The due diligence process in a fund finance transaction can often be the most time-consuming part of the transaction. To that end, this article sets forth some of the fundamental elements of the process, noting that each transaction is unique and has its own considerations. The first step is determining what type of transaction is being structured. Subscription lines or capital call facilities are typically revolving lines of credit based on the remaining amount of outstanding capital calls from the investors in the fund. Due to this concept, subscription lines are typically used in the earlier part of a fund’s life cycle. On the other hand, net asset value facilities (“NAV”) facilities are credit facilities based on the value of the investments held by the fund. Hybrid facilities combine elements of both subscription lines and NAV facilities, but this article will be limited to just subscription lines and NAV facilities. As part of the diligence process for any of these facilities, it is important to start the diligence process as early as possible in order to identify any potential concerns.
The initial diligence request for all fund finance facilities should consist of the fund’s structure chart, all organizational documents, and the private placement memorandum. Communicating with the lender client will shape the due diligence process; depending on the makeup of the fund’s investors, lenders will also want to review (or have lender’s counsel review) investor subscription agreements, side letters, and may also require investor letters (pursuant to which an investor confirms its capital commitment and acknowledges a lender’s rights and obligations when stepping into the GP’s shoes) or evidence that a certain percentage of capital calls have already been made.[1] Typically, the lender will want its lawyers to conduct more diligence with subscription lines than with NAV facilities, as much of the investment-level diligence for a NAV facility is conducted by the lender itself or a third-party vendor engaged by the lender for such purpose. By design, with subscription lines lenders frequently have little to no direct contact with the investors, but in the wake of JES (see below), some lenders are requiring additional contact with, or investor letters from, institutional investors and/or investors with proportionally higher commitment levels as compared with the rest of the investor pool in order to gain comfort regarding commitment amounts and collectability. Further, lenders may have different preferences as to the breadth or depth of diligence performed, ranging from such areas of focus as only investors that are included in the borrowing base, only investors with a commitment above a certain threshold, investors with side letters, or a number of other ways to narrow or broaden the scope of review, depending on certain concerns or credit factors that the lender may have.
Basic Diligence
At the onset of any fund finance transaction, the initial diligence request from the fund and its counsel should include the fund’s structure chart, its organizational or governing documents, and the private placement memorandum describing the fund’s investment objectives. One of the most basic, but fundamental, principles in conducting a due diligence review of these documents is to check that they are complete (including all schedules, attachments, and exhibits), signed, dated, not in “draft” form, and contain no blanks or brackets. Oftentimes, a fund will amend and restate its limited partnership agreement in connection with its initial closing, so it is important to make sure the limited partnership agreement for the fund is the most up-to-date version available. If any of the above-mentioned documents have been amended, those amendments should be provided with the rest of the documentation. Any discrepancies noted in the due diligence review should be resolved prior to closing the transaction, to the satisfaction of the lender and its counsel.
Historically, fund financing transactions are incredibly successful and reliable forms of debt financing for lenders, with very few defaults, especially with respect to institutional investors. Two fairly recent cases of publicly reported defaults involve (1) Abraaj Capital,[2] which largely involved fund mismanagement and abuse, and more on point to the topic of this article (2) JES Global Capital, in which Elliott Smerling, in his management role for a fund’s general partner, Global Capital GP III, misrepresented various aspects of the fund, such as the amount of capital commitments, institutional investors with strong reputations that had not actually subscribed to the fund, the amount of funds already invested, and even submitting various fraudulent diligence documents, including a fabricated audit.[3] While blatant fraud may not always be detectable, careful diligence by lenders and lender’s counsel, with an awareness of issues such as these, can make sure lenders are better protected when entering into fund finance transactions.
Subscription Lines ("SCF")
Subscription lines are revolving credit facilities that are typically used by a fund early in its life cycle in order to access debt for working capital purposes. The collateral securing these facilities typically consists of the investors’ unfunded capital commitments to the fund, all rights related to such commitments, such as the ability to call capital and to enforce remedies, and, if applicable, the deposit account into which investors fund their capital contributions. The most important items in the diligence process for these types of facilities are the fund’s limited partnership agreement, any investment management agreement, the subscription agreements entered into by the limited partners, or investors, of the fund, any side letters relating to those investors and the private placement memorandum. This section will address each of those items, together with what to look out for in connection with the diligence process.
