Private equity fundraising in the first half of 2017 was at its strongest for that period since the financial crisis, according to PEI data. Secondaries funds in particular brought in more than double the amount raised in Q4 2016. Many sponsors of secondaries funds, as well as private equity funds of funds, are increasingly entering into credit facilities supported by their sizeable fund portfolios to amplify rates of return and provide some measure of liquidity. Sponsors, however, should be mindful of the critical issues that can arise when structuring and negotiating these financing arrangements.
In many PE fund of funds and secondaries fund structures, a domestic or offshore fund invests in a portfolio of LP interests. Fund structures may also include tax-blocker entities and Irish- or Luxembourg-based entities to address investor-specific demands. A lender will extend credit to the parent fund entity, which will hold the LP interests directly or through a subsidiary. The parent fund will then pledge as collateral all or part of its portfolio of LP interests.
PE collateral issues
General partners of the underlying funds typically place restrictions on the ability of limited partners to transfer, assign or pledge their equity interests in the fund. Borrowers generally will address this limitation in one of three ways: by consent, through use of a special purpose vehicle subsidiary or through use of a securities account.
The borrower may simply request the consent of the GP of each of the funds being pledged to the lender. However, some funds of funds may have a large number of underlying funds and the time and expense of negotiating consents with the GPs may be prohibitive.
In certain cases, the borrower may establish an SPV to hold the LP interests with the intent of eliminating the need for GP consent. Interests held by the PE fund may be transferred to the SPV when the related LP agreement allows transfers without GP consent to affiliates of the holder of the LP interest. Upon a default, the bank may foreclose on the equity of the SPV and then control the management or disposition of the LP interests without any change in record ownership.
Another structure to address transfer restrictions involves the borrower holding the LP interests in a securities account at a custodian that functions as a securities intermediary. Under Article 8 of the Uniform Commercial Code, the lender can obtain a perfected security interest in the securities account and the securities entitlements (that is, the LP interests in the account) by way of an account control agreement. Upon a default by the borrower, the bank delivers a notice of exclusive control and can direct the securities intermediary to dispose of the LP interests.
Collateral, borrowing base and advance rates
Lenders and borrowers will also negotiate the nature and types of LP interests and other collateral assets that may qualify as “eligible investments.” If certain events have occurred in respect of an LP interest, this interest may no longer qualify as an eligible investment. A lender, for example, will usually exclude an LP interest for which the borrower is in default on a related capital call. Other common reasons for disqualifying LP interests include the existence of conflicting liens and material write-downs or write-offs of portfolio investments.
A lender will assign a certain amount of collateral value for each category of eligible investment. For example, a lender may assign LP interests in a particular private equity strategy (such as buy-out funds) a value of 60 percent of their net asset value. The lender will then only extend credit or “advance” funds in an amount equal to 60 percent of the value of the buy-out fund collateral.
The borrowing base is the aggregate amount of value in the collateral portfolio that a lender is willing to finance and is calculated by summing up the advance rates against each eligible investment. The borrowing base will typically be subject to reductions if the collateral portfolio exceeds certain concentration limits on an aggregate basis. Lenders place these restrictions on the collateral to avoid or mitigate concentration risk in a particular type of asset or strategy.
As investors allocate increasing amounts of capital to PE secondaries funds and funds of funds, the demand for credit facilities secured by LP interests will continue to grow. Financing of LP interests, however, can generate complex issues that sponsors and managers need to carefully consider. Provided the facilities are properly structured and negotiated, sponsors will be able to use these facilities to help meet investment return objectives and address important portfolio management needs.
Kerfoot, Alicandri and Perkins are partners in Dechert’s New York office.