Private equity funds receive capital from their investors pursuant to capital calls issued periodically by the general partner or other manager of the fund. When issuing capital calls, the manager faces potential uncertainties relating to whether or not the funds will be received as required, as well as built-in time delays imposed by fund governing documents which typically require 7 to 15 business days advance notice. This, at the very least, hampers a fund’s flexibility in deciding when to call capital and also creates risk of a potential default by a fund in meeting its contractual obligations, such as paying the purchase price at a closing, because it does not have the money in hand. To deal with these concerns, funds are increasingly turning to lenders as a quick and certain source of interim funding.
In this article, we address some issues that the lenders face in structuring these loans and some matters that fund managers should consider in negotiating the loan documents.
The pre-negotiation planning stage for a capital loan is very important for a fund manager. As discussed further below, prior to finalizing the fund’s organizational and other documents, a fund manager (with the assistance of counsel) should examine what steps can be taken to facilitate a future capital loan program, including addressing any potential restrictions or impediments under the terms of any proposed or existing documents or otherwise.
Typically, capital loans are revolving credit loans to the fund secured by a pledge of the fund’s rights against its investors to enforce the capital commitments, including the right to make the capital calls.
The capital funding obligations of the investors are set forth in the fund’s governing instruments, typically a limited partnership agreement (or a limited liability company agreement) to which the investors are parties, and the subscription agreements executed by each investor. These provisions include the amount of each investor’s capital commitment, the procedures for calling capital, the permitted uses of capital, the date by which the capital must be received by the fund, the dates or circumstances after which capital may no longer be called and the rights and remedies of the fund in the event of a default by an investor.
Collateral for Capital Loans
For the most part, capital loans are secured revolving credit facilities with a term between one and three years. Unlike traditional secured loans for an operating company where the collateral securing such loan is comprised of a broad range of assets (e.g., inventory, equipment, intellectual property, accounts and real property), the collateral securing capital loans to private equity funds is often very limited. The primary collateral securing capital loans are the capital commitments of the investors in the fund. Additional collateral will include the rights of the fund manager to call, enforce and receive payments with respect to the capital commitments. The final element of the collateral is frequently a lien on a deposit account into which proceeds of all capital calls are to be deposited.
It would be unusual for a lender under a capital call loan arrangement to have a lien on or a claim against any management fees owing to the fund manager; however, a lender may seek to require that the payment of management fees be subordinated to the repayment of the capital loan after the occurrence of an event of default. The fund manager needs to consider carefully whether to agree to subordination since this could affect the operations of the fund manager, including the ability to pay the professionals and other staff of the manager and to satisfy overhead expenses.
Documenting and Perfecting Liens on the Collateral
The manner in which a lender would document and perfect its lien on the collateral securing a capital loan is similar to the steps a lender would take in connection with other types of secured loan transactions. The fund and the general partner of the fund will enter into a security agreement pursuant to which they grant a lien in favor of the lender in their respective rights under the partnership agreement and their respective rights to the capital commitments and the capital contributions made by the fund’s investors. As mentioned above, the lien will also cover the fund’s rights to a designated deposit account into which capital contributions are deposited.
Documentation — Specific Provisions
The documentation for a capital loan will look substantially similar to a traditional secured loan credit facility. Some of the key provisions for a capital loan include the following:
- Borrowing Base. Many capital loan facilities provide that the amount of the loans made from time to time (and outstanding) will be based on a certain percentage of the unfunded capital commitments of certain investors. For instance, an investor rated AA- could have a 100% advance rate but an investor rated BBB- could have an 80% advance rate. In addition, for unrated investors, the advance rates could be tied to the net assets of such investors. There would also be concentration limits such that the aggregate unfunded commitment of any one investor included in the borrowing base cannot exceed more than a specified percentage of the entire borrowing base.
- Eligible Investors/Excluded Investors. Not every investor will be included in the borrowing base. If the investor meets the minimum requirements (e.g., rating and/or net worth) then the investor is included, but if certain events occur, such investor can become an “excluded investor.” Such events include (i) bankruptcy or insolvency events, (ii) the investor fails to make a capital contribution or defaults under the terms of the partnership agreement or its subscription agreement or (iii) the investor challenges or declares unenforceable its obligations to make a capital contribution or repudiates any material terms of the partnership agreement or its subscription agreement.
- Maturity of Loans. As noted above, capital loans typically have a term between one and three years. From a lender’s perspective, the maturity date for a capital loan should be well before the end of the fund’s commitment period during which the fund manager is permitted to make capital calls (generally 4 to 5 years, subject to certain exceptions such as for follow-on investments or satisfaction of liabilities).
- Specific Covenants. On a regular basis the fund will be required to provide the lender with the following information: the amount of unfunded capital commitments, the amount of capital commitments funded, the calculation of the borrowing base, and notices of the occurrence of any event which makes an investor an “excluded investor.” The lender will normally require a copy of each capital call notice.
Certain restrictions will be imposed on the fund under the terms of the loan agreement, including, unless the lender consents, restrictions on changes to the management company and restrictions on amendments to the management agreement that would be adverse to the lender.
Additional common restrictions imposed on the fund capital loan arrangements include (i) a prohibition on distributing investment proceeds to the investors if an event of default has occurred or perhaps if any principal or interest on the loans is then outstanding and (ii) a prohibition on the right of the general partner to consent to an investor transferring its rights and capital commitment if after giving effect thereto an event of default exists or the outstanding loans would exceed the borrowing base or perhaps if the lender has not approved the transferee.
