Private funds often seek subscription facilities for short term bridging of capital calls in order to, among other things, avoid the need to call capital in advance of closing an investment and backstop late capital call proceeds from the fund’s limited partners. As collateral, lenders providing such facilities receive a security interest in investors’ capital commitments, capital contributions and the general partner’s right to make capital calls on the investors and enforce payment thereof.
A common issue for lenders arises when a fund creates Alternative Investment Vehicles (“AIVs”). In this instance, capital can be called from investors by a general partner of the AIV to finance investments, regardless of whether the AIV is a borrower or whether the investment is financed with proceeds of the subscription facility or not. Two primary market approaches have developed to protect the lender’s security interest in this instance:
- Incurrence and Maintenance Covenants. The first approach is to require that a borrowing base test be satisfied at the time of making a loan (“incurrence”) as well as at all times the loan is outstanding (“maintenance”). The ratio for the financial test is set at an amount derived from the lender’s internal financial models to ensure sufficient collateral coverage; the level of risk associated with this ratio may also affect pricing for the transaction. The ratio should be set at the level at which the lender is no longer comfortable that the commitments will be sufficient to repay the loans in full.
- Require all existing and future AIVs to become Borrowers. Under the second approach, all AIVs are joined as borrowers (and any future AIVs are required to become borrowers). Each AIV-borrower is severally liable for the amounts it borrows, and each AIV pledges to the lender the account into which the proceeds of the capital calls will be remitted and the general partner pledges its rights and remedies with respect of such call capital.
Although the second approach is often appealing to lenders, it will include additional time and financial expenses for later AIVs formed. Moreover, this option still allows an AIV-borrower to call capital, diminishing the total unfunded capital commitments, for investments not financed with loan proceeds (but funded with the cash from the capital call itself). Because of the several nature of the loans, having an AIV as a borrower does not allow the lender to call capital of that AIV to pay loans of other borrowers – rather, only to repay loans made to the particular AIV. If the AIV borrows no funds, no capital call of its investors would be made to repay the loans.
For these reasons, the general protections for a lender making a subscription facility available to a private fund are the incurrence and maintenance covenants described above. As a business matter, the lender should ensure the ratios of those covenants provide sufficient collateralization of loans to be made under the facility, such that even if unpaid capital were called for non-loan purposes, there is still sufficient collateral remaining to proceed against. Although joining all AIVs as borrowers is an approach taken in the market, lenders and their counsel should examine whether the benefits provided to the lender offset the additional cost of joining such entities.