1 Introduction
The purpose of this chapter is to examine how global fund finance practices have evolved for more than a decade. This chapter will examine how practices have evolved in the Grand Duchy of Luxembourg, the United States, England and Wales, France, and will also briefly consider the Asian market.
2 From subscription credit facilities to NAV, hybrid and other types of facilities
The typical fund finance transaction a decade ago was carried out via a subscription facility agreement. In this type of transaction, a loan facility is granted at fund level based on the creditworthiness of the investors. Hence, the credit underwriting is against the investors and security interest is taken over both the undrawn commitments of the investors and the bank account of the fund where such commitments are to be paid. The purpose is that in the event of default, the lenders may "step into the shoes" of the general partner or the manager of the fund and claim to the investors direct payment of their undrawn commitments.
Over the course of the last decade, other types of transactions have emerged, such as net asset value (NAV) credit facilities and hybrid credit facilities. The difference between subscription credit facilities and NAV credit facilities is that the credit underwriting exercise is performed against the assets of the fund rather than against the investors. Such facilities are also known as being "asset-based". Security is taken over the shares of the portfolio companies and/or on the accounts where the proceeds deriving from the investments are to be received. Hybrid credit facilities combine aspects of both subscription credit facilities and NAV credit facilities.
More recently, we have also seen the emergence of fund finance solutions designed to provide liquidity options to general partners and fund managers, namely: general partner credit facilities and management fee facilities. The most common global set-up for a private equity fund is a partnership with a general partner and limited partners. However, the general partner may choose or may be required, depending on the relevant jurisdiction and the regulatory requirements, to delegate the management to a fund manager (such as an alternative investment fund manager). As such, there are fund finance solutions tailored by lenders in favour of the general partner. Here, the general partner will grant a pledge over the management fees to be received by it (if any), the distributions to be received from the fund, and over the bank accounts where the proceeds related to such distributions will be paid.
Similarly, there are fund finance solutions that exist for fund managers, which are secured by a pledge granted over the management fees to be received from the fund and over the relevant accounts where such fees are to be paid. Finally, we have seen increased interest in bespoke transactions as preferred equity solutions.
3 From investor letter transactions to non-investor letter transactions
A decade ago, a fund finance transaction would not close if satisfactory investor letters were not provided for the investors to be included in the borrowing base. In a typical subscription credit facility transaction, collateral is granted over the undrawn commitments of the investors. As a consequence, in the event of default, the lenders may claim direct payments from the investors. That being said, the investors may have legal grounds to refuse payment, such as a right of set-off or counterclaim. Since the credit of the investors is the core element of this type of transaction and that the loan is granted on the assumption that the investors will pay in the event of a default of the fund under the facility agreement, it is of paramount importance to ensure that there is no legal gap. To close the gap, the lenders seek to receive letters from the investors waiving any right of defence, set-off, counterclaims and other similar rights in respect of the payment of their commitments to the lenders. However, with the progressive increase of lenders and competition in the market, and the progressive recalibration of bargaining power between lenders and borrowers, it has become increasingly difficult for lenders to obtain investor letters. Consequently, solutions needed to be found in order to provide a similar level of comfort to lenders, and the necessary waivers started to be included directly in the fund documents, for the benefit of the lenders, in order to achieve such a purpose. This is based on different legal grounds depending on the law of domicile of the relevant fund. As to funds domiciled in Luxembourg, the technical legal grounds to achieve this were found in the toolkit provided by the Luxembourg Civil Code and the Luxembourg law of 5 August 2005 on financial collateral arrangements (the Luxembourg Financial Collateral Law). The Luxembourg Civil Code provides for the mechanism of third-party stipulation (stipulation pour autrui), whereby a party to an agreement may agree with its counterparty to grant rights in favour of a third party. In the context of a fund finance transaction, the investor will agree with the fund to grant rights to the lender. With the third-party stipulation mechanism, the fund and the relevant investor may agree to confer certain rights to the lenders, such as an undertaking from the investor to pay to the account determined by the lender pursuant to a drawdown notice sent by the lender in the event of default. Such mechanism needs to be captured in a contractual document, which, in the context of a fund finance transaction, would be the limited partnership agreement and/or the subscription agreements. On the basis of article 2 (5) of the Luxembourg Financial Collateral Law, the investor may waive any defence, right of set-off, counterclaim or any other similar type of right vis-à-vis the lender. Such waiver needs to be documented in a document signed by the investor, which may be the limited partnership agreement and/or a subscription agreement. Hence, in a transaction with a Luxembourg fund, in order to ensure that there is a similar level of comfort for the lenders than in a transaction with investor letters, both mechanisms should be appropriately captured in the fund documents.