Financial covenants are normally limited and may comprise simply of a minimum funding covenant (i.e., unfunded capital commitments plus the net worth of the fund must be in excess of a certain multiple of the fund’s total debt).
- Select Closing Conditions. Many of the conditions to closing a capital loan agreement will mirror those in any other secured financing arrangement. Conditions that are specific for a capital loan may include (i) delivery to the lender of a blank capital call notice addressed to each investor and signed by the general partner and (ii) a letter from the general partner to the investors notifying the investors that the fund has entered into a loan arrangement with the lender and that the capital commitments have been pledged as collateral for the loan.
- Events of Default. The capital call loan agreement will contain events of default specific for an equity fund, such as (i) the occurrence of events under the partnership agreement which would terminate the right of the fund manager to call unfunded capital commitments, (ii) the occurrence of a “Key Person Event” under the organizational documents, e.g., the death, resignation or departure of certain key persons in the fund manager and (iii) the resignation, withdrawal or removal of the fund manager without the appointment of a successor acceptable to the lender.
Because the occurrence of an event of default can trigger onerous consequences, such as full acceleration of all amounts outstanding, the fund manager should review whether certain proposed events of default should instead be merely bars to further loan drawdowns or prepayment events so as not to trigger cross-default provisions under other agreements. For example, a Key Person Event which does not result in a termination of the right to call unfunded capital commitments might be excluded from the definition of events of default.
- Remedies of the Lender. If an event of default occurs under a capital loan the lender will typically have the right to (i) require the fund manager to deliver capital call notices to the investors to satisfy the default loan amounts, (ii) designate investors as “defaulting investors” and (iii) require the fund manager to exercise some or all of the penalties and remedies under the partnership agreement against defaulting investors directly (including taking legal action to collect the defaulted payment obligation and interest and collection expenses and/or causing the sale of the defaulting investor’s interest in the fund in accordance with the fund’s organizational documents).
The lender may also want to have the right to exercise these remedies directly, without the involvement of the fund manager. Thus, the collateral documents frequently grant a power-of-attorney to the lender to take these actions in the name of the fund or the fund manager. In addition, it is not uncommon to have blank capital call notices signed by the fund manager of the fund and delivered to the lender at closing. However, the fund manager will want to negotiate for limitations on the lender exercising all of the fund manager’s rights against a defaulting investor. For example, a fund manager will normally want to maintain control of the sales process of a defaulting investor’s interest).
Enforcement by the Lender Against the Investors
It is common to have investors in a fund organized and/or located in multiple jurisdictions, including foreign jurisdictions. It is important for a lender, after an event of default occurs, to be able to seek the capital contributions from the investors, but this can be a complicated process when a reluctant foreign investor is involved. The lender would likely have to obtain a judgment against such investor from a court located in the jurisdiction designated for disputes under the partnership agreement, and then the lender will be required to have such judgment recognized and enforced in the jurisdiction where the investor is located. Advice from counsel in the subject jurisdictions is important on these issues.
Due Diligence Matters
From a lender’s perspective, it will have to conduct adequate due diligence on each investor, including financial and legal due diligence. The fund’s organizational documents, the partnership agreement, each subscription agreement and all side letters will have to be reviewed to ensure there are no limitations on the fund entering into the capital loan arrangements and pledging the unfunded capital commitments and the related pledged assets. Sometimes a fund’s organizational documents restrict the fund’s ability to borrow except for bridge financing (such as a capital loans program). In such cases, the fund’s organizational documents may also limit the amount that can be so borrowed, such as not more than 15-25% of aggregate capital commitments. In addition, a lender will need to confirm that there are no set-off rights or counterclaims or defenses to the capital calls or any circumstances under which an investor will have a right not to fund its capital commitment at a time when the lender exercises its remedies under the loan documents. For example, one or more investors may have contractual rights under the fund’s organizational documents or side letters to be excused from their capital contribution obligations for investments in certain types of industries or investments which raise certain tax issues (e.g., unrelated business taxable income in case of tax-exempt investors) or potential ERISA issues (e.g., a prohibited transaction in case of private pension plans). Such rights could affect the borrowing base.
Advance Planning for Capital Loans
The time for a fund manager to plan for a capital loan program is before, not after, the formation of the fund. For example, the fund manager in consultation with legal counsel in the jurisdiction in which the fund is organized should determine whether the fund has inherent authority under applicable law, or it is necessary to include authorizing provisions in the organizational documents (or in subscription agreements executed by the investors), to do the following:
- pledge the unfunded capital commitments and the right of the fund manager to make capital calls;
- disclose financial and know your customer information about the investor;
- provide copies to the lender of subscription agreements and side letters executed by the investors; and
- guarantee the obligations of the fund’s subsidiaries, if a subsidiary of the fund will be the borrower and the fund will be required to guarantee the subsidiary’s obligations.
Specific provisions may be required to meet certain lender contractual requirements, such as the investors agreeing to provide supplementary and/or periodic updates on their financial condition and/or acknowledging to the lender that a security interest in their capital commitments has been granted to the lender.
Consultation with counsel and one or two lenders in advance of finalizing the fund documentation as to what provisions to incorporate in the fund documents and what related disclosures need to be made to the investors will facilitate the entering into of these loan arrangements.
As evidenced by their growth in popularity, capital loan programs can be a useful financing technique for private equity funds. Planning for them as part of the fund formation process — rather than after all the fund documents are set in stone — can facilitate implementing a program with the best terms.