Due diligence in fund financing transactions is critical, now more than ever, for investment funds as well as lenders. Fund financing transactions have traditionally been viewed as a low risk, meaningful reward for both funds and lenders. Over the past few decades that these products have been widely used, there have only been a couple publicly reported issues and nearly zero publicly reported defaults. However, relatively recent incidents involving alleged fraud (Abraaj and JES Global Capital), which negatively impacted the lenders on those fund financing credit facilities, have caused concern for lenders industrywide and heightened the focus on due diligence in fund financing transactions. Below, for subscription credit facilities (“SCF”) and then net asset value (“NAV”) credit facilities, we: (i) briefly explain the product, (ii) describe some of the current diligence practices typically involved in each type of credit facility transaction and (iii) discuss potential changes to due diligence in these fund financing transactions.
What Are Subscription Credit Facilities?
SCFs are revolving lines of credit where a fund (such as a private equity, private credit, real estate, hedge, or venture capital fund) borrows money for a variety of reasons, and the financing is secured by: (i) investors’ unfunded capital commitments to the fund, (ii) related rights (e.g., to call capital and enforce remedies for a failure to fund) and (iii) the deposit account into which investors fund their capital contributions. An SCF can provide short-term capital to the fund (for example, to bridge the timing gaps between capital calls to investors) or longer term capital (for example, where a fund may draw down to provide credit support to portfolio companies until portfolio company-level financing is obtained). The size of the SCF and advances are based on value of pledged uncalled capital commitments as well as the number and creditworthiness of eligible investors. Accordingly, SCFs are most common for funds in the early to mid-stage of their life cycle, when the fund has significant unfunded capital commitments to borrow against. Investors’ capital commitments are documented by: (i) subscription agreements, in which the investors agree to be bound by the fund’s limited partnership agreement (“LPA”) and commit to contribute capital up to a specified amount and (ii) (sometimes) side letters, which supplement the terms of the LPA and subscription agreement.
Due Diligence Practices for Subscription Credit Facilities
Due diligence reviews for SCFs are typically focused on four types of documents: (i) subscription agreements, (ii) LPAs, (iii) side letters and (iv) offering documents such as private placement memoranda. These documents are reviewed to ensure that the SCF is permitted and to determine the enforceability of the documents (and the underlying uncalled capital commitments that are the core component of the credit facility and collateral). This due diligence may include (without limitation) review to confirm that:
- The documents are fully completed (i.e., that the correct boxes have been checked for that type of investor, dates and other fields are completed, and attachments such as tax forms or authorizing resolutions (for entities) are included);
- The documents are executed (with some lenders requiring that at least subscription agreements be executed in “wet ink” as opposed to being signed electronically);
- The legal name of the investor and their capital commitment amount is correct and consistent throughout the documents;
- The general partner of the fund has accepted the investor’s capital commitment and signed an acknowledgment of the same;
- The SCF (including the pledge of security and potential for the lender to exercise remedies in the event of the fund’s default under the SCF) is permitted by each of the documents; and
- There are no potential obstacles (e.g., conditions precedent to calling capital) to the operation of the SCF and the lender’s potential exercise of remedies in the event of the fund’s default under the SCF.
Due diligence must be completed before the lender and fund can close the SCF. The
scope of that due diligence and time required depends on a variety of factors, including (without limitation): (i) the nature or identity of the investors (i.e., whether institutional investors, sovereign wealth investors, high-net-worth individual investors, etc.), (ii) the number of investors (which may range from one to hundreds for any given fund) and (ii) the substance, length, and complexity of any side letters. Due diligence for SCFs may involve anywhere from a few hours to hundreds of hours of work, completed over days or weeks.
Potential Changes to Lenders’ Due Diligence for Subscription Credit Facilities
In light of the relatively recent fraud claims involving Abraaj and JES Global Capital, lenders may adopt additional diligence practices, such as:
- Requiring “investor letters” be provided to the lender, whereby an investor expressly and directly acknowledges to the lender, the SCF and its obligations under the fund documents, for at least certain “material” or “larger” investors (e.g., where there are only a few institutional investors and mostly high-net-worth investors, and/or for investors with capital commitments in excess of 20 percent of the aggregate amount), in situations where investor letters would not have previously been required;
- Requiring a “seeding call” (i.e., that the fund shall have called and received capital contributions of 5-10 percent of aggregate capital prior to allowing the fund to draw down on the credit facility) and/or copies of the fund’s bank records showing that investors have already funded a certain amount of their aggregate capital commitment before advances may be made under the credit facility (on the theory that, if investors have already funded one or more capital calls, they are more likely to fund capital as and when called to repay the credit facility obligations); and/or
- The lender directly contacting certain “material” or “larger” investors via email and/or telephone in “spot checks” to verify the authenticity and capital commitments of those investors.
