The rise of the direct lending market has led to a dramatic rise in supporting liquidity strategies to optimize the market. These strategies include the use of financings to provide market participants with leverage and/or supplemental liquidity to support their direct lending activities. These financing go by various names, including private credit ABL, SPV drop-down, CLO-lite, and CLO warehouse, among others, but have a common general structure that draws from traditional secured lending and structured financing transactions. In this Legal Update, our team addresses some of the basic characteristics, structural considerations and complexities that are present in these facilities.
Direct lending involves the extension of credit by nonbank institutions and Insurance Companies to private funds and other borrowers generally in the middle market. Over the past twenty years, the direct lending market has experienced dramatic growth. Because middle-market loans are generally not traded on the secondary market, the strong growth in direct lending has created a commensurate demand for strategies to optimize the capital structure of the nonbank participants in the market. Strategies that provide leverage or additional liquidity, such as private credit financings, are in high demand by these market participants and that demand is projected to continue to grow with the direct lending market. This Legal Update addresses some of the basic characteristics, structural global considerations, and complexities that are present in these facilities.
Benefits and Basic Structure
Private credit portfolio back leverage, also commonly referred to by other names, including SPV drop-down facilities, CLO warehouse, CLO-lite, ABL CLO facilities or simply back leverage, among others, is meant to provide financing to direct lenders. While the nomenclature is not consistent, the benefits and the financing structures are. A typical private credit portfolio back leverage financing facility will have the following structure. The direct lender (the "Non-Bank Lender") creates a special-purpose vehicle (the "SPV Borrower") that is 100% owned (directly or indirectly) by the Non-Bank Lender that will enter into a financing facility (the "Loan Agreement") with one or more financial institutions as lenders (the "Lenders"). The collateral securing the Loan Agreement will predominantly consist of a revolving pool of direct lending loan obligations under which the Non-Bank Lender acts as lender ("Loan Assets"). The Loan Assets are sold or contributed by the Non-Bank Lender to the SPV Borrower pursuant to a sale or contribution agreement. The sale or contribution is intended to transfer legal title of the Loan Assets to the SPV Borrower so that the financial and operational risk of the Non-Bank Lender (including a Non-Bank Lender bankruptcy) does not impact the SPV Borrower or its assets. Collections on the Loan Assets, paid by the underlying obligors, are deposited directly into a controlled account and such collections are released at designated dates under the Loan Agreement in accordance with a negotiated waterfall of payments to the appropriate parties (as described in more detail below). The Non-Bank Lender or one of its affiliates will often act as servicer or collateral manager ("Servicer") under the Loan Agreement, and will be responsible for the servicing, administration and management of the Loan Assets.
The transaction documents for the facility will generally consist of a Loan and Security Agreement, a sale or contribution agreement, one or more fee letters, and a securities account control agreement that will cover a group of accounts opened in the name of the SPV Borrower, each with specified purposes (depending on the transaction, such accounts could include an account to receive interest collections, a separate account for principal collections, a payment account from which all payments are made, an interest reserve account and unfunded reserve account, among others – depending on the needs of the specific transaction). Additionally, facilities may utilize third-party service providers to act in various capacities, such as collateral agent, custodian, verification agent and/or backup servicer. Facilities may be bilateral or syndicated and may include multiple tranches of advances and alternative currency advances.
These private credit portfolio back-leverage financings benefit Non-Bank Lenders in several ways. These facilities increase a Non-Bank Lender's lending capacity by upstreaming loan proceeds received by an SPV Borrower under a Loan Agreement. The SPV Borrower is not upstreaming loan proceeds as a dividend, but uses the loan proceeds to purchase the Loan Assets from the Non-Bank Lender. The Non-Bank Lender can then use the proceeds from such Loan Asset sale to acquire or originate additional Loan Assets without calling on equity. By using loan proceeds in lieu of equity, the Non-Bank Lender also reduces its cost of capital as interest under the Loan Agreement is expected to be less expensive than the target return to the Non-Bank Lender's equityholders. In addition, using the SPV structure isolates the Loan Assets in the SPV Borrower and avoids introducing operational or financial risk issues (including a Non-Bank Lender bankruptcy) that a Lender might have if it were lending directly to the Non-Bank Lender against the same Loan Assets. This isolation of assets and limitation of risks increases the leverage a Non-Bank Lender may receive from Lenders with respect to any given Loan Asset, may lower the interest rate that the SPV Borrower pays and ultimately lower the Non-Bank Lender's cost of funds. By using these private-credit financing strategies, a Non-Bank Lender is able to optimize its capital structure and to continue to expand its operations in the direct lending market.
Key Characteristics of Private Credit portfolio back leverage facility
Bankruptcy Remote SPV Borrower. A key component of most structured financing products is the use of a bankruptcy-remote entity. Private credit portfolio back leverage financings are no exception to that rule. A "bankruptcy remote" entity is one that through its organizational documents and contractual agreements is subject to certain obligations that minimize the risk of the entity being subject to a voluntary or involuntary bankruptcy proceeding. The organizational documents and contractual undertakings of an SPV Borrower in these transactions would typically include the following traditional characteristics to evidence that the entity is bankruptcy-remote. The SPV Borrower will have a limited purpose, tailored to the activities necessary to effect the specific transaction for which it was formed. The SPV Borrower will generally be subject to a requirement to maintain an independent director whose vote would be required for the applicable entity to file a voluntary bankruptcy petition. The SPV Borrower will be subject to separateness covenant obligations including, among other items, to: (i) maintain its own books and records separate from any other entity, (ii) maintain its accounts separate from other entities, (iii) not commingle assets, (iv) maintain separate financial statements, and (v) conduct business in its own name, among other traditional indicators of separateness. The goal of these bankruptcy-remote requirements is to limit the potential that the SPV Borrower will become subject to bankruptcy proceedings, which would introduce material limitations and delays on a creditor to take enforcement actions against a borrower or the assets against which it extended credit.
