Fund finance operations are based on efficient and reliable processes, which ensure secured and robust business practices. This reliability is achieved through the credit underwriting process, the terms of the facility agreement and the security package.
We thought that it would be helpful to have a document available for lenders, borrowers and lawyers, describing the main aspects of the security package in the most common jurisdictions involved in fund finance transactions.
We want to thank all the contributors around the globe for joining us in this initiative and helping us to put this together.
Contributed by Michael Mbayi | Wildgen S.A.
- Description of the security package
One of the key elements that differentiates fund finance products is the credit underwriting. On a subscription facility transaction, the lenders underwrite the credit of the investors of the fund. As a consequence, in the event of default, the lenders want to have the possibility to step in the shoes of the fund or its general partner and claim direct payment from the investors for their undrawn commitments.
This objective, form a Luxembourg perspective, is commonly covered by a pledge over the claims (gage sur créances) of the investors vis à vis the fund. Furthermore, article 5 (4) of the Luxembourg law of 5 August 2005 on financial collateral arrangements ("Luxembourg Collateral Law") states that "the pledge of a claim implies the right for the pledgee to exercise the rights of the collateral provider linked to the pledged claim". On such a basis, where a claim of an investor vis-à-vis the fund is pledged, it may be considered that it encompasses the right to claim payment (i.e. in practice the right to send a drawdown notice to claim such a payment).
The security package would be incomplete without a pledge over the bank accounts where the commitments of the investors are to be paid. Hence a Luxembourg pledge over the relevant Luxembourg bank account of the fund is as well required.
The standard Luxembourg security package includes then a pledge over undrawn commitments (technically a pledge over claims) and a pledge over bank accounts but depending of the fund documents or the fund structure, adaptations to the security package may be necessary (for instance cascading pledges, additional guarantees, etc.).
To close this section, we may mention that Luxembourg collateral law is the most advanced implementation of the EU Financial Collateral Directive1 and offers generally "bankruptcy remote" security interest for the pledges under its scope.
- Perfection formalities
Pledge over claims: Article 5 (4) of Luxembourg Collateral law states "the transfer of possession is effected as against the debtor and the third parties by the mere conclusion of the pledge contract." Although, the debtor may be validly discharged if such a debtor pays the relevant creditor as long as such debtor is not aware of the pledge.
Hence, from a strict Luxembourg substantive law perspective, the perfection (dépossession), is effected by the mere execution of the pledge. However, a notification should be considered so that the investors are aware of the pledge from the outset.
This being said, an important caveat is that fund finance transactions are generally global and involve investors located in a wide variety of jurisdictions. Consequently, Luxembourg specific conflict law rules concerning the enforceability of pledges over claims vis-à-vis third parties must also be taken into consideration.2 In this respect, there is a traditional view and a modern view. According to traditional Luxembourg conflicts law rules, the perfection formalities of the domicile of the debtor (i.e. the investors in the context of a fund finance transaction) are considered. According to the modern view, the perfection formalities of the law governing the claim (i.e. Luxembourg law, in the context of investors commitments governed by Luxembourg law) is to be considered. A route to address this could be to require a notification of the security to the investors, since this is a perfection formality in many jurisdictions, but your Luxembourg counsel must be involved from the outset to discuss these questions and to structure the security appropriately in light of the particular transaction.
Pledge over bank accounts: for such a security, a notice is sent to the account bank and the account bank send an acknowledgment of the pledge to the parties. The acknowledgment is of particular importance since the account bank has generally a pledge over the accounts by virtue of its general terms and conditions and such a pledge must be released in the acknowledgment so that the lenders may have a perfected security over the bank account.
- Fund finance provisions vs investor letters
One of the key assumptions of the credit underwriting process is that in the event of default under the facility agreement, that the investors will pay their commitments to the lenders without exercising any right of set-off, counterclaims or other type of legal defences. Lenders also want that it is expressed for their benefit that the investors commit to fund their commitments on the collateral account.
Nowadays, the typical way to cover these two elements is to have specific fund finance provisions in the limited partnership agreement or in the subscriptions agreements or other contractual documents between the fund and the investors (depending on the type of fund, corporate from or fund structure).3
This is implemented technically using two concepts, one provided by Luxembourg collateral law in its article 2 (5) which provides that: "the debtor of a claim provided as financial collateral may waive, in writing or in a legally equivalent manner, his rights of set-off as well as any other exceptions vis-à-vis the creditor of the claim provided as collateral and vis-à-vis persons to whom the creditor assigned, pledged or otherwise mobilised the claim as collateral". The second concept is provided by the Luxembourg Civil Code and is the third party stipulation (stipulation pour autrui).
Where there is no waiver of defence, set off, counterclaims and other specific fund finance provisions in the contractual fund documents, a solution to address this is to request investor letters where such waivers are provided. The due diligence will be an important step to determine whether this is requested.
In addition, on separately managed accounts transactions or where there is an important concentration in terms of investors (for instance, for funds of one), investor letters may be as well typically requested.
- Description of the security package
On a NAV facility transaction, the lenders underwrite the assets of the fund. This is a totally different exercise than for the subscription facilities since the focus is looking down in the structure on the assets and the exercise may differ depending of the relevant asset class.
Therefore, understanding the fund structure, the underlying assets as well as undertaking a comprehensive due diligence are steps of a paramount importance to determine the security package.
Luxembourg counsel is typically involved in NAV transactions where the borrower is a Luxembourg entity or for transactions where the borrower is not a Luxembourg entity, where the assets to be pledged are located or deemed to be located in Luxembourg.
For private equity funds, the holding company and the portfolio companies, down in the structure as well as the bank accounts where the proceeds of the investments are paid may be pledged. In practice, this means that Luxembourg pledges over shares are taken in respect of Luxembourg companies and Luxembourg bank account pledges for the accounts located in Luxembourg.
For debt funds, pledge over receivables/claims and pledge over bank accounts may be taken. Where there is a holding company in the structure possessing the assets, a pledge over shares may be taken as well.
For secondary funds, a pledge over the limited partnerships interests owned by the funds may be taken as well as a pledge over the accounts where the proceeds deriving from the investments are paid.
All the above is stated under the caveat that the security package may change in light of the relevant fund structure or the relevant assets, since NAV transactions tend to be bespoke.
- Perfection formalities
Pledge over shares: In practice a copy of the shareholders' register of the relevant Luxembourg company recording the pledge granted is requested.
Pledge over limited partnership interests: a copy of the register of the limited partners mentioning the pledge granted is requested. A particular attention must be made where reviewing the relevant constitutional documents to check whether there are particular transfer restrictions (such as, typically a consent from the General Partner). Depending of the form of the fund, there may be as as well legal transfer restrictions (in other words, investing into a particular fund may be limited by law to certain type of investors).
Pledge over claims: we refer to the considerations developed under the section "Perfection formalities" of the section "Subscription Facilities", which applies mutatis mutandis, with the reference here to a debtor instead of an investor.
Pledge over bank accounts: we refer to the developments made under the section "Perfection formalities" of the section "Subscription Facilities".
To view the full article please click here.
1. Directive 2002/47/EC of the European Parliament and of the Council of 6 June 2002 on financial collateral arrangements.
2. We invite you to read our contribution to the GLI Fund Finance 2022: More than a Decade of Global Fund Finance Transactions, if you want to further dig into these aspects.
3. To dig more into the evolution of this practice, we invite you to read our contribution on the GLI Fund Finance 2022 mentioned above.
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.