Subscription Lines: Key Legal Terms for LP Consideration
/Here are my notes from ILPA’s 2020 Members’ Conference workshop on subscription lines. Michael Mascia from Cadwalader, Wickersham, & Taft LLP led the workshop.
The workshop was a thorough review of both common subscription facility terms and more advanced provisions. The workshop was valuable for both investors unfamiliar with subscription facilities as well as experienced investors.
Note: any errors are my own and in no way attributable to Michael Mascia or ILPA
Collateral
• Includes the fund’s right to call capital from LP, capital contributions themselves, and the collateral account
• Includes any enforcement rights
• Does not include any security interest in the fund investments or distributions
Underwriting
• Based almost entirely on LP creditworthiness
o Reputation of sponsor is less important
o Agnostic towards the assets/investments
• There are other facilities that do care about underlying assets – stretch facilities used near the end of the fund’s life; hybrid and NAV facilities (discussed below)
• Full recourse loan to the fund – fund is obligated to repay even if collateral is insufficient
• Almost all subscription facilities are committed facilities – lender is obligated to make the loan
• Always a revolving facility; rarely do you see term sub facilities
• Sub facilities must be explicitly authorized by LPA
• An LP is only obligated to their capital commitment; LP doesn’t have to provide other credit enhancement to the lender
Borrowing Base
• Lender will make an advance up to the borrowing base – percent of the fund’s uncalled capital commitments; max size of the loan is always less than available capital call amount
• As capital is called, uncalled capital commitments decrease and therefore lower the borrowing base
• Doesn’t expand purchasing power like traditional leverage
Sub Facility Repayment
• Subscription lines are typically repaid by capital contributions
• One exception, for example: a real estate fund buys a property with sub line, then takes out permanent financing and repays sub line with the loan
Sub Facility Tenor
• Majority 1-3 years
• Any individual loan may have earlier clean down provision
• Extensions are typically 1 year
Sub Facility Interest Cost
• Average 165 bps over LIBOR
• 150 bps over LIBOR very common
• Lowest source of financing for a fund
o Less expensive than all other asset or investment-level debt
o Smaller deals have higher margins
• Pristine credit performance of sub lines
• Pricing is tiered based on quality of L.P. investors
o Very little information is needed from LPs
o Lenders rely on public information
Borrowing Base Determination
• Borrowing base – 90% for rated institutions (public pension); 65% for unrated institutions – Family Office, HNW investors
• There are concentration limits limiting the borrowing base attributable to a single LP
o Can be 15% for highly-rated institutions; 1% for non-rated institutions or HNW investors
• Will exclude certain investors from borrowing base; but ALL investors are in the collateral base
• Lenders will use shadow ratings – for example, will use corporate parent credit ratings as a proxy for creditworthiness of pension plan
• LPs that use an SPV provide very little information, lender will try to identify credit linkage to the parent company; but obviously there’s a reason the LP formed an SPV
• There is flexibly to increase borrowing size as additional closings occur
Other Borrowing Base Alternatives
• VC lenders use a flat rate: 50% of all unfunded capital commitments
• Coverage ratios: maintain uncalled capital to debt of 2:1
• Less sensitivity to underlying LP classification
Investor Letters
• If LPA provisions are not adequate, lenders may request investor letters
• Investor letters: LPs give various acknowledgments, representations, and covenants to give lenders comfort of LP’s ability to make good on facility
• 25 years ago, sub lines required investor letters from every LP
• Now getting investor letters is a nuisance; large movement away if investors give appropriate acknowledgments in the agreements
• Exceptions where investor letters are used
o If the LPA didn’t adequately address sub line in a way that the lender can get comfort
o An SMA or transactions where 1 or 2 investors have high concentration risk and lender has high exposure – lender wants additional comfort
o Use of investor letters in prior funds
• Typical letter is structured between investor and lender so lender can issue capital call
Exclusion Events
• LP’s will drop out of borrowing base if they file bankruptcy