Investor letters should not be confused with notices of security interest. Notices of security interest generally have two main functions. The first function is a legal technical function, where a notice of the collateral over the undrawn commitment is necessary for the perfection of the security, in light of the law governing such a security. The second function is a more commercial or informative function, where notice is not necessarily legally required, but is requested by the lender to ensure that the investors are aware that the relevant security agreement is in place. Concerning Luxembourg more specifically, the Luxembourg Financial Collateral Law provides that the perfection (dépossession) of security occurs by the mere conclusion of the pledge over claims, which is the form of pledge commonly used to have a security interest over the undrawn commitments of the investors. Although, the debtor may be validly discharged if he pays his creditor as long as he is not aware of the pledge. Fund finance transactions are generally cross-border and involve investors outside Luxembourg, so conflict of law rules must also be considered to determine the perfection requirements for the enforceability of the Luxembourg pledge vis-à-vis third parties. In this respect, Regulation (EC) 593/2008 of the European Parliament and of the Council of 17 June 2008 on the law applicable to contractual obligations (Rome I) is silent concerning the law applicable to determine the enforceability of a pledge over claim vis-à-vis third parties. Therefore, we need to look into specific Luxembourg conflict of law rules. In this respect, there is both a traditional view and a modern view. Under the traditional view, the perfection formalities applicable in the domicile of the debtors (i.e. the investors) are considered. In application of the modern view, perfection formalities of the law governing the relevant claim (i.e. Luxembourg law, in the context of investors' commitments governed by Luxembourg law) are considered. Therefore, these points need to be discussed between counsels, and the Luxembourg security needs to be appropriately structured in order to grant sufficient comfort to the lenders in this respect. Hopefully, such questions will be soon settled by the European Union as part of the Capital Markets Union initiative, which aims to set conflict of law rules applicable to the third-party effects of assignments of claims. The applicable law on the basis of the envisaged rule would be Luxembourg law.
4 Evolution of the security over undrawn commitments
In a subscription facility transaction, in terms of collateral over the undrawn commitments of the investors, the objective has not evolved as such. The idea is to have the possibility for a lender to step into the shoes of the general partner or the manager of the fund in the event of default and to claim direct payment to the investors. However, in some jurisdictions, the technical means of achieving this have evolved. To achieve this objective in Luxembourg, at the start of the last decade, there was generally a transfer of property for collateral purpose of the undrawn commitments from the fund to the lenders. However, the market has evolved to a pledge over claims whereby the undrawn commitments of the investors are pledged. The Luxembourg Financial Collateral Law provides that a pledge over claims encompasses the exercise of the rights attached to the pledged claims (droits liés à la créance gagée), hence, in respect to undrawn commitments, the right to claim payment of the same (i.e. the capital call right). Originally, for this type of transaction in England and Wales, a power of attorney by way of security was granted, so that in the event of default, the lender would have the possibility to exercise such power of attorney and send drawdown notices to the investors. Such a set-up evolved to an assignment of rights of the general partner and the manager of the fund under the limited partnership agreement to the lenders. In the United States, the approach has been consistent over the last decade: the state involved is generally Delaware, and a UCC-1 financing statement is filed against the fund and the general partner in order to have the possibility to call capital and enforce such right in the event of default. In France, to achieve the envisaged objective, the mechanism used is a stipulation for a third party. We see here the difference with Luxembourg where a pledge, which is a security interest as such, is used. Such difference is explained namely because, in France, the types of funds generally involved in fund finance transactions are not subject to bankruptcy; therefore, a third-party stipulation is sufficient. Conversely, in Luxembourg, the funds may be subject to bankruptcy proceedings, but Luxembourg financial collateral arrangements are bankruptcy-remote and remain enforceable even when bankruptcy proceedings occur. We see here two different ways in two different jurisdictions to reach the same objective.