Limited Partnership Agreements
The limited partnership agreement (“LPA”) is the governing document of the fund which sets forth the various rights and obligations of the fund, its limited partners, and its general partner. In reviewing the LPA, there are many considerations to take into account from a diligence perspective. A lender may be concerned about such aspects as structure, creditworthiness, and general security/collectability of their loan. Further, the priority or urgency of these concerns may change depending on the makeup of the investors in the fund.
Structure related concerns are going to vary both by lender and the complexity of fund itself. It is important to understand which entities are expected to be borrowers, guarantors, subsidiaries, feeders, blockers, etc. Some more complex structures are arranged for tax, ERISA, or other cross-border considerations of the various investors involved. There may be restrictions on certain entities’ abilities to be direct borrowers or pledgors of investor commitments. If the fund structure contemplates main funds and parallel funds or alternative investment vehicles, the first step is to confirm whether joint and several liability is even permitted by the LPA(s) in question. Similarly, if a guaranty structure is contemplated, the LPA needs to permit guarantees (and may have limits or restrictions related thereto). One additional consideration is whether an investment manager is involved in the structure, as management agreements may delegate certain powers usually reserved to a General Partner under the LPA to the manager instead. Finally, if the credit facility is set up as a “fund-of-one” structure pursuant to which there is only one investor with a very large capital commitment, the LPA governs the entire relationship between the General Partner and that investor. These are all gentle reminders that getting the LPA and structure chart as early in the process can help direct not only your diligence concerns but also the drafting of the loan documents.
A lender’s most obvious concern when considering and approving an SCF is the collateral and the lender’s ability to be paid back. Making sure that the LPA permits the amount, type, and term of indebtedness being considered by the parties is key and it is important to note that depending on where the fund is in its life cycle (e.g., whether the fund is still closing in investors, whether the investment period is ongoing, or whether the fund is in its post-investment period), these provisions may change or have different or additional limitations. Further, a lender’s comfort with, and lender’s counsel’s advice regarding, the terms and restrictions on an SCF may change depending on if an LPA explicitly permits indebtedness, pledge of capital call rights, etc. as opposed to simply being silent. Sometimes an amendment to the LPA may need to be negotiated and approved to get the lender comfortable where there is ambiguity or silence.
The primary aspect to consider for both fund counsel when drafting the LPA and lender’s counsel when reviewing it is to ensure that the terms of the LPA permit the fund to incur any indebtedness contemplated in connection with financing. Luckily, modern fund lawyers have updated most LPAs to include such provisions, but this is not always the case. A related item to be aware of is whether the provisions permitting the incurrence of any debt are limited in any way. If there is a debt ceiling in the LPA, one must ensure that the contemplated financing (including the exercise of any accordion or upsize provisions) fits within that limitation. Further, there may be limitations (generally referred to as “clean downs”) as to how long debt may be outstanding or how quickly it must be repaid after being borrowed. There may also be separate or combined limitations on direct indebtedness versus guaranteed indebtedness. A related item is to examine whether the LPA permits the general partner to call capital in order to repay indebtedness and if there are any restrictions on the timeframe for doing so. For example, some LPAs may restrict the ability to repay indebtedness following the end of the investment period of the fund or certain events may trigger a termination of the commitment period or cessation of the general partner’s ability to call capital, such as the occurrence of a key-man event.[4]
Next, the LPA should permit the fund to grant a security interest in the capital call commitments, the related rights to call capital and enforce remedies and, if applicable, the deposit account into which the capital commitments are funded. In addition to permitting the incurrence of debt and the grant of a security interest, lenders generally prefer to see explicit provisions granting the lender rights as third-party beneficiary and the ability of the third party to enforce capital calls. This relates to the lender’s ability to step into the place of the general partner and call capital if needed as a secured party remedy following an event of default under the financing agreement. Another item to look for is the type of remedies that the general partner has access to in the event that a limited partner fails to fund its share of a capital call. Some LPAs contain provisions (generally known as “overcall provisions”) that permit the general partner to require the limited partners to fund any shortfall as a result of another limited partner failing to fund, subject to certain limitations. It is important to understand any limitations or additional requirements that the lender may face with respect to exercising these other remedies as well, especially with respect to enforcing the capital calls to the same extent the general partner could in a defaulting partner situation.