• Rare to see this happen in practice given the reliability of LPs
Mandatory Prepayment
• If loans exceed borrowing base
• Haven’t really seen this in practice because LPs haven’t defaulted
• Will see this if capital call goes out that reduces uncalled capital base; loan may then be over maximum and will have to be prepaid until under maximum limit
Information Exchange
• Banks wants fund financials as well as any material notice LPs give fund
o For example: to end investment period early
Lesser-Known Benefits
• Avoid the need for true-ups among different close investors:
o Will hold investments on sub line until all closings are complete; then can issue one capital call
• Guaranteeing debt of portfolio company
o Instead of portfolio company paying 10%+, the fund has portfolio company join the sub facility as an additional borrower
o Fund will guarantee borrowing and get the debt at the fund rate - massively reduces interest cost
• Use lender for currency exchange so fund doesn’t have to swap currencies
• Sub line is the working capital line – pay accounting, etc via sub line and then clear out with capital call
• For levered funds - can use sub line to create leverage until fund has built up enough assets to get asset level leverage
• Avoid financing condition in purchase document (for example, real estate – don’t need to have permanent financing committed at purchase)
• Fund can use sub line to assist with hedging activity; can use capital calls and hedging program as security interest
Using Subscription Lines to Fund Distributions
• Lenders don’t like this and will prohibit because they want borrowed fund to go into the asset base that would be part of bankruptcy case in worst case scenario
o Rarely happens in practice
• Can be an option if LPs want a dividend recap
Remedies in Default
• GP will issue cap call if still involved; if GP is removed, lender will issue capital call
• Lenders can prohibit distributions to LPs until loans repaid
• Lenders have the ability to step into GP role and pursue an LP that defaulted; almost never happens given LPs rarely default
Topics Exaggerated in the Press
• Concern regarding uncommitted facilities - gives lender discretion to fund or not
o Tiny portion of market
o GP’s like it because it’s a little cheaper and they can always call capital if needed
• Demand feature on sub lines – lender can terminate facility with short notice (i.e. 12 days)
o GPs stay away because they want certainty of facility
• Concern regarding umbrella facilities – collection of separate sub lines that are documented under one credit
o Agreement with separate schedules for each fund
o No cross-collateralization or cross defaults
o Avoid the need for large GPs to have numerous different facilities
o Any special terms are part of the specific fund schedule
Other Terms
• Capital Call Lines of Credit – same as a traditional sub line but with different terminology; sub lines with flat advance rates are called capital call lines of credit
• Qualified borrowers – portfolio company joins sub facility; portfolio company only has to repay its own loan, not any other loans of the fund
Other Lending Structures – NAV and Hybrid Facilities
NAV Facilities
• Can be a term or revolving facility
• Collateral based on investments, equity of holding companies, and distribution proceed
• Borrowing base reflects eligible investments and applicable concentration limits
• Investment valuations are critical; focus on LTV
• Represents actual leverage compared to a traditional sub line that does not
• NAV facilities are a much smaller market than a typical sub line
• More expensive with more risk for the lender
• Lenders need to understand fund risks and investments
• Typically used for debt funds and Fund of Funds
o Can’t get leverage at the investment level in these funds
o Implemented during or after investment period
Benefits
• Liquidity to support portfolio companies when all capital commitments have been called
• Availability to do follow on investments
• Cheaper than investment-level debt
Hybrid Facilities
• Both collateral and borrowing base incorporate uncalled capital commitments and investment value
Market Update
• Haven’t seen any decline in deal volume through COVID-19
• Credit performance was perfect in GFC and has been through COVID-19
• Had expected NAV facilities to cash sweep (if LTV of loan gets to high – cash flows need to pay down the loan)
o Haven’t seen this because prices have rebounded so quickly;
• Haven’t seen as many underlying companies become qualified borrowers
• Virtually zero LP transfers
• Increased interest in NAV facilities to defend portfolios