Fund of Funds Financing: Secondary Facilities for PE Funds and Hedge Funds

Article Fund of Funds Financing: Secondary Facilities for PE Funds and Hedge Funds By Todd Bundrant, Mark Dempsey and Ann Richardson Knox1 Real estate, buyout, infrastructure, debt, Facility”), particularly in the context of Funds secondary, energy and other closed-end funds which invest in other Funds (“PE Secondary (each, a “Fund”) frequently seek to obtain the Funds”). In a typical structure, the PE Secondary benefits of a subscription credit facility (a Fund arranges for a credit facility to be provided “Subscription Facility”). However, to the extent to a subsidiary of the Fund (the “Vehicle”) as the that uncalled capital commitments may not be borrower that is established for purposes of available to support a Subscription Facility (for holding/ acquiring Investments on behalf of the example, following expiration of the applicable PE Secondary Fund, and such Vehicle is restricted investment or commitment period, a Fund’s from having any indebtedness other than the NAV organizational documentation does not Facility. As security for this type of NAV Facility, contemplate a Subscription Facility) or a 100 percent of such Vehicle’s equity is pledged in Subscription Facility already exists, alternative favor of the Lender (along with its bank accounts fund-level financing solutions may be available to receiving both capital contributions from the Funds based on the inherent value of their parent Fund(s) and distributions from the investment portfolios (each, an “Investment”). As Investments). Additionally, in many transactions, Fund finance continues to grow in popularity, guarantees from the PE Secondary Fund are banks (each a “Lender”) have been working with provided in support of such Vehicle’s obligations their private equity and hedge fund clients in under the NAV Facility and/or support the particular to assist them with unlocking the value payment of any unfunded commitments relating of their Investments. The appetite for liquidity to the Investments. Certain contractual rights may among these Funds dictates facilities that share also be provided to permit the Lender to require similar characteristics, although hedge fund or direct the disposition of Investments held by financing includes unique issues to address in this the Vehicle after a default of the NAV Facility. expanding market. This general structure is often used to secure a NAV Facility, such that a PE Secondary Fund is One solution for providing liquidity to a Fund is to able to pledge the equity of the entity holding the structure borrowing availability based on the net Investments as collateral. We note that as with asset value (“NAV”) of a Fund’s Investments. any NAV-based credit facility, due diligence with Although lending against a Fund’s Investments is respect to the Investments may be required to a far different credit underwrite than a traditional confirm that transfer restrictions2 in the Subscription Facility, we have seen a steady underlying subscription documents and increase in NAV-based credit facilities (a “NAV partnership agreements relating to such private equity Investments would not be violated by the applicable to the Investments, in the context of pledge of such equity, and if necessary, Secondary Facilities for a Hedge Fund of Funds, appropriate consents to such pledges can be the applicable Master Fund segregates the obtained. Hedge funds investing in other hedge Investments serving as collateral into a “securities funds (each, a “Hedge Fund of Funds” or “Master account” under Article 8 of the UCC which is Funds”) are increasingly seeking to utilize a subject to a control agreement executed by a similar structure to obtain the benefit of Fund- securities intermediary (“Securities level financing for purposes of portfolio Intermediary”) in favor of the Lender. By management (access to liquidity without the segregating these assets into a separate securities necessity of exiting illiquid positions in an account, the Securities Intermediary becomes the untimely manner), facilitating redemptions legal owner of each hedge fund Investment in and/or to enhance returns through leverage. which the Master Fund invests by executing the Recently we have noted an uptick in Lenders applicable subscription documents of the providing financings for Hedge Funds of Funds underlying hedge fund Investment (while the based primarily on the NAV of its Investment beneficial ownership of such Investment remains portfolio, i.e., the limited partnership interests in with the Master Fund). This structure thereby other funds (hereinafter, a “Secondary Facility”). enables the Master Fund borrower to pledge its In this article, we set out the basic structure and “security entitlement” (described below) in the likely