One additional important consideration for an SCF lender to understand is the provisions in the LPA surrounding when investors may not be required to fund, may withdraw from a fund, or may transfer their interest in the fund. A huge part of the credit evaluation of an SCF from a lender’s perspective is the make-up of the fund investors. In large part, lenders want to ensure that the credit agreement protects against or provides additional approval rights for investors leaving the fund, new investors coming into the fund, or investors transferring their commitments to another investor that may not have the same credit rating, reputation, or may cause certain concentration concerns. Further, lenders and lender’s counsel should understand the provisions that govern when an investor may be excused from answering a capital call. All of these provisions may affect a fund’s creditworthiness or the lender’s ability to collect.
Private Placement Memorandum (“PPM”)
Another, usually less controversial, but potentially problematic document to review in connection with an SCF is the Private Placement Memorandum and any amendments thereto. This is the marketing document in which the fund essentially advertises itself to potential investors and describes certain risks associated with investing in the fund. One of the main concerns to look out for is if the PPM describes different strategies, limits, or prohibitions for the fund that the SCF would need to permit or the LPA permits.[5] A PPM may note that an SCF or other form of debt financing is contemplated and should not contain any limits on indebtedness or pledge of capital call commitments and related collateral that would be in conflict with what the lender would expect in an SCF. Further, the description of the investments and investment strategies should conform to the lender’s expectation. An addenda may need to be issued in order to clarify these discrepancies or provide explicit permission/note of an SCF if not previously included in the PPM.
Investor Subscription Agreements
With respect to diligence on the individual investors, a crucial document (or set of documents) to review in connection with a subscription line is the subscription agreement, which is the document by which the investor becomes a limited partner of the fund. The agreement should be executed by the investor, set forth the investor’s commitment amount to a particular fund (especially in structures with feeder funds, parallel funds, or alternative investment vehicles), and must include the general partner’s acceptance thereof. Another feature of the subscription agreement is the investor questionnaire, where the investor certifies certain representations and warranties as to its entity type. The lender sometimes uses this information to exclude certain investors (usually high net worth individuals and high net worth individual aggregator vehicles) from the borrowing base calculation. Lenders may differ as to additional identifying information that they are concerned about, such as ERISA status, sovereign immunity status, or if the investor is subject to other regulatory concerns.
Side Letters
Side letters are used by investors to modify the terms of the LPA or the subscription agreement, and the variations are infinite. It is crucial to review these in depth, as they can have significant effects to which the lender should be aware. Most importantly, it is important to look for any provisions that excuse the investor from providing its capital call or limit the general partner (or lender in the general partner’s shoes) from exercising certain enforcement remedies. Some side letters may also institute additional steps or waiting periods with respect to capital calls such as giving additional time to fund after a call is received or formalities surrounding who can make a call and how (i.e., if it can only come from the general partner, must be uploaded to a portal, or must be delivered to at least two of the investor’s contacts). Additionally, some letters may provide additional indebtedness limitations or clean-down requirements.
Some side letter provisions are tailored to the type of investor or its specific legal or regulatory concerns. Such examples provide additional excuse rights due to particular governmental or other limitations. Sovereign immunity is another area of concern for lenders because this could limit the lender’s ability to call capital from certain investors unless they waive such sovereign immunity. Sovereign immunity may be a more important focus for some SCFs where an investor claiming sovereign immunity may be the only investor in the fund (“fund-of-one” mentioned earlier) or may make up a particularly large percentage of the commitments to the fund. Certain foreign or state governmental entities may cause more concern with respect to sovereign immunity than others, as the applicable laws may not permit waiver thereof, which increases the risk to a lender looking to enforce capital calls or other remedies, especially if litigation may be required.
Another key feature to look for in a side letter is an MFN, or most-favored-nation, provision. These provisions are often used by investors to obtain better terms if a subsequent investor receives more beneficial provisions in connection with its investment. Oftentimes, these can be inappropriate, depending on the profile of the investor, so it may be worth asking the fund to re-negotiate the side letter to more narrowly tailor the terms of the MFN provision. In some funds, MFN grants are not provided until all investors have been closed in and others are elected through a separate letter, so it is important to be aware of what additional documentation may be required or may not yet be available.
