The fund-raising market continues to be challenging for alternative investment funds. With the withdrawal of many high net worth investors following the financial downturn and the scarcity of traditional bank financing, sponsors have had to look for alternative sources of capital to bridge the funding gap. At the same time, the alternative fund landscape has experienced (or is in the process of experiencing) significant regulatory change and uncertainty, particularly in North America and Europe.
However, the subscription finance market is thriving. This is not surprising as it has experienced few defaults historically, and is therefore attractive to lenders. There is also evidence that pension funds, endowments, public investors and Sovereign Wealth Fund investors are increasing their investments into actively managed alternative funds to access opportunities in their struggle to find returns. After all, global equities have been underwater since 2007 and are not expected to recover from their financial crisis losses before 2015 (having halved in value not once, but twice in a decade), real interest rates are negative in some parts of the world and government guaranteed investments are no longer seen as risk free.
Our various offices have been actively involved in structuring and providing advice to numerous subscription finance deals and have identified some recent and emerging trends.
The Big Balance
Many funds now seem to have fewer investors, but those investors are investing larger amounts into single funds. The funds tend to be larger and in some cases are dominated by large investors. The big and often powerful investors are increasingly imposing bespoke terms on funds and often drive the structuring process - to enable them to access the fund. As a result, the traditional financing and fund deal models are evolving and developing. Now, more than ever, sponsors are having to balance the expectations of lenders whilst preserving (or at least not damaging) their relationships with their powerful investors.
The subscription finance market has traditionally been dominated by a handful of active lenders, but as new lenders enter the market, this is putting a downwards pressure on lenders' fees and their negotiating power at a time when the fund structures and their deal terms are evolving, and investors are becoming more dominant.
Getting the Basics Right
Fund terms vary enormously depending on the asset classes and strategy. Recent experience has shown that subscription financing is now being made available to funds with strategies and asset classes that historically have not been supported by these facilities. Extra vigilance is therefore required to ensure that, the credit and security terms are consistent with the fund document terms, and that commercially, the lender is fully collateralised and can properly enforce its security.
Under the laws we practise, the rights of the parties in these deals are derived under contract. This means that the fund documents must permit the fund to incur indebtedness and to grant the security required to complete the financing. The investors should have notice of the security granted, and a mechanism should be put into place to allow the lender to step in on default to enforce its security. There must also be express wording included in the fund documents whereby each investor acknowledges that its obligation to make the capital contributions is made without any right to set off, counter claim or waiver. These provisions are fundamental to protect a lender.
Side letters have become a common feature in the alternative investment fund landscape. A side letter is an investor's separate agreement with the fund that alters the terms of an investor's subscription. In their enthusiasm to accept subscriptions in a difficult fund raising environment, sponsors often do not engage their lawyers to review these letters and their terms are often inconsistent with the fund documents or include provisions that are not enforceable. These letters can impact on the lender's collateral base and security generally. The letters should be reviewed to check this and to ensure consistency with the fund documents, facility and security documents.
All Kinds of Everything
Blockers and master feeder structures are already used extensively in the US market to enable investors to access tax efficient fund structures. From a lender's perspective, it is critical that the security package flows all the way through the structure with cascading security arrangements supporting the cascading call obligations.
The use of managed accounts to access funds has increased, and we expect that they will continue to gain in popularity in the future. A managed account allows an investor to have its own SPV that will sit completely independent of the fund but invest in parallel with it. There are possibilities for financing on an independent basis here at the managed account vehicle level, with the collateral being supported solely by the SPV owner. However, the lender could argue that the obligations of the managed account vehicle (and its investor) should be assigned jointly and severally with those of the investors investing directly into the parallel fund. In one way, it could be said that a subscription finance deal is a loan by the lender in relation to the investment management strategy of the manager, supported by the creditworthiness of the investors to fund that collective strategy and that the managed account vehicle and the fund are simply conduits to allocate the monies to the manager for collective investment. However, an owner of a managed account vehicle with deep pockets might think otherwise and not be so receptive. These different interests need to be addressed.
Bespoke sidecars can address regulatory issues, e.g. AIFMD and are regularly being used. A non-EU manager of a non-EU fund can avoid compliance with AIFMD altogether if it is not soliciting investment in the EU. If it does solicit investors from the EU, the manager has AIFMD obligations. By bundling the EU investors into their own parallel fund or sidecar with an EU manager, that fund can be passported into the EU and the AIFMD compliance costs can be limited to the EU fund and its investors. The two funds essentially comprise one fund structure as they have only been separated for regulatory reasons and the investors in both funds should arguably comprise the borrowing base for the lender. On the documentation side, this would involve cross covenants and cross events of default but this can be achieved.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
