Subscription Credit Facilities: A Comparison of Borrowing Base Structures

By Kiel Bowen, Todd N. Bundrant, Mark C. Dempsey and Christopher N. Ellis 1

Subscription credit facilities, which are lines of  Calculation of the Borrowing Base: A credit in favor of and similar subscription credit facility borrowing base is investment funds primarily secured by the usually calculated by taking (x) uncalled capital commitments of the fund’s investors, capital of each Eligible Investor multiplied are most commonly structured using a by (y) the Advance Rate with respect to such borrowing base structure similar to other Eligible Investor and (z) subtracting any types of asset-backed loans. Many factors will haircuts related to Concentration Limits dictate the best borrowing structure for a and/or Borrowing Base Deductions. fund, the most important of which are the  Eligible Investors: The uncalled capital make-up of the fund’s investor pool and commitments of some investors will be where the fund is in its life cycle (raising included in the calculation of the borrowing capital, harvesting investments, etc.). base (“Eligible Investors”) and the uncalled Historically, each market lender has been tied capital commitments of other Investors will to a single borrowing base philosophy that not be (“Excluded Investors”). Determining keyed squarely into its unique credit and which investors will and will not be included underwriting requirements. As industry varies greatly in the different market competition has continued to grow, approaches to structuring a borrowing base. have realized that a one-size-fits-all approach Typically, both an investor’s may not be the best long-term approach in creditworthiness and its investor the market. Accordingly, many lenders have documentation (e.g., the existence of a adjusted their credit and underwriting policies problematic side letter provision) will be the to permit more flexibility in structuring key factors in determining if an investor will borrowing bases to better fit a particular be included or excluded from the borrowing fund’s investor pool. Sometimes this has been base. As described below, some borrowing accomplished by adjusting the borrowing base approaches use bright-line categories base inclusion criteria, advance rates or of Eligible Investors, meaning the inclusion concentration limits, while other times, it is process, approval rights, and requirements accomplished by taking a completely different for these categories are explicitly set forth in approach to structuring the borrowing bases. the loan documentation, while other approaches employ more relaxed standards. Prior to discussing the differences between It is important to note, that even though the various borrowing base structures, it is Excluded Investors do not contribute to the helpful to first outline the common tenants of calculation of the Borrowing Base, their the various borrowing base structures: uncalled capital is collateral and, similar to Concentration Limits provide over- other asset-backed lending structures, collateralization. provides the lender with “over-  Borrowing Base Deductions: Some lenders collateralization.” may also include deductions from the  Exclusion Events: Upon the occurrence of borrowing base that limit the amount certain negative events, Eligible Investors available under the facility. For instance, will automatically be excluded from the recourse outside of the facility is borrowing base and become Excluded commonly deducted from the borrowing Investors. Standard exclusion events base on a dollar-for-dollar basis. This include, among others: (a) an investor elects concept is premised on the lender’s to stop funding its commitment or such understanding that all debt (and not just investor repudiates or challenges the their borrowings) should be covered by the enforceability of its commitment; (b) an borrowing base. investor fails to fund its capital contribution With the above background, there are three when due; (c) an investor defaults in any standard borrowing base approaches representation or warranty made in any common in the US subscription facility market: fund document; (d) rated investors fail to (1) a borrowing base of only highly-rated satisfy the applicable requirement (or any included investors with a high advance rate other inclusion standard) or unrated (the “Included Investor Model” or “II Model”); investors have a significant drop in net (2) a two-tier approach, which provides for worth; (e) an investor transfers its interest or both highly-rated included investors with a otherwise ceases to be an investor or high advance rate and a designated investor requests a withdrawal from the fund; and class, where the latter has a lower advance (f) bankruptcy of an investor. rate (the “Included/Designated Model” or the  Advance Rates: This is the percentage of “II/DI Model”); and (3) a flat advance rate uncalled capital commitments of each across all (or most) investors (the “Flat Eligible Investor that will be used in the Advance Rate Model”), which may also be calculation of the borrowing base. It is structured as a coverage ratio (the “Coverage typically less than 100% to provide Ratio Model”). additional over-collateralization. Below we explore these traditional structures  Concentration Limits: In order to provide and then discuss how these structures are greater risk diversification, concentration evolving to address increased competition limits are often included in subscription and the particular needs of fund borrowers. credit facilities. Concentration limits are restrictions on how much borrowing base A. Included Investor Model credit will be given to any particular In the traditional Included Investor Model, investor’s uncalled capital commitments— only highly-rated investors that meet a often calculated as a percentage of an pre-defined set of criteria (e.g., a minimum individual investor’s uncalled capital credit rating (typically set at BBB+) and, commitment against the total amount of all with respect to pensions, a minimum uncalled capital commitments or all Eligible “funding ratio” (often 90%) or, in some Investor uncalled capital commitments. cases, minimum assets (typically Additionally, aggregate investor class $1 billion)) will be designated Eligible concentration limits might be included. Like Investors (“Rated Included Investors”). For Excluded Investors and Advance Rates, these investors, typically the only approval