NAV Facilities
Net asset value (“NAV”) facilities are revolving credit facilities that are used later in a fund’s life cycle to access debt. These facilities are typically tied to a fund’s investment portfolio. As such, the documentation to be reviewed is very similar to those in a subscription facility, but the scope of the diligence extends to the investments of the fund. To that end, the lender typically does much of its own diligence or engages a third-party vendor for such purpose, depending on the asset. One item to be wary of when reviewing the LPA, is if there are debt limitations that are potentially tied to remaining unfunded capital, as this number will continue to diminish over the fund’s life, as NAV facilities tend to be used. An additional item of importance in the LPA is to verify that the fund’s assets may be pledged and cross-collateralized.
It is important to understand what collateral a lender is relying on with respect to a NAV facility: pledges of equity in the underlying investments or just the economic benefit/cash flows from those investments. If the former, not only should the LPA of the fund be reviewed to ensure the fund’s equity in such portfolio companies can be pledged, but it is vital to review the organizational documents of the portfolio companies, as well as to identify any restrictions or prohibitions on a member’s or limited partner’s pledge of equity or transfers of equity. Relatedly, it is important to review the portfolio company’s organizational documents to ensure that the exercise by the lender of its secured party rights does not trigger any change of control provisions in such portfolio company’s organizational documents. Further, even when only a pledge of economic benefits is contemplated, underlying portfolio company documents should still be reviewed to confirm that a pledge of merely economic interests associated with partnership/membership is not prohibited.
Lenders will very likely take a heavier hand in the financial-related diligence in a NAV facility. Not only will lenders consider the current value of the underlying investments, but they will often also engage additional resources to evaluate a fund’s historical performance, financial statements, and returns on investment. Lender’s counsel should expect that the lender’s review of these items will heavily influence financial covenants and negotiation thereof in the credit agreement, but generally would not be expected to take the lead on the financial diligence aspects of NAV financing.
Summary
While fund financing transactions have a record of being extremely safe and successful endeavors for lenders and an extremely accessible and convenient form of liquidity for funds, diligence of the fund and investor documents is crucial to provide the lender security and shape its understanding of risk and exposure. Diligence in fund finance transactions varies depending on a few primary factors: (1) whether the facility is based on subscription-backed capital calls or on the net asset value of the underlying investments of the fund, (2) for SCF facilities, the makeup of the investor pool, and (3) the lender’s general understanding and direction regarding the number of investors and side letters involved. A primary takeaway for lender’s counsel is to keep an eye out for conflict between different levels of strictness among the various fund documents including the LPA, PPM, subscription agreements, side letters, and underlying portfolio company organizational documents. All of these types of documents interplay to help a lender understand the risk associated with individual investors or investments, as well as its ability to get repaid. The diligence review process should be started early on and be an ongoing discussion with your lender throughout the review, drafting, and negotiating process.
References
- Anastasia N. Kaup and Louise Melchor, Duane Morris LLP, Fund Finance: How to Mitigate Risk and Facilitate Financing (Dec. 30, 2021), https://www.duanemorris.com/articles/fund_ finance_how_to_mitigate_risk_facilitate_financing_1221.html.
- Brent Shultz, Haynes and Boone LLC, Due Diligence for Subscription Facilities in the Wake of the Abraaj and JES Global Capital Litigation: Recapping the Due Diligence and Lessons Learned Panel at the 2022 FFA Global Symposium (Feb. 25, 2022), https://www.haynesboone.com/news/alerts/due-diligence-for-subscription-facilities-in-wake-of-abraaj-and-jes-global-capital-litigation.
- Joshua S. Almond, Fund Finance Fraud: JES Global Capital and Implications for Subscription Line Lender Due Diligence, 27 N.C. Banking Inst. 210 at 212-214 (2023), https://scholarship.law.unc.edu/ncbi/vol27/iss1/12.
- Id at 221.
- Anastasia N. Kaup and Melissa A. Sharp, Duane Morris Banking and Finance Law, Best Practices for Diligence in Financing (Dec. 2, 2012), https://blogs.duanemorris.com/bankinglaw/2021/12/02/best-practices-for-fund-document-diligence-in-fund-financing-transactions/#more-392.
