Private equity firms have increased their use of continuation funds over the past few years. These funds allow sponsors to acquire and hold assets that have uncrystallised value from a fund that is winding down.
Continuation funds, like traditional funds, can benefit from the use of subscription credit facilities, which enable them to seize investment opportunities without having to wait for capital calls.
When structuring subscription facilities for use by continuation funds, there are a number of unique features that lenders and borrowers will need to consider.
Subscription Credit Facilities Generally
Private equity funds have historically used subscription credit facilities to bridge capital calls and other types of permanent financings. Fund borrowers can therefore have fast access to cash while lenders can rely on collateral (which includes the unfunded capital commitments of a fund’s limited partners, the rights to make and enforce capital calls and the bank accounts into which the limited partners must fund their capital contributions) for credit support.
Continuation Funds: Formation and Features
A continuation fund is usually formed as a new fund with the limited purpose of acquiring specific assets from an existing private equity fund. The investors in the liquidating fund will be notified of the continuation fund’s formation and will be offered the option of either exiting the fund or rolling their investment into the continuation fund. New investors can also invest in the continuation fund and their cash contributions will be used to pay out the exiting investors. Continuation funds may also be structured to include unfunded capital commitments from investors – and increased commitments from rollover investors – to acquire or increase follow-on investments.
Subscription Credit Facility Considerations for Continuation Funds
While a subscription credit facility for a continuation fund will likely contain representations, warranties, covenants, events of default and collateral like a traditional fund, lenders and fund borrowers must consider the unique features of a continuation fund to create a workable facility. Lenders are particularly concerned about (i) determining the investor capital commitments (including for rollover investors) and distributions to exiting investors, (ii) creating safeguards to account for a more concentrated pool of assets and (iii) adding covenants to address valuing fund assets.
1. Investor Commitments
Subscription facility lenders apply their credit models to determine individual investor advance rates and concentration limits, the financial wherewithal of the investor pool and the track record of investors and fund sponsors. They pay particular attention to rollover investors whose capital commitments may not be confirmed until assets are sold to the continuation fund and sale proceeds are allocated or distributed to the investors.
Lenders may therefore consider requesting additional investor deliverables, investor letters, parent comfort letter and evidence that investors are authorised to enter their subscription documents.
They may also exclude rollover investors’ commitments until lenders have received acceptable documentation confirming the final amount of their capital commitments. Exclusion events such as failure to maintain minimum net asset value may also be required by lenders.
2. Protections for Concentrated Asset Portfolios
Because continuation funds generally have more concentrated asset portfolios, subscription facility lenders will craft additional covenants related to the assets. Requirements relating to the minimum number of unrelated investments and minimum overall net asset value may be included.
Some lenders will also require that distributions, dividends and other payments received by the continuation fund from assets (or an agreed percentage thereof) be applied to repaying the credit facility.
Other covenants such as requirements relating to asset value and restrictions on material asset sales may be included.
3. Addressing Asset Valuations
Lenders may also look to include covenants that address NAV determinations. The prohibition of allowing loan processes from being made to make distributions to limited partners may be included, although proceeds may be permitted to be used in the case of a distribution to partners if subject to a recall.
Lenders can also require more detailed or frequent reporting from the borrowing bases. This usually includes investor events, investor composition changes and net asset values.
Some lenders may also require additional collateral under the subscription credit facility. This can include a pledge of the continuation fund’s equity interest in one or more holding vehicles that own or hold the underlying assets. The pledge can also include the deposit and securities accounts into which distributions from the assets are funded.
The above investor, asset and valuation requirements have proved workable for both fund sponsors and lenders in the context of subscription financing.
Subscription Credit Facilities Can Be Valuable for Continuation Funds.
Given their unique features, continuation funds highlight challenges in structuring liquidity options. However, if lenders and sponsors keep in mind the above best practices, they can collectively ensure a subscription facility can be appropriately structured to meet all parties’ needs.
Aimee Sharman and Kiel Bowen are partners and McKay Harline is an associate within law firm Mayer Brown’s banking and finance practice.