In this In Practice article we will explore the benefits of obtaining a rating for a subscription facility. By reference to ratings criteria announced by the main agencies, we will explore how the limited partnership agreement, side letters and the related finance documentation are analysed to arrive at a rating.
Subscription credit facilities are typically structured as a revolving facility, designed to provide liquidity to a fund pending receipt of call proceeds from its investors. Such facilities may be drawn for the purpose of funding the equity portion of investments acquired by the fund, for the fund's general working capital purposes or for any other purpose permitted by the fund documents.
1 Credit ratings for subscription lines
The rating of facilities has emerged as a way of bridging a liquidity gap in a lending market that has at times struggled to keep pace with the demands of its customer base. Banks have scaled back their subscription line lending, in part due to capital adequacy considerations. A lender obtaining a rating for a facility may enable them to access more favourable capital treatment for that lend. Ratings can also bolster interest from non-bank lenders (such as insurance companies and pension funds) in the fund finance market. This entrance of institutional capital into the lending pool has also featured banks introducing the wider syndication of facilities to their own institutional investor base, as investors actively seek to purchase portions or tranched exposure to bundled subscription line loans. As a rating can bring wider access to potentially deeper and cheaper pools of capital, it has the potential to bring more favourable pricing; a benefit to sponsors.
To date several rating agencies have published methodology supporting the assignment of ratings to fund obligations backed by capital call commitments. In our analysis below, we focus on the stated ratings criteria of Fitch Ratings (Fitch) and Kroll Bond Rating Agency (KBRA). Moody's Investor Service have also published methodology for rating subscription facilities and S&P Global have indicated an intention to do so.
The security package of a subscription line will typically include security over the unfunded capital commitments of the fund's investors and the right to make capital calls on them. Consequently, the rating of a subscription line involves extensive analysis of the credit quality and diversification of the limited partner (LP) pool. A common theme is that a thorough review of a fund's governing documents and the facility agreement itself form an integral part of the qualitative assessment within the ratings process.
2 Limited Partnership Agreement and side letters
Defaulting LP remedies
LP default remedies are actively considered when producing ratings. Limitations on these remedies are considered one of the higher impact terms in Fitch's qualitative assessment. Robust LP default remedies included in the limited partnership agreement (LPA) can increase recovery rates and provide significant economic incentive for LPs to fund capital calls, and therefore will positively impact the facility rating. Consequently, LPA or side letter provisions that limit the general partner's (GP) and/ or fund's ability to exercise its defaulting LP remedies will have a negative ratings impact. The Fitch methodology looks specifically at projected recovery rates, so those remedies that will directly lead to a higher recovery in the event of a default (such as a forced transfer or sale of the defaulting LP's interest and overcall) may result in a greater uplift than those remedies that act primarily as economic incentives (such as suspension of voting rights and exclusion from future investments). The KBRA methodology looks at defaulting LP remedies as part of the alignment of interests between the fund and the LPs, and there is not the same stated focus on how a particular remedy affects the fund's recovery.
Overcall
The ability to overcall in the event of a defaulting LP is unsurprisingly specifically noted by both Fitch and KBRA as a desirable LP default remedy. Although neither of the methodologies go into specific detail, it would be reasonable to expect that LPAs that provide for the GP's ability to overcall without limitation (up to the amount of each non-defaulting LP's undrawn commitment) will receive more favourable treatment than overcall provisions that include limitations on the amount or number of subsequent calls or the items for which overcalls may be made. It remains to be seen how the ratings agencies evaluate LPAs that do not have explicit overcall rights, but which do not explicitly prohibit or limit overcalls – funds lawyers in Europe often taking the view that if an LPA is silent, the GP can effectively overcall by simply calling capital again, but this does remain largely untested in practice.
Lender protections
Although not explicitly set out in either published methodology, an LPA that expressly contemplates subscription facilities, where LPs acknowledge related lender protections, should positively impact the facility rating. These provisions will likely make it harder for an LP to refuse to fund to a lender, thereby boosting the expected recovery rate on a default. Relevant provisions would include: (i) specific powers of the GP and fund to incur subscription facility debt and secure such debt with capital call rights, capital contributions, and remedies against a defaulting LP; (ii) an acknowledgment by LPs that their capital commitments and capital contributions may be pledged to a lender in respect of subscription facility debt; (iii) agreement by LPs to fund their capital contributions, called for the repayment of subscription facility debt, without defence, set-off or counterclaim and in accordance with lender instructions; (iv) an acknowledgment by LPs that their claims are subordinated to the lender's claims; and (v) express third-party rights being afforded to subscription line lenders.
