Q&A: fund financing credit support – guarantees, security and collateral in Luxembourg

Credit support – guarantees, security and collateral

Which entities are typically obligors in the case of subscription facilities?

Typically, all the entities of a fund group, in particular, the master fund, any feeder fund (subject to regulatory considerations), any alternative investment vehicle, and any parallel fund are obligors or security providers. It is common for the lenders to request an additional covenant in the facility agreement with respect to the mandatory accession as obligor or security provider of any future established entity within the fund group of the current borrowers or guarantors (in particular feeder funds and alternative investment vehicles, given that the establishment of such fund entities could negatively impact the rights of subscription line lenders if not joined to the financing).

Are pledged assets typically held at the fund level and pledged directly, or moved to a special purpose vehicle? Is there fund-level recourse in the case of NAV facilities?

It is common to see net asset value (NAV) facilities being made available at the level of an special purpose vehicle (SPV) (held by the fund) holding the underlying investments that lenders agree to lend against.

In such case, NAV lenders may, in addition to a pledge over the equity interests in the SPV, require additional credit support from the fund. Subject to indebtedness limitations affecting the fund and its existing contractual obligations (such as a subscription line financing), a guarantee or equity commitment letter may be required from the fund. In certain scenarios or in the case of hybrid financings, NAV lenders may also require that available commitments form part of the collateral.

What is the typical collateral package for subscription facilities?

Subscription line facilities are secured by the available commitments of the fund's investors. The collateral package typically includes: (1) a pledge by the fund over the rights in and to the available capital commitments of the investors, and the claims against the investors in relation to those capital commitments (with the general partner or the relevant management entity that has the power to make capital calls being also a separate party to the pledge agreement); and (2) a pledge by the fund over the bank account(s) to which investors are required to fund their capital contributions.

What underlying assets most commonly secure NAV facilities?

Depending on the investment strategy of the fund, the underlying assets that most commonly secure NAV facilities are debt investments, participations in other investment funds (for funds of funds, and secondary funds), private equity investments and real estate investments.

Which parties are typically required to pledge capital-call collateral and how are the pledges structured?

Each fund in a fund group having investor undrawn commitments is usually required to pledge its undrawn commitments and collection accounts in favour of the lenders (or a security agent).

If an investor facing vehicle (typically a feeder fund) is unable to grant direct pledges for tax or regulatory reasons and due to restrictions included in its limited partnership agreement, a cascading security structure will need to be set up. In such case, the feeder fund grants security interests over its investors' undrawn commitments and its collection bank accounts, in each case in favour of its master fund to secure its own capital contributions obligations regarding the master fund. In turn, the master fund grants a security interest over its investors' undrawn commitments (including the undrawn commitments of the feeder), in favour of the subscription line lender (or security agent) in order to secure its own obligations under the subscription line facility. In an enforcement scenario, lenders will be able to enforce the pledge granted by the master fund and exercise all accessory rights attached to the pledged claims or commitments, including the pledges granted by the feeder fund in favour of the master fund to secure such pledged claims. When structuring a cascading pledge, it is important to ensure that the claims of the feeder fund regarding the master fund (documented pursuant to a subscription or commitment agreement) will at all times be at least equal to the available investors' commitments at feeder fund level.

If assets are held in a special purpose vehicle (SPV), are the assets pledged directly by the SPV, or is the pledge achieved indirectly through a pledge of equity interests in the SPV? Are any other pledge structures commonly seen?

The security package is determined on a case-by-case basis depending on (1) the fund's investment strategy and the nature of the underlying investments, (2) the borrowing structure and (3) regulatory and tax considerations.

It is, however, customary to see NAV facilities being made available at the level of an SPV held by the fund, allowing lenders to obtain a pledge by the fund over the equity interests in such SPV (with a pledge by the SPV over its bank accounts). This security structure allows lenders to take control of the SPV and enforce over the SPV's bank accounts, which results in the lenders being the sole beneficiaries of any underlying investments' distributions paid to the SPV.

For secondary funds and funds of funds, an SPV will almost automatically be set up to hold the underlying investments (ie, limited partnership interests in other funds) due to the transfer restrictions generally affecting equity interests issued by investment funds.

For credit funds, it is typical for the fund or SPV borrower to grant an English law debenture or a US law security agreement over the loan portfolio. Transfer and assignment restrictions and pre-consent included in the underlying loan agreements need to be assessed by lenders.

For private equity funds, it is common to see a pledge granted over the holding entity that owns the underlying investment. Lenders will have to determine whether the entry into and the enforcement of such pledge will trigger the application of any change of control provisions at a portfolio company level. If shares in a joint venture holding entity form part of the collateral, shareholders' arrangements of this entity may contain restrictions in relation to the transfer of equity interests, including drag or tag along rights, specific board or committee consent, pre-emptive rights, adherence to the shareholders' agreement by the transferee and other transfer restrictions or conditions. It should also be assessed whether any transfer of the equity interests could have implications on the regulatory or tax status of the portfolio company.

In addition, it is worth noting that for commercial, existing contractual obligations, tax and regulatory reasons, or due to existing contractual restrictions (notably change of control provisions), NAV facilities can also be unsecured or secured only by a pledge over the bank account into which the borrower receives distributions from underlying investments.

