There are recommendations, and then there is what’s actually done in the market. Institutional limited partners (“LPs”) investing in private investment funds, and other parties involved in subscription credit facilities for such funds, will be interested in this article, which: (i) summarizes selected points from the most recently published industry best practices applicable to such facilities, (ii) describes the extent to which those best practices have been implemented since publication, and (iii) notes recent market trends with subscription credit facilities.
The Institutional Limited Partners Association (“ILPA”) is the leading trade association for LPs including pensions, endowments, foundations, family offices, insurance and investment companies, development financial institutions and sovereign wealth funds. These LPs invest in private investment funds on behalf of beneficiaries including retirees, teachers, first responders, universities, charities and insurance policy holders. Last year, ILPA published its Principles for Fostering Transparency, Governance and Alignment of Interests for General and Limited Partners (the “Principles” or “best practices”). Although the Principles are focused on private equity investments, some of the content is also relevant to LPs investing in other asset classes (e.g., real estate or private credit).
Private investment funds in which LPs invest may utilize debt financing to achieve various objectives, including for administrative ease (e.g., borrowing more frequently and calling capital from LPs less frequently and/or on a schedule), bridging timing in cash flows including inflows of capital contributions from LPs, leveraging investments and more. Subscription credit facilities are a type of fund financing in which the fund (and/or its affiliated investment vehicle(s)) borrows money from a lender, with those borrowings secured by the unfunded capital commitments of the LPs, related rights (e.g., to call capital and enforce payment) and a security interest in any bank account of the fund into which capital contributions are made.
LPs have differing views regarding funds’ use of subscription credit facilities. Some LPs recognize and appreciate the benefits of such facilities, including administrative ease (e.g., less frequent and more predictable capital calls on LPs) and that the fund will have access to short-term liquidity to meet its needs and capitalize on time-sensitive and opportunistic investments. Other LPs dislike when funds employ such facilities because: (i) the LP would prefer that the fund put the LP’s capital to work more quickly rather than drawing on the facility to make investments; (ii) LPs dislike lender-imposed restrictions on transfers of their fund interests; and (iii) LPs dislike lender diligence requests for documents and financial information. LPs often negotiate side letters with the fund in which they’re investing to address some of these preferences and concerns.
Summary of Selected ILPA Principles
Specifically with respect to subscription credit facilities, the Principles focus on (i) economics, (ii) disclosure and reporting and (iii) certain key business terms. Each of these topics are addressed briefly, below. These topics often generate robust discussion and can serve as a source of contention between funds and LPs, and between funds and the lenders to those funds, in fund financing transactions.
The Principles recommend a couple best practices that can impact fund economics. The main economic recommendation with respect to subscription credit facilities is that, if capital is drawn from a facility, the preferred return for LPs should be calculated from the date capital is at risk (i.e., the date of the borrowing rather than the date at which the capital is ultimately called from LPs to repay that borrowing). Additionally, not all subscription credit facilities permit borrowings to pay management fees, but where that is permitted under the fund’s governing documents and the facility documents, the Principles provide that there should be transparency and consistency in calculating the basis for management fees and accounting for borrowings used to pay them.
Disclosure and Reporting
The Principles recommend enhanced disclosure and periodic reporting on the fund’s use of subscription credit facilities from the time of the fund’s initial closing or the closing of such a facility (if later), including on the following points:
- The anticipated size of the facility;
- The length of time each borrowing remains outstanding and the overall term of the facility;
- The intended use of proceeds;
- The total amount outstanding under the facility;
- Any costs incurred by the fund related to the use of the facility (e.g., estimated basis points on the front end, unused fees and interest rates); and
- How the facility will be treated in the context of overall leverage limitations on the fund.
Additionally, the Principles provide that, during the fund’s fundraising period and in periodic reporting, LPs should be provided with performance information (e.g., IRR or MOIC figures), with and without factoring in any subscription credit facility, to enable the LPs to compare performance across funds in which they invest.