2 Mayer Brown | Subscription Credit Facilities: A Comparison of Borrowing Base Structures right is in favor of the administrative agent creditworthiness to include in the (and not any facility lenders). Other non- borrowing base (these investors are rated investors that, in the determination commonly referred to as “Designated of all lenders, would be rated investment- Investors”). The inclusion of any grade if they had a rating (“Non-Rated Designated Investors typically requires all Included Investors”) will also usually be lender consent and has historically Eligible Investors in an II Model. required some evidence of credit- The Advance Rate for all Eligible Investors worthiness or credit support, such as in an II Model is typically set between 80% publicly available financial information or and 100%2 and Concentration Limits have evidence of a strong relationship with a historically been determined by a static creditworthy parent. grid ranging from 5-15%, in each case Advance Rates and Concentration Limits dependent on the Eligible Investor’s rating with respect to Included Investors usually or classification as a Non-Rated Included mirror the Advance Rates and Investor. Non-Rated Included Investors Concentration Limits typically used in the (and sometimes lower-rated Rated II Model. The Advance Rate for Designated Included Investors) are usually also subject Investors is typically set at either 60% or to an aggregate Concentration Limit. 65%. Additionally, Designated Investors Since the borrowing base only includes are usually subject to both individual and uncalled capital commitments of aggregate Concentration Limits. We often investment-grade investors, lenders see a 5% individual Concentration Limit typically offer favorable pricing and looser and an aggregate Concentration Limit of terms compared to other borrowing base 35% with respect to Designated Investors. structures. Funds that use the II Model The II/DI approach is currently the most usually have a diversified class of highly commonly used in the syndicated market. rated investors and use subscription This approach is often used by funds that facilities mostly for bridging purposes— need larger credit facilities with a and not long-term leverage. These funds borrowing base than a traditional II Model typically don’t require high overall or Flat Advance Rate Model approach effective advance rates against the entire would be unlikely to support over the life investor pool because they regularly repay of the fund, and usually offers the highest borrowings and prefer the less expensive overall effective advance rate. To account pricing and looser terms that the II Model for the fact that lower-rated investors are provides. included in the borrowing base, pricing B. Included/Designated Model may be higher than facilities employing the II Model and these facilities may be The Included/Designated Model builds off tighter on other terms and reporting the II Model’s technology. In addition to requirements than the other models. classifying Rated Included Investors and Non-Rated Included Investors (collectively C. Flat Advance Rate Model and Coverage referred to as “Included Investors”) as Ratio Model Eligible Investors, the II/DI model includes Unlike the other two approaches that have a third category of investor that the highly structured inclusion criteria, the lenders have determined is less presumption in a Flat Advance Rate Model creditworthy than the Included Investors, is that all investors will be included in the but still maintains sufficient