5 Cross-border and domestic Luxembourg market
At the beginning of the last decade, the clear tendency was for foreign law-governed subscription credit facility agreements (generally New York law or the law of England and Wales), as the main actors granting facilities to Luxembourg funds were established in the United States or the United Kingdom. More recently, we have seen more local lenders and a tendency to have Luxembourg law credit facility agreements when local lenders are involved. This being said, in most fund finance transactions for Luxembourg funds, the facility agreements tend to be governed by New York law or the law of England and Wales.
6 Legal opinions
The position regarding responsibilities in relation to the issue of legal opinions has been quite consistent. In Europe, there is generally a split of opinion: the fund's counsel provides the capacity opinion, while the lender's counsel provides the validity and enforceability opinion. Conversely, in the United States, it is generally the fund's counsel that provides the full set of opinions. It should also be noted that, in practice, different lenders may have different requirements in terms of the content of opinion and so requesting the relevant lender's opinion checklist at the outset of the transaction is advised.
7 ESG fund finance, the last child
We have recently observed an increased demand for fund finance solutions with Environmental, Social and Governance (ESG) features. First, a clarification of terminology is necessary. There are typically two main types of loan involved in this field: green loans and ESG-linked loans. A green loan is a loan granted whose proceeds are used exclusively for green or environmental purposes. Conversely, for an ESG-linked loan, there is no limitation on the use of the proceeds, but the focus is on key performance indicators (KPIs) to be met in order to obtain a decrease of the pricing. Green loans are more suitable for impact funds while ESG-linked loans are more suited to private equity funds.
In this context, we have recently seen the emergence of ESG-linked subscription facility agreements. The mechanic and the security package are mainly the same as for a standard subscription facility agreement, but a margin ratchet mechanism is embedded in the documents so that there is a reduction of pricing where the agreed KPIs are met. One important step for ESG-linked subscription facility transactions is the prior due diligence, where the lender tries to understand the ESG policy of the relevant fund and agrees with it on the KPIs. The idea is generally to build on the existing policy, the existing standard adopted by the relevant funds, and the existing frequency of reporting. Examples of KPIs seen include gender diversity in management, certain carbon emission targets, and specific governance requirements. In order to avoid "greenwashing", it is of paramount importance to have measurable KPIs, and another core aspect in this respect is monitoring. Monitoring may be done externally, by a rating agency, for instance, or internally by the relevant lender where it has the qualified personnel in this respect. In terms of volume of this type of fund finance transaction, Europe is leading the way. It should also be noted that fund finance lawyers advising on this type of transaction in the European Union need to master the increasing EU regulation around sustainability; for instance, Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability‐related disclosures in the financial services sector (the Disclosure Regulation) and Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment (the EU Taxonomy). The EU Taxonomy may be seen as a framework, a classification, or a dictionary setting out what is sustainable or not, so that there is a common understanding on the subject. The EU Taxonomy will be completed by delegated acts from the European Commission setting up relevant technical screening criteria.
8 Fund finance in Asia
Fund finance has become a very active market in Asia in approximately the last six years. Generally, the set-up of a fund finance transaction in Asia is somewhat similar to some fund finance transactions seen in the United States: there is typically a Cayman fund and a credit facility agreement governed by New York law, with a similar security interest to that in a standard US fund finance transaction. The difference is simply that the investors are located in Asia. This being said, while the Cayman Islands remains the domicile most commonly seen in Asian fund finance transactions, there is an emergence of Singapore and Hong Kong funds. In Hong Kong, the Limited Partnership Fund Ordinance (Cap. 637) entered into force on 31 August 2020 and introduced a new limited partnership fund regime to enable private funds to be registered in the form of limited partnerships in Hong Kong. The idea is to foster the development of private equity funds in the special administrative region. From a Luxembourg perspective, there have been more and more fund finance transactions involving Asia. Luxembourg remains the domicile of choice for European investors. In such context, where European and Asian investors invest in the same pool of assets, European investors would invest through a Luxembourg fund while Asian investors would invest through a fund most commonly used in Asia. In such a configuration, Luxembourg legal requirements are implied in Asian fund finance transactions.
9 Conclusion
Luxembourg is a unique jurisdiction from which to observe the evolution of fund finance globally, as it is a domicile of choice for private equity funds and there are often Luxembourg aspects in global fund finance transactions. Global fund finance is constantly evolving and is an industry where innovation is always present. The fund finance market will certainly continue to evolve and grow in the coming years in view of the number of outstanding and innovative experts in this industry.
Originally Published by Global Legal Insights
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