Key Credit Facility Terms
The Principles also suggest that, as best practices, that subscription credit facilities include certain key business terms, such as the following:
- Use of proceeds: for the benefit of the fund (i.e., administrative ease or as bridge financing, rather than chiefly for the purpose of enhancing reported IRR in order to accelerate the accrual and distribution of carried interest);
- Tenor: 180 days or less for each borrowing, and an overall term of one year or less (absent LP advisory committee approval);
- Debt limitations: facility debt limited to a maximum percentage of fund commitments (e.g., 20%);
- Interest, fees and expenses: costs associated with the use of the facility should be paid by the fund;
- Capital call timing: the facility should permit 10 business days or more for LPs to fund capital calls; and
- Terms: LPs should be able to review the terms of any facility.
It is important to note that the Principles provide, notwithstanding the specificity of some of the above recommendations, that: (i) the best practices suggested therein are intended to inform discussions between each fund and current and prospective LPs, and ILPA is not seeking to bind any LP or fund to any specific terms; (ii) the Principles are not supposed to be applied as a checklist; and (iii) each fund (and investment by an LP therein) should be considered separately and holistically.
Post-Publication of the ILPA Principles
Since publication of the Principles, we’ve seen funds adopt some, but far from all, of the recommended best practices. In our experience, funds have been: (i) pushing back on ILPA’s suggestion for calculating the preferred return from the date of any subscription credit facility borrowing; (ii) increasingly providing the ILPA-recommended enhanced disclosure and periodic reporting; and (iii) increasingly incorporating ILPA’s recommended terms with respect to the tenor of draws and facilities, debt limitations and capital call timing. Certain LPs that have negotiating leverage, due to longstanding relationships with fund sponsors and/or large capital commitments, have been able to negotiate for the inclusion of certain other recommended terms in fund and facility documents. On the whole, although the subscription credit facility market has grown in size, scope and complexity since release of the Principles, the core terms of many (if not most) facilities have been largely unchanged by them.
Notwithstanding the current macroeconomic climate, fund financings generally have continued largely unaffected. For a short time after pandemic lockdowns went into effect in many jurisdictions around the globe, the rate of new subscription credit facility closings slowed (particularly with respect to facilities for “funds of one” with a single LP). During that time frame, many funds with facilities extended, fully drew down on and sought to add qualified borrowers to those existing facilities. During the same period, some lenders (predominantly money center banks) declined to extend facilities to prospective new clients, tightened pricing and other key terms in refinancings, extensions and amendments, and sought to assign or participate out loans to funds with certain investment focuses where the lenders were over-concentrated (e.g., real estate). As a result, alternative lenders such as private credit funds seized on the opportunity to provide refinancing and new financing to funds, at sometimes-higher pricing than those funds likely would have accepted even a few months prior. Where possible, funds have drawn down on subscription credit facilities rather than calling capital from LPs―even large institutional LPs and sovereign wealth LPs with strong credit profiles and flawless track records in funding capital calls.
Time will tell whether and to what extent ILPA’s Principles will be incorporated into fund governing documents and subscription credit facility documents. As sponsors start their next fundraising cycles and funds without facilities seek them, LPs will have additional opportunities to negotiate for inclusion of ILPA’s recommended terms into fund and facility documents. LPs, funds and lenders to such funds would be well served to consult with counsel knowledgeable about and experienced with the topics and considerations discussed herein when structuring, negotiating and documenting fund documents and subscription credit facilities.
Anastasia Kaup is a partner in the Corporate Practice Group of Duane Morris LLP. Ms. Kaup structures, negotiates and documents complex financing transactions around the globe. Ms. Kaup advises clients on a wide array of financing transactions, including subscription credit facilities, net asset value credit facilities, general partner lines of credit and other types of fund financing.
 ILPA, ILPA Principles 3.0: Fostering Transparency, Governance and Alignment of Interests for General and Limited Partners, https://ilpa.org/wp-content/uploads/2019/06/ILPA-Principles-3.0_2019.pdf (last visited October 13, 2020).