3 Mayer Brown | Subscription Credit Facilities: A Comparison of Borrowing Base Structures borrowing base unless something is accommodation to the sponsor (to curry problematic about an investor or type of favor with the sponsor), (3) in investor (for example, high net worth uncommitted and on-demand credit investors or investors that are affiliated facilities (where the takes comfort in with the fund are often not included in a the fact that a decline in the credit quality Flat Advance Rate borrowing base). of the overall investor pool can be Accordingly, Flat Advance Rate Model rectified by calling the facility or refusing transactions typically include all or almost to fund), (4) where the investor pool all investors in the borrowing base at a would not support a borrowing base single “flat” advance rate. The advance under the II Model or the II/DI Model, and rate may vary widely based on the (5) where the fund’s investor pool is highly composition of the investor base but concentrated, such that traditional typically range from 50-65% (however, we concentration limits would be have seen advance rates range from 20- problematic. Depending on the 90% depending on the fund and the circumstance, the pricing of these facilities makeup of the investor pool). Usually, Flat varies greatly, but they are often priced Advance Rate Models do not include similar to or higher than facilities using concentration limits. Flat Advance Rate the II/DI Model. transactions are most often bilateral or While the foregoing approaches have been club deals. historically rather inflexible—forcing funds to A Flat Advance Rate borrowing base can pick one approach—lenders are now blending be structured as a coverage ratio covenant the aspects of the different approaches and in the loan documents. This requires that employing tailored variations. While this trend the uncalled capital commitments of the is noticeable (and likely the result of increased investors shall, at all times, cover the competition), in our experience, lenders are amount of outstanding loans under the altering their approach judiciously and credit facility at an agreed upon ratio. The carefully evaluating and structuring around Coverage Ratio Model is currently more the risks. Listed below are some of the more common in Europe but is also seen in US common variations currently being utilized: bilateral deals done as accommodations  Concentration Limit Holidays – A for sponsors. These Coverage Ratio Model common accommodation used in deals will include Borrowing Base connection with the II/DI Model is to not Deductions for other indebtedness of the apply any Concentration Limit to the Rated fund (including guaranties of portfolio Included Investors in the borrowing base companies) and equity commitments the until the earlier of (x) one year after the fund has made to its portfolio companies credit facility closing date and (y) the fund’s or third parties. final closing date. While the Concentration Both the Flat Advance Rate Model and Limits with respect to Non-Rated Included Coverage Ratio Model are used in a wide Investors and Designated Investors typically variety of circumstances, including: still apply, this variation gives funds (1) where a fund does not desire or need a flexibility during the early stages of large facility amount and prefers lighter fundraising and when their investor base legal documentation and relaxed might be highly concentrated. Lenders cite reporting requirements, (2) when a lender comfort in the fact that this approach is is advancing a small facility as an used at the beginning of the fund’s lifecycle

