commitment caps and capital call formalities. In
addition, lenders are concerned about most favored nations (MFN)
provisions, which allow investors to elect the same terms that are
available to any other investor with the same (or a smaller)
commitment amount. Why? Because as an investor, you want value for
your money – if you have committed a certain amount of
capital to a fund, wouldn’t you want at least the same rights
as anyone else who has committed the same amount? For an overview
of common side letter provisions relevant to subscription lenders,
see here.
II. Documentation – run before
you walk!
The standard loan documents for a
subscription credit facility include the credit agreement, security
agreements (which may include local and foreign security agreements
depending on the jurisdiction of the borrower), collateral account
pledges, deposit account control agreements (DACAs), fee letters
and other ancillaries. The credit agreement sets out the terms of
the facility, including lenders’ obligation to fund, borrowing
procedures, interest and repayments, representations and warranties
of the borrower and other credit parties, affirmative and negative
covenants, conditions precedent to closing, events of default and
other mechanics. In the U.S., credit agreements are generally based
on the Loan Syndications and Trading Association (LSTA) form,
whereas in the UK, credit agreements are generally based on the
Legal Marketing Association (LMA) form.
Once the loan documents are signed
and signatures released by the parties to the transaction,
attorneys are responsible for ensuring that the lender’s
security is perfected by (i) control, i.e., the execution
of the DACA for any collateral account, and (ii) by filing Uniform
Commercial Code (UCC) financing statements with the appropriate
filing office in respect of the intangible rights.
III. Structuring and Negotiating
It almost seems counterintuitive
that the role of structuring a subscription facility comes later
than both diligence and documentation. But in order to structure a
product, you must first understand it. What does this mean for
anyone that is new to fund finance? Review, review, review. Review
the structure chart (which in practice will certainly include more
than one fund borrower), review the organizational documents and
review the investor documents. Only by understanding the fund
structure (including where a borrower sits relative to its related
entities) can we begin to provide advice on the building blocks of
a transaction. This means understanding where investors are coming
in (to which entity investors are subscribed), and tracking the
flow of funds to ensure that the loan documents adequately capture
the relationship between the various entities, the capital
commitments, capital call rights and ancillary rights.
Conclusion – Welcome to the Kiddie
Pool!
As Malcom Gladwell discussed in one of his bestsellers,
Outliers, to become an expert, it takes approximately
10,000 hours (or approximately 10 years) of deliberate practice.
The words I impart upon you today are words I have repeated dozens
of times as I welcome new attorneys and bankers alike to the world
of fund finance. As to whether it really takes 10,000 hours, only
time will tell. My advice? Ask questions, read widely and gain
exposure, and when in doubt, trawl through the wide range of
resources made available by Cadwalader’s Fund Finance Friday. If you need a starting
point, an index of primers is available here.
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.
