Capital call (aka “subscription” or “equity bridge”) facilities have garnered attention recently due to their strong performance in the wake of the financial crisis. The popularity of these facilities grew substantially in 2012 and 2013 despite fundraising challenges in the private equity market, with further growth anticipated as investment continues to climb and market players become more familiar with these facilities.
Capital Call Facilities – The Basics
Capital call facilities provide short-term funding on a revolving basis to private equity funds to bridge the time between when an investment is made by the fund and when capital contributions are received from investors to finance that investment (typically between 30 and 90 days after a capital call notice is delivered to investors by the fund). Loans are repaid with capital contributions once received from investors.
Capital call facilities are typically secured by (i) the fund’s pledge of unfunded capital commitments of investors, (ii) the fund’s pledge of the accounts into which investors deposit capital contributions and (iii) the granted by the fund or its general partner of the right to deliver capital call notices to investors (via a power of attorney). The lender’s obligation to make loans will typically be contingent upon the fund’s compliance with a borrowing base test requiring that collateral (including unfunded commitments) exceeds outstanding loans by a certain percentage.
Capital call facilities were historically limited to real estate funds. However, these facilities have expanded to all types of private equity funds, greatly increasing the number of interested borrowers. Additionally, an increased number of banks have become active in this arena, many out of their private banking arms partially due to existing relationships with high net worth individual investors and funds.
Challenges For Lenders and Funds
1. Deficient Fund Documentation
Some funds will find that their fund documents were not drafted to contemplate loans to fund investments and bridge capital calls, and may be missing crucial acknowledgements, waivers or provisions. For example, fund documents should include:
- Explicit permission for borrowings to finance investments;
- Explicit permission to pledge unfunded capital commitments, right to deliver capital call notices and other collateral;
- Irrevocable and unconditional obligation of investors to fund capital calls;
- Investor acknowledgement of the facility and the lender’s right to deliver capital calls pursuant to a power of attorney; and
- Prohibition on transfer of investor’s interest without the consent of the fund.
It can be time consuming (and costly) for funds to amend their underlying documents to meet lender requirements. However, Lenders may be willing to structure transactions around these issues – however borrowers will face increased spreads for these accommodations, or higher borrowing base requirements to compensate for the added risk.
2. “Bespoke” Funds Don’t Fit the Mold
While the private equity market has shown signs of recovery from the financial crisis, the fundraising environment remains difficult, resulting in a proliferation of “bespoke” fund structures tailored to the specific needs of investors. For example, “open-end” funds allow investors to voluntarily redeem their investments, and in some cases redemption results in cancellation of the remaining unfunded capital commitment (which is a part of the collateral and the borrowing base). This potential fluidity with respect to investors and the collateral raises concerns for lenders, and requires more creative structuring than the typical mold of capital call facilities.
Such a transaction may be structured to include an event of default that occurs once a threshold of investors have requested redemption. Another solution is to remove any redeeming investor from the borrowing base test while also allowing sufficient time to make a capital call to cure any borrowing base overdraft in the time between receipt of a redemption request from an investor and the time when the investor has been redeemed.
3. Sovereign Immunity Issues
Sovereign wealth funds, state endowment funds and governmental pension plans are common investors in private equity funds. These investors present challenges to lenders because they possess sovereign immunity rights in enforcement proceedings that undermine the traditional capital call facility structure. Furthermore, even if a governmental investor waives sovereign immunity, enforcing a judgment can still be difficult.
In transactions with these sorts of investors, lenders will be wise to obtain explicit waivers of immunity from investors (if these investors have not already provided such waivers for the benefit of lenders in side letters) – though there are also statutory or common law waivers that lenders could fall back upon in certain circumstances, which should be reviewed on a case-by-case basis. In any event, history shows that governmental investor defaults are incredibly low. This may be due in part to a risk of credit rating and reputational harm upon a default, as well as severe default penalties in underlying partnership agreements, and may provide additional comfort to lenders.
The capital call facility market is expected to continue its upward trajectory as lenders become more familiar with these facilities and the private equity market continues to recover from the financial crisis. As described above, lenders will face challenges in this expanding and changing market. However, lenders who are able to provide customized and creative solutions to their funds clients will view this as an opportunity and stand to benefit.