4 Mayer Brown | Subscription Credit Facilities: A Comparison of Borrowing Base Structures before any possible unexpected negative Oftentimes, these “Hurdle Investors” will investment performance is likely to surface toggle back and forth between Designated which may impact investor confidence in Investor and Excluded Investor status, the fund. depending on whether the conditions  Concentration Limit Waivers – Similarly remain satisfied (i.e., if net asset value lenders are now selectively waiving declines below the negotiated minimum or concentration limits if investors deliver if funded capital drops below the threshold investor letters in favor of the lender. Since as a result of returned capital). The market these investor letters provide direct has generally accepted the use of Hurdle contractual privity and reinforce the key Investors because once the hurdles are aspects of the facility, lenders are more satisfied, the investor has “skin-in-the- willing to take a greater concentration risk game” (reflective of the funding on an investor. requirement), which is subject to loss if the investor fails to make capital contributions  Relaxed Concentration Limits – Although when required3 and, accordingly, the the concentration grids employed in the II investor has an incentive to maintain its Model and the II/DI Model have historically investment since the fund is performing been static and non-negotiable, lenders (reflective of the net asset value prong). have slowly started to relax concentration limits—especially in bi-lateral deals with  Hurdle Advance Rates and Hurdle strong borrowing bases. This allows funds Concentration Limits – With the market to receive an advance rate against greater increasingly comfortable with Hurdle percentages of the uncalled capital Investors, some lenders have started to commitments, even with less diversification employ the hurdle technology to Advance in the investor pool. Rates and Concentration Limits. Instead of investors “hurdling” from Excluded Investor  Hurdle Investors – The accommodation status to Designated Investor status, under that has perhaps gained the most traction this approach, a pre-defined select group of in the market is the designation of “hurdle” high-quality investors will “hurdle” into investors. This approach is often used where higher Advance Rates and/or relaxed investors either have legal or side letter Concentration Limits when the hurdle issues (e.g., sovereign immunity concerns, conditions are satisfied. Like Hurdle placement agent issues) or other concerns Investors, Hurdle Advance Rates and Hurdle regarding their ability to honor capital Concentration Limits typically toggle to contributions to a lender (e.g., insufficient account for net asset value and the amount financial information available to validate of capital funded. This approach is seen the investor’s creditworthiness). These most regularly as being applied to high net investors will initially be excluded from the worth investors and other investors that are borrowing base, and after satisfying certain not investment grade. conditions, will “hurdle” into the borrowing base as a Designated Investor. While such  After-Care Flat Advance Rates – Many “hurdle” designation is always linked to the lenders and funds convert transactions applicable Investor having funded a certain formerly based on the II/DI Model to a Flat percentage (often 40%) of its total capital Advance Rate Model after the investment commitment, some lenders are also period has expired (such facilities, “Aftercare requiring the fund to maintain a pre- Facilities”). While these credit facilities are negotiated minimum net asset value. usually smaller than more traditional

5 Mayer Brown | Subscription Credit Facilities: A Comparison of Borrowing Base Structures subscription facilities, they often have a this tactic is that the fund might not be able high Flat Advance Rates (up to 80-100%). to lock down favorable pricing or other Lenders often include additional net asset terms if the market turns for the worse value covenants and may take a pledge of and will likely have to negotiate two the other assets of the fund to secure the separate facilities. obligations (thereby converting the  Multiple Borrowing Bases – One of the subscription facility to a hybrid facility—at more creative approaches being used is least from a collateral perspective). Similar including multiple borrowing base models to the analysis underpinning the hurdle into the loan documentation. Under this concepts explored above, lenders take approach, the fund has a one-time option comfort in the fact that investors have “skin- to switch to an alternative borrowing base in-the-game” and the fund is performing. approach within a short window following  Relaxing Designated Investor Criteria – the final investor closing (e.g., starting with As noted above, unlike in Flat Advance Rate a II Model and switching to a II/DI Model). Model deals, the classification in the For the fund, this foregoes the expense of other models is Excluded Investor. The II/DI negotiating two credit facilities and locks Model has historically required that lenders down pricing (even if that pricing toggles have strong visibility into the upon any conversion of the borrowing base creditworthiness of potential Designated approach) and other terms. For the lender, Investors and that the lender determine that this approach offers a competitive there is creditworthy value in the uncalled advantage against other lenders that may capital commitment of such potential not be able to provide such flexibility. Designated Investors. While that  Syndicated Flat Advance Rates – Many presumption remains true, many lenders funds prefer the simplicity of the Flat have recently relaxed their criteria on Advance Rate Model due to the relatively classifying Designated Investors— lax reporting requirements and inclusion oftentimes requiring less insight into the criteria associated therewith. While Flat investor’s financial standing and/or less Advance Rate deals have not been concrete linkage to a high-quality parent. historically used for large syndicated  Short-Term Bridge Facilities – Instead of facilities in the US, recently lenders have entering into a long-term facility in been more open to use a Flat Advance Rate connection with their initial closing, some Model with top-tier sponsors. Unlike funds are now entering into short-term traditional Flat Advance Rate deals, bridge facilities during their fundraising however, other parts of these transaction period. Such short-term facilities are often remain highly structured. structured on an uncommitted/on-demand Unlike pricing and tenor—where the market basis using the Flat Advance Rate Model or has been relatively uniform—there has been a bilateral deal with relaxed concentration significant creativity in structuring borrowing limits that could be difficult to support in a base approaches in the subscription credit subsequent syndication. This approach facility market recently. We expect this trend allows the fund to determine which to continue as more lenders change their borrowing base approach will work best for longstanding credit and underwriting policies their ultimate pool of investors once to allow more tailored solutions to a wider fundraising has been completed. The risk of range of investor pools.