Ability to call following end of investment period
Any limitation on the GP's ability to call from LPs during the life of the facility could impair recovery rates and will likely factor into the facility rating. We would expect that LPAs that specifically provide that capital can be called to repay indebtedness at any time, including after the suspension, termination or expiration (scheduled or otherwise) of the investment period, would have a positive impact on the rating, particularly if the LPA specified that such calls could be made regardless of when the debt was incurred (pre- or post-expiry of the investment period).
Transfers and withdrawals by LPs
The pool of included (and to some extent non-included) LPs at any given time is key to the ratings analysis. LPAs and/or side letters that allow LPs to transfer and/or withdraw without GP consent in certain circumstances may negatively impact the facility rating, as the fund may come to comprise a less creditworthy pool of LPs over time. Under the Fitch methodology, two special purpose vehicles (SPVs) with a common parent may even be rated differently because a SPV's rating is not based solely on its sponsor's own rating; hence it is conceivable that even affiliate transfers (often permitted under fund documentation without GP consent, or with consent not to be unreasonably withheld) might impact the applicable facility rating.
Fund jurisdiction
Funds organised outside of the typical fund jurisdictions used by the majority of borrowers in the European market (which, although not specified in either methodology, would presumably include Delaware, England, Scotland, the Channel Islands, Luxembourg, Ireland and the Cayman Islands) may be given a lower assessment in Fitch's recovery rate analysis, as there may be some uncertainty regarding governance and enforcement in these jurisdictions.
Key person risk
A factor to be considered in the KBRA methodology is key person risk in the investment team. As a result, it is possible that LPAs that only allow LPs to suspend or terminate the investment period after multiple key persons have departed (and with a narrow definition of "departure" and/or permissive replacement processes) may be evaluated differently to LPAs under which a "Key Person Event" is triggered after the departure of one or a small number of identified key persons.
Most favoured nation
"Most favoured nation" (MFN) clauses that give LPs the benefit of favourable provisions contained in the side letters of other LPs in the borrowing base impact the ratings analysis. Ratings agencies may reduce by several notches the credit rating of an LP that benefits from broad MFN clauses.
Sovereign immunity
An LP comprising a government/state entity could claim sovereign immunity in a dispute relating to the fund documents. In the absence of a waiver of this right, ratings agencies have noted that they may notch down LP ratings by up to three notches.
3 Finance documentation
Under currently published guidance, key provisions contained in the finance documentation that may have a bearing on an overall rating include controls, rights and triggers, which directly pertain to the day-one and ongoing make-up of the borrowing base and related advance rates.
Structurally, baseline expectations of a typical capital call security package (with linked account controls and powers of attorney) will be measured, as will the level of over-collateralisation (ie level of uncalled commitments secured versus debt quantum). Whether an "all-investor" or "cherry-picked" borrowing base is adopted under the facility will likely be relevant to the assessment of its current and future make-up, as will whether flat or stepped advance rates are employed (usually by reference to how "called" the investor base is at any given time). In a similar fashion, appliable concentration limits, LP ratings triggers and the relative strength and breadth of "Exclusion Events" for removing LPs from the borrowing base will also be highly relevant, including the extent to which such provisions extend to ultimate beneficial owners and credit support providers of SPV or non-substantive direct investment vehicles. Likely positive factors may also include any requirements for minimum capital calls either before initial utilisation and/or regularly during the life of the facility and robust protections around changes to the fund structure and required future accessions of feeder funds and/or AIVs (alternative investment vehicles) (where applicable).
Whilst not currently covered in detail in the published methodologies, it seems highly likely that the construction and number of financial covenants contained in the subscription line will also be examined, to determine the relative strength and breadth of downside warning triggers and protections. In this context, beyond standard UCC cover, the inclusion of downwards-looking financial covenants in the form of minimum NAV or NAV-linked loan-to-value covenants or investment value-based tests are likely to be seen as positive factors directly linked to maintaining investor willingness to fund capital calls. Logically appropriate parameters around a borrower's exercise of covenant cure rights are also likely to be reviewed, as is the inclusion and scope of protections and events of default linked to overall LP base defaults, exclusions and shifts (via LP transfers) – all potentially providing further comfort on changes in LP sentiment, behaviour and concentration.
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.