Although the potential for fraud can never be entirely eliminated, taking additional measures such as these in the due diligence process will increase the likelihood of detecting fraud before advances are made, thus reducing: (i) the risk of loss for the lender and (ii) the risk of reputational harm or loss of access to capital under the SCF for the fund.
What Are NAV Credit Facilities?
Unlike SCFs, which “look up” to the uncalled capital commitments of investors as the core component of the collateral, NAV facilities “look down” for the collateral, to the fund’s investment portfolio, distributions from investments, and/or an equity interest in the entity that owns those investments. Accordingly, NAV facilities are often used toward the mid- to late-stage in the fund’s life cycle, when there are minimal unfunded capital commitments against which to borrow under an SCF, but the fund has made investments generating value that the fund can borrow against. Due diligence for NAV credit facilities is generally much more complex and intensive than the due diligence for an SCF, and may include the review of a variety of potentially numerous organizational and other documents relating to each of the fund investments, collateral audits, and more.
Due Diligence Practices for NAV Credit Facilities
Due diligence remains important in NAV credit facility transactions, as well, notwithstanding the recent heightened focus on diligence in SCFs due to the widely reported alleged fraud in Abraaj and JES Global Capital. The scope of due diligence and the specific practices employed may vary for each NAV credit facility (the collateral for, and structure of, NAV credit facilities tends to vary far more than for SCFs).
NAV credit facilities are frequently structured such that a holding company subsidiary of the fund is the borrower (however, this is not always the case—sometimes the fund itself is the borrower). While some funds are able to obtain NAV financing on an unsecured basis, in our experience, NAV financing is usually secured. In such cases, collateral for NAV credit facilities may include: (i) a pledge of equity interests in the holding company that owns the investments to be included in the borrowing base, (ii) a pledge of distributions and other amounts (e.g., disposition proceeds) received from investments and/or (iii) the bank account into which such amounts are deposited. Additionally, in such cases, NAV credit facilities sometimes also include a guarantee by the fund of the holding company’s obligations under the NAV credit facility. In the event of a default under the NAV credit facility, where there is a pledge of equity interests, the lender could foreclose on and sell the equity interests to a third party, potentially force a sale of the investments, or take other action to facilitate repayment.
Accordingly, due diligence for NAV credit facilities often includes a review of: (i) the documents relating to the fund’s underlying investments (e.g., a mortgage for a real estate fund), (ii) the organizational documents for the borrower and any related parties (e.g., any fund guarantor) and (iii) in some cases, depending on the nature of the fund’s investments, a collateral audit, on-site inspections or appraisals, and more.
Underlying Investment Documents
A pledge of equity interests (or the distributions therefrom) to secure NAV credit facility obligations, or foreclosure on the equity interests in the event of a default under a NAV credit facility, may constitute a direct or indirect “transfer” or “change of control” under the fund’s investment documents. As such, consent of a third party may be required to permit these actions and the NAV credit facility. The fund’s failure to obtain such consent may render such a “transfer” or “change of control” void ab initio, or potentially subject the fund to legal liability and other negative consequences. Accordingly, the parties would be well-advised to review and analyze applicable documents to identify potential transfer restrictions or issues earlier rather than later. Ideally, the fund would work with advisers experienced with NAV financing when negotiating the documentation for the fund’s investments to avoid issues “up the chain” later that may prevent or delay the NAV financing.
If consents are required, the fund should build time (potentially weeks to a month or longer) into the transaction timeline to obtain those consents. With sufficient advance planning and knowledgeable and experienced advisers, a fund can obtain NAV financing on a more expedient timeframe, when desired, and at lower cost.
In addition to obtaining consents related to underlying investments, a fund or the holding company borrower may also need to amend its fund/organizational documents or obtain approval from investors or other equity holders to permit the NAV financing as contemplated. Because funds often employ different counsel for different purposes (e.g., to prepare the fund’s formation documents, to negotiate and document the fund’s investments, and to negotiate and document fund-level financing), the fund’s or borrower’s fund/organizational documents may not initially provide sufficient flexibility to permit NAV financing. Additionally, if the holding company whose equity interests are being pledged has not opted in to Article 8 of the Uniform Commercial Code, the NAV credit facility lender may require that its operating agreement be amended and its equity interests be certificated and delivered to the lender to perfect its security interest (for a secured NAV financing). Counsel for the lender as well as the fund should review the fund/organizational documents to determine what steps and/or internal consents may be required to permit the NAV financing and provide the lender with a first priority perfected security interest (assuming the NAV financing is secured).
Counsel for funds as well as for lenders can take proactive steps when drafting fund documents, organizational documents, and underlying investment documents in order to facilitate future SCF and NAV financing. Working with counsel, advisers, and other parties experienced with these issues and due diligence for fund financing can maximize a fund’s opportunities to utilize fund financing products when desired, maximize protection for the lender in the unlikely event of fraud or default, and help ensure a successful transaction for all involved.
 These incidents are beyond the scope of this article and have been described in detail elsewhere in the legal media, and so are not recounted here.