6 Mayer Brown | Subscription Credit Facilities: A Comparison of Borrowing Base Structures Endnotes

1 Mayer Brown is a distinctively global law firm, uniquely positioned to advise the Kiel Bowen is a partner in Mayer Brown's Banking & world’s leading companies and financial institutions on their most complex practice, where his practice centers on fund deals and disputes. With extensive reach across four continents, we are the only integrated law firm in the world with approximately 200 lawyers in each of finance. Todd Bundrant is a partner in Mayer Brown’s the world’s three largest financial centers—New York, London and Hong Banking & Finance practice. Mark is a partner in Mayer Kong—the backbone of the global economy. We have deep experience in high- Brown's Banking & Finance and Fund Formation & stakes litigation and complex transactions across industry sectors, including our signature strength, the global financial services industry. Our diverse teams of Investment Management practices. David Ellis is a partner lawyers are recognized by our clients as strategic partners with deep of Mayer Brown. His work focuses on private equity commercial instincts and a commitment to creatively anticipating their needs and delivering excellence in everything we do. Our “one-firm” culture— transactions, mergers and acquisitions, joint ventures and seamless and integrated across all practices and regions—ensures that our commercial transactions with particular emphasis on the clients receive the best of our knowledge and experience. real estate sector. Please visit mayerbrown.com for comprehensive contact information for all Mayer Brown offices. 2 In most syndicated facilities, a flat 90% Advance Rate is Any tax advice expressed above by Mayer Brown LLP was not intended or written to be typically applied to all Eligible Investors in light of many used, and cannot be used, by any taxpayer to avoid U.S. federal tax penalties. If such advice was written or used to support the promotion or marketing of the matter addressed credit policies prohibiting a 100% advance rate to any above, then each offeree should seek advice from an independent tax advisor. investor. This Mayer Brown publication provides information and comments on legal issues and developments of interest to our clients and friends. The foregoing is not a 3 Organizational documents of funds typically include a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek legal advice before taking any action with respect to contractual remedy to reduce an investor’s capital account the matters discussed herein. and/or sell an investor’s interest in the fund at a steep Mayer Brown is a global services provider comprising associated legal practices that are separate entities, including Mayer Brown LLP (Illinois, USA), Mayer Brown International discount if an investor fails to honor its capital LLP (England), Mayer Brown (a Hong Kong partnership) and Tauil & Chequer Advogados commitment or otherwise defaults with respect to its (a Brazilian law partnership) (collectively the “Mayer Brown Practices”) and non-legal service providers, which provide consultancy services (the “Mayer Brown contractual obligations. Consultancies”). The Mayer Brown Practices and Mayer Brown Consultancies are established in various jurisdictions and may be a legal person or a partnership. Details of the individual Mayer Brown Practices and Mayer Brown Consultancies can be found in the Legal Notices section of our website. “Mayer Brown” and the Mayer Brown logo are the trademarks of Mayer Brown. © 2019 Mayer Brown. All rights reserved.

7 Mayer Brown | Subscription Credit Facilities: A Comparison of Borrowing Base Structures