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Home , Leverage (finance), Repurchase agreement

Utilizing Repurchase Facilities and Related Protected Contracts as an Alternative Source for Fund Liquidity

By Todd N. Bundrant, Susannah L. Schmid, Eric M. Reilly, and Monique J. Mulcare 1

to capital commitments of to I. Introduction determine availability), Repurchase Subscription-backed facilities (also Facilities look “down” to beneath the known as “capital call” or “capital Fund level. Repurchase Facilities can also commitment” facilities, and each a be used effectively in tandem with “Subscription Facility”) have served as the Subscription Facilities. cornerstone of the fund market for the Repurchase Facilities are often used to provide past 20 years. Loan availability under a temporary financing of an until an exit Subscription Facility is subject to a borrowing strategy (like pooling into a securitization) can base, which is typically tied to the remaining be pursued. In addition to Repurchase amount of the pledged uncalled capital Facilities, there are other tools available to commitments of investors satisfying certain Funds for purposes of obtaining liquidity from eligibility requirements, multiplied by an portfolio assets, including “note on note” advance rate. However, in connection with the financings (whereby a lender provides an ongoing evolution of the fund finance market, advance against a loan asset and in turn takes we have seen a growing interest among real an assignment of the underlying loan estate and other private credit funds (each, a documentation as for repayment) “Fund”) for additional fund financing tools to and “CLO light” structures (whereby a lender the value of their portfolio assets and provides a temporary warehouse optimize investment returns. for loan assets meeting certain specified In order to meet the financing needs of these eligibility criteria). Repurchase Facilities, Funds, a growing number of and other however, include distinct structural elements credit institutions (each, a “Buyer”) are resulting in an increased appetite from market entering into financing arrangements, participants for this type of financing commonly known as repurchase agreements arrangement. In light of this trend, this article or securities contracts, with subsidiaries of will discuss some common features of these Funds (each, a “Seller”) whereby the Repurchase Facilities and certain other related Buyer provides liquidity by “purchasing” “protected contracts” and the benefits of this certain portfolio assets with an obligation of alternative source of liquidity associated with the Seller to “repurchase” these same assets Fund assets. on a specified date in the future (each a “Repurchase Facility”). In contrast to Subscription Facilities (which look “up” II. Benefits of Protected Contracts outstanding obligations) promptly upon the bankruptcy of the . Additionally, each of Protected contracts are specific types of the Bankruptcy Code’s protected contract contracts designated under Title 11 of the provisions makes clear that a protected party United States Code, as amended (the can freely exercise its rights under any “Bankruptcy Code”) to receive “safe harbor” agreements, guarantees, reimbursement protections that allow the qualifying party to agreements or other credit enhancements that liquidate and close out the protected contract relate to the primary protected contract and when its counterparty becomes the subject of a that those related contracts are each eligible, in bankruptcy case, and to do so free from the their own right, for treatment as protected automatic stay and certain other significant contracts. As a result, enforcement actions by restrictions of the Bankruptcy Code. the protected parties of these related protected In most lending arrangements, if a contracts are exempt from the automatic stay counterparty files for bankruptcy, an and can be undertaken without prior approval automatic stay of actions is imposed which of the bankruptcy court. prevents a lender from (i) foreclosing on the The Bankruptcy Code also shields protected property of the debtor, (ii) commencing or parties from a variety of avoidance powers continuing certain enforcement actions that are generally available to a bankruptcy against the debtor or its property and/or (iii) trustee (or debtor-in-possession) with respect setting off amounts owed under such to transactions engaged in by the debtor prior arrangements (in each case unless a motion to commencement of the bankruptcy case. seeking relief from the stay is filed and Most importantly, under Section 546(e) of the granted in the related bankruptcy case). In Bankruptcy Code, certain payments and other addition, provisions in these lending contracts transfers received by the protected party from that allow for the termination or modification the debtor in connection with a Repurchase of a contract based on the debtor’s Facility, prior to commencement of the case, bankruptcy or financial condition (also known may be retained by the protected party. as “ipso facto clauses”) are prohibited from Likewise, because the Bankruptcy Code being enforced. permits the close-out of the Repurchase In contrast, if a contract is a “protected Facility, those post-bankruptcy actions also contract” and the party seeking enforcement cannot be “avoided” by the trustee (or the is a “protected party” (e.g., in the case of debtor-in-possession). securities contracts, a financial institution or a As a consequence, because a counterparty to financial participant as defined within the a protected contract has more certainty in Bankruptcy Code), then ipso facto clauses that contract enforcement upon a debtor would not otherwise be enforceable can be bankruptcy, the counterparty is able to enforced and the actions taken by the undertake a different calculus in determining protected party to enforce the protected the necessary resources to recover on a claim contract are not subject to the automatic stay. against the bankrupt debtor, the amount The safe harbor provisions, therefore, enable recoverable, the timeframe in which the counterparties to protected contracts to recovery can be achieved and, equally terminate their financial contracts and exercise important, the ability to retain the recovery contractually agreed upon rights of liquidation, once achieved. As a result of these changes to termination and acceleration (e.g., enforcement the protected counterparty’s “calculus,” the through the netting and setoff of then Seller under a Repurchase Facility or a

