Leverage in a private equity fund structure is mostly injected at acquisition level and rolled on to the portfolio companies themselves. But there are other purposes for which the fund partnership itself may wish to borrow:
- The fund may need to be able to close transactions rapidly, whereas drawing down capital from its investors usually takes a couple of weeks. So the fund may use bridge finance to pay for investments that will ultimately be funded by investor capital contributions.
- A fund may want to have external finance available in case of sudden shortfalls, e.g. if an investor defaults on a capital call.
- Occasionally, a fund may want to use debt to pay management fees or other expenses, eventually repaying the loan out of fund income.
What collateral is available?
Corporates can easily secure their debt against a wide range of operating assets, from cash deposits to plant machinery to real estate. PE funds are different. Its assets – ownership stakes in the companies that it buys – are built up slowly over the fund’s investment period and then whittled down. Shares in portfolio companies may themselves serve as collateral for acquisition-level debt so long as the fund owns the company, and thus be unavailable as primary collateral for a direct creditor of the fund.
But PE funds have another kind of asset – the capital commitments that LPs make to the fund, which are typically drawn down in tranches over time. The legal position is a little peculiar, since capital calls are not a possession of the fund but rather an intangible right (technically, a chose in action) that the fund’s partners ‘own’ and (at the same time) ‘owe’ to each other. However, so long as there is significant undrawn capital ‘in the pipeline’, a lender will usually be willing to accept it as collateral.
The security would be structured to cover certain GP rights in the LPA, including the right to issue drawdown notices to LPs, the power to act against an LP that defaults on its drawdown obligations, and control over the proceeds once received.
The lender may also ask for loan repayments to have contractual priority over management fees if there is an event of default. However, GPs should be very cautious about agreeing to this: if the lender is able to cut off what is probably the manager’s main source of income, a fund default could end up crippling the manager.
Other salient issues when taking security over capital calls include:
- Lender control over the money contributed (via blocked accounts, to ensure security is “fixed”).
- Lender veto over key partnership decisions, including LPA amendments, early termination of the investment period, voluntary liquidation of the fund or additional borrowing by the fund.
- Financial covenants at the fund level, such as the extent of undrawn capital (which, remember, normally declines over time).
- The creditworthiness of the fund’s LPs – because their financial resources are ultimately what the lender will depend on to cure a default. Consequently, lenders often seek a veto over any change in the composition of the LP base – transfers, admissions and withdrawals. More ambitiously, lenders may seek LP-level financial covenants or cross-default triggers.
- Ideally, the lender will want to have acceleration of capital calls built into the LPA, triggered by an event of default. However, GPs and LPs will generally resist cementing the lender’s position into the LPA.
- Perfection of the security against the GP at Companies House.
Are the LPs involved?
It is rare for LPs to provide direct guarantees to the lender. Nor are LPs typically willing to give security over their personal property in the fund partnership, which would carry the risk of extending their liability beyond the limited liability afforded to them by the limited partnership structure.
The LPs don’t necessarily want to find themselves facing a bank across the table, instead of the GP. Some LPAs tightly limit the GP’s ability to incur indebtedness and prohibit it from charging its rights against LPs (e.g. without prior investor consent), to ensure that debt and security is pushed down to the underlying portfolio companies.
Other fund income as collateral
The lender may also take security over the fund’s right to receive dividends from its acquisition SPVs. Much like a fund’s right to call capital from investors, this right is a chose in action. At the same time, the lender will need a security power of attorney from the SPV. This enables the lender as chargee to ensure that the SPV complies with the terms of the security and serves notice on the SPV directing it to pay distributions to a blocked account, instead of paying dividends to the GP.
The lender would want an irrevocable power of attorney (POA) from the GP/manager, allowing it to exercise collateral rights directly without the latter’s involvement. But funds operate in an increasingly regulated environment, and the lender will be concerned to ensure that no regulatory clearance is necessary before it can ‘step into the shoes’ of the (FCA-regulated) GP/manager. Conversely, the GP will want to tightly restrict the scope of the POA, in order to minimise creditor interference in the fund’s ordinary operations.
Even with a strong POA, many practical barriers to contractual enforcement persist. For instance, it’s not uncommon for investors in alternative funds to be spread out internationally. If an LP in a far-off place contests a drawdown notice issued by the lender, the lender will need to incur costs and hassle to obtain judgment against the LP and then try to enforce it in potentially unfriendly foreign jurisdictions.
A proper assessment of appropriate security requires the lender to undertake detailed due diligence on the fund’s structure, the LPA and the LP base. It also needs to assess the consequences of d, the practicalities of enforcement, ensure perfection of the security and monitor the borrower. Because a PE fund structure often weaves its web internationally, the creditor has to take a multi-jurisdictional approach and get comfortable with conflict-of-law issues too.