Fund Finance Starter Pack October 2022 | Issue 197 – Fund Finance 101 – Back to Basics | Cadwalader, Wickersham & Taft LLP
After Mike Mascia Last word Delivered to young fund finance professionals at last month’s FFA University 1.0, I wanted to bring things back to basics for those just starting their fund finance career.
“Are they lending above the fund or below the fund?”
These are the first words that come to mind when I think of the beginning 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 thought possible to cram into my brain about an area of finance that, until I was asked this foreign question, I had little understanding.
Several articles, flowcharts and PowerPoint presentations later, I started making progress in installing this new language in Fund Finance Fiona 1.0. As I continued to take the next steps in my career, the amount of legal and business jargon I needed to learn increased, but my confidence also increased.
As we welcome this year’s new cohort of freshman associates, now seems like the most appropriate time to get back to basics – because nothing beats such effective teaching to reinforce your own learning. So, if this is one of the many articles, flowcharts, and PowerPoint presentations you’ve reviewed, or remain on your horizon, know that in time, the stranger will become the familiar.
So what is fundraising? What is a fund? What is above and below? What are the key considerations for lenders when structuring, negotiating and documenting these credit facilities?
What is a fund?
- A vehicle for making investments
- Commonly structured as a limited partnership
- Composed of investors (limited partners) and administered by the general partner
Investors will subscribe to a fund by signing a subscription agreement and commit up 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 a Where separately managed account/ADM) or a variety of investors, and arrange multiple closings to attract additional investors for its investment purposes. Investors are not required to fund their entire commitment up front, but rather each investor is contractually obligated to fund capital calls of the general partner on behalf of the fund. The general partner will call the capital by delivering a notice to its investors, and each of these notices (a capital call notice) will indicate the amount and purpose of the call for funds (for examplean investment, a follow-on investment or, especially from the lender’s point of view, the repayment of a debt).
Note: Investors or sponsors are not involved in the management of the fund and have limited liability, generally limited on the basis of the aggregate value of their capital commitment.
What is fund financing?
“A revolving credit facility is like a credit card for a fund!”
The best place to start when learning something new is to build its foundation on the concepts you already know and understand. So why do we compare a typical fundraising transaction to a credit card?
The types of loans we typically deal with in the subscription loan world (see below) are revolving credit facilities. This means that a borrower is able, during the life of the loan, to borrow, repay and borrow again – in the same way that a retail consumer would use a credit card, but with a custodial: Loans are typically two to three years in duration (with possibly an extension) and may include extension mechanisms at the borrower’s option or subject to lender approval.
What happens above and below the fund: an introduction to subscription loans, net asset value and hybrid facilities.
There are two main types of facilities in fund financing: underwriting credit facilities and net asset value (NAV) facilities. With respect to a subscription credit facility, the lender takes into account the uncalled capital commitments of investors in the fund (the amount the investor has committed to the fund that has not been called of capital) 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 investors by delivering capital call notices) and the account(s) from which the capital calls are funded. Net asset value facilities, on the other hand, are collateralized by the actual assets or investments held by the fund or the interests in the vehicles that hold those investments.
As demonstrated above, underwriting facilities look to investors’ uncalled capital commitments (that’s to say, above the fund) and net asset value facilities look to fund assets (that’s to say, under the fund).
Breaking down the role of a fundraising lawyer
For the purposes of this article, we will focus on subscription loan facilities.
APL – to bank or not to bank?
Often, even before an agreement is commissioned, lawyers will be engaged to check the limited partnership agreement (LPA) of the potential borrower. The LPA will define the obligations of the limited partners, the rights and the role of the general partner and the procedures for raising capital. LPA conditions can make the difference between a bankable transaction and one that is not! From a lender’s perspective, the fund must be permitted under its LPA to borrow and pledge investors’ capital commitments, state that investors are obligated to fund capital calls without compensation, counterclaim or defense, and have typical remedies in the event of investor default. Among other things, lenders are also interested in the possibility of overvaluation (that’s to sayto call on other investors to finance the capital in the event of a loss of earnings caused by the rights of excuse or the default of other investors).
Side letters – mine is bigger than yours!
As indicated above, investors subscribe to a fund by signing a subscription agreement. But what if an investor wants to change his rights and obligations? Since a subscription contract is usually a form, any additional rights or obligations will need to be documented separately in a cover letter. Although certain provisions of the cover letter are not relevant in the context of funding (for examplenegotiated management fees), a lender is interested in anything that will interfere with its ability to be repaid in the event of default – that’s to say, anything that limits the ability to call on limited partners’ capital, such as rights to cease funding or withdraw, overcall limitations, sovereign immunity reserve, commitment caps and formalities of call for capital. In addition, lenders are concerned about most-favoured-nation (MFN) provisions, which allow investors to choose the same terms that are available to any other investor with the same amount of commitment (or less). ). Why? Because as an investor you want to get what you pay for – 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 applicable to subscription lenders, see here.
II. Documentation – run before you walk!
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 borrower’s jurisdiction), collateral account pledges, Deposit Account Control Agreements (DACAs), Fee Letters and other ancillaries. The credit agreement sets forth the terms of the facility, including the lenders’ funding obligation, borrowing procedures, interest and repayments, representations and warranties of the borrower and other credit parties, positive and negative clauses, conditions precedent to closing, events of default and other mechanics. In the United States, credit agreements are generally based on the Loan Syndications and Trading Association (LSTA) form, while in the United Kingdom, credit agreements are generally based on the Legal Marketing Association (LMA) form.
Once the loan documents are signed and the signatures issued by the parties to the transaction, the lawyers are responsible for ensuring that the lender’s guarantee is perfect by (i) control, that’s to sayexecution of DACA for any collateral account, and (ii) filing Uniform Commercial Code (UCC) financing statements with the appropriate filing office with respect to intangible rights.
III. Structuring and Negotiation
It seems almost counterintuitive that the role of structuring an underwriting facility comes after due diligence and documentation. But to structure a product, you must first understand it. What does this mean for someone who is new to financing finance? Review, review, review. Review the organization chart (which in practice will certainly include more than one borrower of funds), review the organizational documents, and review the investor documents. It is only by understanding the structure of the fund (including the position of a borrower in relation to its related entities) that we can begin to advise on the constituent elements of a transaction. This means understanding where investors are entering (which entity investors are subscribed to) and tracking the flow of funds to ensure that loan documents adequately reflect the relationship between different entities, capital commitments, rights to capital call and ancillary rights.
Conclusion – Welcome to the kiddie pool!
As Malcolm Gladwell explained in one of his bestsellers, Outliers, to become an expert, it takes about 10,000 hours (or about 10 years) of deliberate practice. My words to you today are words I have repeated dozens of times as I welcome new lawyers and bankers to the world of fund finance. Whether it really takes 10,000 hours, only time will tell. My advice? Ask questions, read a lot and gain visibility, and when in doubt, browse the wide range of resources made available by Cadwalader’s Finance Fund Friday. If you need a starting point, an index of primers is available here.