issues that may be presented in the context underlying hedge fund assets in the securities of a Secondary Facility for Hedge Fund of Funds. account to the Lender while the direct owner of such Investment remains unchanged without Basic Structure violating certain transfer restrictions which may otherwise be applicable (similar to the PE Secondary Facilities for Hedge Funds of Funds are Secondary Fund structure described above). a highly specialized type of NAV facility and can take multiple formats, including that of a However, the right to foreclose on any applicable Investments will remain subject to any applicable straightforward credit facility, a note purchase transfer restrictions, so the Lender’s primary agreement or a pre-paid forward sale under an ISDA master agreement used in over-the-counter remedy is redemption (where the Lender instructs the Securities Intermediary to redeem the hedge derivatives transactions. Regardless of form, these fund interests credited to the securities account facilities contain common components. Traditionally, availability under a Secondary pursuant to the terms of the control agreement). And although such redemption also remains Facility is limited to an amount equal to the subject to any timing constraints set forth in the “Eligible NAV” of the “Eligible Investments,” multiplied by an advance rate. The “Eligible NAV” hedge fund subscription documents, transfer restrictions should not preclude a practical typically equals the NAV of the Eligible realization on the underlying collateral. Investments, less any concentration limit excesses deemed appropriate by the Lender under the It should also be noted that feeder funds (each, a circumstances. “Eligible Investments” will “Feeder Fund”) can obtain similar financing by typically be a subset of Investments that are not establishing a securities account with respect to subject to certain exclusion events or other its Investment in the Master Fund (thereby limitations as described in further detail below. enabling the Investment in the Master Fund to serve as the “Eligible Investment” for the While a common approach to collateralizing NAV Facilities for PE Secondary Funds is for a Lender Secondary Facility). In this scenario, the portfolio requirements established by the Lender in order to obtain an equity pledge of the Vehicle in order to determine the suitability of the collateral to address potential transfer restrictions 2 Mayer Brown | Fund of Funds Financing: Secondary Facilities for PE Funds and Hedge Funds | Fall 2016 supporting the Secondary Facility (described impacting the general partner of an underlying below) are typically tied to the Master Fund’s Fund (such as general partner “bad boy” acts or portfolio of underlying investments. replacement of the general partner). Appropriate exclusion events and diversification requirements Portfolio Requirements are key elements for any Lender providing a NAV- based credit facility as Investments failing to In many cases Borrowers that enter into Secondary Facilities will have a mature portfolio satisfy these criteria will not be included in the borrowing base (while these requirements must of Investments, so a Lender may assess at the also be balanced with the need of the Master Fund outset which Investments should be included as “Eligible Investments” for the NAV of the to retain appropriate flexibility for purposes of maximizing portfolio value). In any event, Secondary Facility (otherwise Lenders may look ongoing portfolio monitoring and reporting to the investment guidelines provided for in the Master Fund Private Placement Memorandum to requirements will be imposed on the applicable borrower throughout the term of the Secondary establish eligibility criteria for the proposed Facility as further described below. Secondary Facility). Regardless, Lenders will ordinarily be sensitive to the composition of such portfolio of Eligible Investments, and as a result, Advance Rate and Financial Covenants will set forth requirements with respect to In connection with Secondary Facilities for Hedge diversification of the portfolio, investment Funds of Funds, Lenders establish an “Advance strategy and minimum liquidity. Common Rate” with respect to the NAV of the Eligible diversification requirements include the Investments to be acquired and/or refinanced following: limitations on the NAV of the largest with the proceeds of the Secondary Facility, as Investments, sponsor diversification, minimum may be adjusted to reflect a “haircut” specified by number of Investments, limitations on the the applicable Lender. Such a “haircut” (or particular types of Investments involved discount) methodology is Lender specific and will (infrastructure vs. buyout, growth, venture and often be set forth on an appendix to the initial

Load more