2 Mayer Brown | Utilizing Repurchase Facilities and Related Protected Contracts as an Alternative Source for Fund Liquidity securities contract (described below) may government securities (defined as a obtain better pricing as compared to a typical security that is a direct obligation of, asset-level lending arrangement. or that is fully guaranteed by, the central government of a member of III. Common Characteristics of the Organization for Economic Cooperation and Development), or Repurchase Facilities and Securities securities that are direct obligations of, Contracts or that are fully guaranteed by, the United States or any agency of the Protected contracts entitled to safe harbor United States against the transfer of treatment under the Bankruptcy Code include funds by the transferee of such commodity contracts, forward contracts, certificates of deposit, eligible bankers’ master netting agreements, swaps, repurchase acceptances, securities, mortgage agreements and securities contracts. , or interests, with a simultaneous Repurchase Facilities are the most similar to a agreement by such transferee to typical secured lending arrangement and can transfer to the transferor thereof be used as an alternative to a secured lending certificates of deposit, eligible bankers’ arrangement if certain characteristics are met. acceptance, securities, mortgage A Repurchase Facility is similar to a secured loans, or interests of the kind lending facility in that the Buyer (or lender) described in this clause, at a date provides financing to the Seller (or borrower) for certain not later than 1 year after such a period of time and expects to receive a rate of transfer or on demand, against the return on the amount provided to the Seller. The transfer of funds . . . .2 rate of return is typically described as the “price In sum, the underlying asset subject to a differential” and, similar to interest on a loan, is Repurchase Facility must be (a) a security, payable periodically prior to or upon repurchase or an interest therein and (b) of the applicable asset(s) by the Seller. In sold with an automatic obligation to resell addition, Repurchase Facilities are usually such asset within one (1) year. treated by Sellers and Buyers as loans for and purposes. In addition, there are other protected contracts that can be utilized in a manner Unlike most other secured lending similar to secured lending arrangements. arrangements, Repurchase Facilities are “Securities contracts” under the Bankruptcy treated as protected contracts under the Code are similar to repurchase agreements, Bankruptcy Code and are afforded the safe with the notable exception that there is no harbor protections described above. Not every requirement to transfer the asset back to the lending contract can be a repurchase counterparty. However, the Buyer in agreement. In fact, to fit into the “repurchase connection with a “securities contract” must agreement” definition under the Bankruptcy be a stockbroker, securities clearing agency, Code, an agreement must: financial institution or financial participant. In [provide] for the transfer of one or other words, such entity must be: more certificates of deposit, mortgage an entity that, at the time it enters related securities . . . mortgage loans, into a securities contract, commodity interests in mortgage related securities contract, agreement, or mortgage loans, eligible bankers’ , or forward acceptances, qualified foreign contract, or at the time of the date of

3 Mayer Brown | Utilizing Repurchase Facilities and Related Protected Contracts as an Alternative Source for Fund Liquidity the filing of the petition, has one or agreement or securities contract under the more [securities contracts, Bankruptcy Code) should benefit both parties commodity contracts, repos, swaps or by providing the Buyer with safe harbor master netting agreements] with protections for the enforcement of remedies …any entity (other than an affiliate) of in connection with a bankruptcy of the Seller, a total gross dollar value of not less and likely providing the Seller with more than $1,000,000,000 in notional or favorable economic terms. actual principal amount outstanding (aggregated across counterparties) at IV. Conclusion such time or on any day during the 15-month period preceding the date As the fund finance market continues to of the filing of the petition, or has mature, both Funds and financial institutions gross mark-to-market positions of will continue to explore new and innovative not less than $100,000,000 ways to generate liquidity from existing pools (aggregated across counterparties) in of assets. In addition to the rise in Net Asset one or more such agreements or Value Facilities, Hybrid Facilities and transactions with the debtor or any Unencumbered Asset Pool Facilities (looking other entity (other than an affiliate) at beyond just the capital commitments of a such time or on any day during the Fund under a Subscription Facility to the 15-month period preceding the date underlying assets of a Fund as a source of of the filing of the petition…” or is a liquidity), we have seen an increase in the clearing organization (as defined in number of Funds entering into Repurchase section 402 of the Federal Deposit Facilities to obtain asset-level leverage Corporation Improvement (particularly for mortgage loans). Since Act of 1991).3 Repurchase Facilities provide Funds with another cost-effective method for satisfying While under the Bankruptcy Code a “securities their liquidity needs and optimizing returns for contract” is more broadly defined than a Fund investors, we expect to see continued “repurchase agreement”, the universe of growth of these financing arrangements in the potential “Buyer” counterparties to a securities coming years. contracts may be limited. Regardless, structuring asset-level financing as a “protected contract” (whether as a repurchase

Endnotes

1 Mayer Brown is a distinctively global law firm, uniquely positioned to advise the Todd Bundrant is a partner in Mayer Brown’s Banking & world’s leading companies and financial institutions on their most complex Finance practice. Susannah Schmid is a partner in the deals and disputes. With extensive reach across four continents, we are the Chicago office of Mayer Brown’s Banking & Finance only integrated law firm in the world with approximately 200 lawyers in each of the world’s three largest financial centers—New York, London and Hong practice. Eric Reilly is a partner in Mayer Brown's Banking & Kong—the backbone of the global economy. We have deep experience in high- Finance practice. Monique Mulcare's practice focuses on stakes litigation and complex transactions across industry sectors, including our signature strength, the global industry. Our diverse teams of restructuring, insolvency and bankruptcy matters. lawyers are recognized by our clients as strategic partners with deep 2 11 U.S.C. § 101(47). commercial instincts and a commitment to creatively anticipating their needs and delivering excellence in everything we do. Our “one-firm” culture— 3 11 U.S.C. §101(22A). seamless and integrated across all practices and regions—ensures that our clients receive the best of our knowledge and experience.

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5 Mayer Brown | Utilizing Repurchase Facilities and Related Protected Contracts as an Alternative Source for Fund Liquidity