How are security interests in rights to uncalled capital and bank accounts perfected and how is priority established? Is any notice to investors necessary for perfection or priority and, if so, what are the requirements for such notices? In the case of bank accounts, is a tripartite account control agreement with the account bank, or other notice to or acknowledgement by the account bank, required?

Luxembourg law typically governs the security interests granted by Luxembourg funds over the rights in and to the investors' available capital commitments, and any claims against the investors in relation to such commitments, as well as account banks located in Luxembourg. The relevant security interest is in the form of a financial collateral arrangement governed by the Law of 5 August 2005 on financial collateral arrangements, as amended (the Collateral Law). According to the Collateral Law, security interests over claims against the investors may be created by way of pledges or assignments for security purposes, pledges being the most common Luxembourg law security interests over investors' commitments. Under Luxembourg law, pledges that are not notified to or accepted by the investors are fully recognised and enforceable. However, the debtor of a pledged claim may be validly discharged from its obligation regarding the security provider if it had no knowledge of the pledge in favour of the security taker. It is therefore standard for lenders to require pledges granted by the fund to be notified to the investors, to ensure that the investors will act in accordance with the security taker's instructions and pay their undrawn commitments into the pledged account (or as otherwise instructed by the security taker) if the security interest is enforced. Notices to investors may be served by the pledgor by different means such as registered mail, email or via the investors' portal or an investors' report.

The security interest over Luxembourg bank accounts into which investors are required to fund their contributions may be created by way of a pledge in accordance with the Collateral Law. The pledge agreement must be evidenced in writing and perfected in accordance with Luxembourg law. In practice, as a result of their general terms and conditions or the depositary agreement signed with the fund, Luxembourg account banks have a first-ranking pledge over such accounts. Provided the terms and conditions and depositary agreement do not prohibit pledges over the relevant bank accounts, the pledge will become valid and enforceable against the account bank and third parties once the pledge has been notified to and accepted by the account bank (usually by way of an acknowledgment letter signed by the account bank containing the necessary waiver provisions). It is, therefore, standard for subscription line lenders to require that such acknowledgment be a condition precedent to the first utilisation of the loan.

How is a security interest in each type of commonly pledged asset perfected, and how is its priority established?

A pledge over the shares in a Luxembourg private limited liability company (SARL) (which is the most common form of Luxembourg holding or portfolio entities) will be perfected once notified to the company whose shares have been pledged, and although not strictly necessary for perfection purposes, it is market practice to register the pledge in the shareholders' register of the pledged SARL. In addition, if less than 100 per cent of the shares (ie, joint venture SARL) are pledged, the enforcement of the pledge requires the prior approval of the shareholders and, therefore, lenders will seek to obtain such shareholders' approval (pre-approving the pledgee as assignee of the pledged shares) as a condition precedent.

A pledge over limited partnership interests issued by a Luxembourg partnership is perfected when notified to, or accepted by, the partnership. Similarly to SARL, it is standard practice to require the registration of the pledge in the partners' register. The partnership interests may, on pain of nullity, only be transferred or pledged in accordance with the terms of the limited partnership agreement. In addition, in the absence of any rules in the limited partnership agreement providing for stricter transfer or pledge restrictions, (1) any transfer or pledge over limited partnership interest(s) issued by a Luxembourg partnership is subject to the approval of the general partner of such partnership, and (2) any transfer or pledge of a general partner's interest requires the approval of partners deliberating in the manner provided for under the limited partnership agreement for the amendment of the limited partnership agreement. A pledge granted in breach of the partnership agreement or, where applicable, the above default requirements is null and void.

A pledge over Luxembourg bank accounts is perfected once the account bank has been notified of, and has accepted, the pledge and has waived its general right of pledge and other preferential rights arising under its general terms and conditions or depositary agreement.

A pledge or an assignment for security purposes over receivables is perfected by the mere entry into the pledge or assignment agreement by the parties. Nevertheless, it is usual for lenders to require that a pledge or assignment for security purposes of receivables be notified to, and accepted by, the debtor of the pledged or assigned claims, to waive any defences, right of retention or set-off the debtor may have about the pledged or assigned claims and any applicable transferability restrictions.

According to the Collateral Law, the priority of a Luxembourg pledge is determined by the date on which the pledge became enforceable against third parties.

How can a lender assure itself as to the absence of liens, with or without priority to its lien, with respect to each type of collateral? Is a public filing or recordation system available in your jurisdiction to notify third parties of security interests?

Under Luxembourg law, there are no public registrations or other public filing requirements in relation to the execution, performance or enforcement of security interests subject to the Collateral Law. Typically, representations and undertakings are added in the finance documents to certify the absence of existing pledges or liens affecting the relevant pledged assets and to restrict the creation of any future pledge or lien over such pledged assets. In addition, for certain types of assets (such as shares issued by a Luxembourg company and partnership interests issued by a Luxembourg partnership), the absence of existing pledges may be verified by reviewing the shareholders or partners' register of the entity whose shares or partnership interests are to be pledged.