Loan Asset Eligibility Criteria. Given the only credit
recourse of Lenders in a private credit ABL financing is limited to
the assets of the SPV Borrower, it is not surprising that the Loan
Agreements in such transactions typically set forth specific
criteria that the Loan Assets are required to satisfy to be
acquired by the SPV Borrower. In some private credit transactions,
assets that satisfy the eligibility criteria (sometimes referred to
as the "buy box" criteria) will be automatically included
in the Loan Assets of an SPV Borrower when acquired by the SPV
Borrower. In other transactions, the Lender may retain some
discretion to reject assets even if they satisfy the specified
criteria. The requirements that are included in the eligibility
criteria will be specific to the private credit transaction. In
some instances, such criteria is dictated by the exit strategy for
the transaction, such as in a CLO warehouse. If the exit strategy
is the issuance of a CLO, the requirements of the CLO market will
dictate what assets can comprise the Loan Assets and will be
reflected in the buy-box criteria. In other transactions, there may
be more flexibility, such as a private credit portfolio
back-leverage transaction where the Loan Agreement is expected to
mature over a specified tenor without accessing an established exit
market. In such a case, the eligibility criteria will be negotiated
between the parties to fit the particular need of the Non-Bank
Lender and the tolerance of the Lenders and might be expected to
include criteria such as (i) whether a loan is a senior loan, a
second lien loan, unitranche loan, a recurring revenue loan, an ABL
loan or other loan type, (ii) leverage levels of loans, (iii) the
currency of a loan, (iv) the tenor of the loan, and (v) whether the
loan can be a participation interest, among other criteria.
Reinvestment Period/ Amortization Period. Private credit
portfolio back-leverage transactions have varied tenors commonly
ranging from three to five years, but regardless of the tenor,
these facilities typically have two distinct periods. During the
initial period of the facility, the SPV Borrower will be permitted
to draw down loans under the Loan Agreement generally for the
purpose of acquiring additional assets from the Non-Bank Lender
through the loan sale or contribution agreement. This period is
commonly referred to as the "Reinvestment Period" and
would be expected to align with the "investment period"
of the parent Non-Bank Lender. The Reinvestment Period under a Loan
Agreement might run for several years. The second distinct period
of these facilities is commonly called the "Amortization
Period" and (as the name suggests) during this period the
facility will amortize. The amortization schedule for any specific
private credit transaction will be negotiated, but generally the
cash sweep requirements increase over this period, potentially
reaching a 100% capture of principal repayments from the Loan
Assets not later than the last year of the Amortization Period.
Specialized Accounts and Prescribed Waterfall. Collections on the Loan Assets will be credited into blocked accounts and distributed pursuant to a specified priority of payments on a regular time frame (commonly, monthly or quarterly). Because the SPV Borrower is a limited-purpose entity without any practical operations, the collections of the Loan Assets can be aggregated in a "collection" account for the relevant period and released in a waterfall on a regularly scheduled "payment date." The number and purpose of accounts will be detailed in the Loan Agreement, but may often include specialized accounts for the purpose of holding (i) interest payments from the Loan Assets, (ii) principal payments from the Loan Assets, and (iii) reserve funds to cover calls or draws arising from the Loan Assets, among other special purpose accounts. On a "payment date," funds are aggregated from the applicable collection or payment account and distributed in accordance with a specified waterfall. While specifically negotiated, in a private credit portfolio back-leverage transaction, a common waterfall of payments might generally tranche payments along the lines of the following (absent defaults or cash sweep concepts and assuming we are in the Reinvestment Period): (a) first, to fees and expenses to third party service providers (such as an account bank or non-lender collateral agent), subject to a cap, (b) second, to lenders to cover interest and fees, (c) third, to cover mandatory prepayments, (d) fourth, to a reserve account for purposes that may include funding revolving or delayed draw loans under the Loan Assets, (e) fifth, to cover remaining third-party expenses that were capped in the first step of the waterfall, (f) sixth, to cover other obligations under the Loan Agreement, and (g) seventh, to the SPV Borrower (or the Non-Bank Lender as its equityholder). Upon an event of default under the facility, the Lenders will have the right to accelerate the maturity date of the facility, demand the SPV Borrower repay the obligations under the Loan Agreement in full and, if necessary, foreclose on and sell all of the Loan Assets and all other assets of the SPV Borrower in order to satisfy the SPV Borrower's obligations.
Dispersion of Agent Roles. In private credit back-leverage transactions, the roles of agents may be more dispersed. In a typical secured credit transaction, often the lead lender acts as administrative agent and collateral agent. In a structured finance transaction, agents may have more prescribed roles and the roles may be filled by third-party agents that have no "skin in the game" as a lender or in any other capacity. For example, a third party might be asked to act as a "document custodian" or "verification agent" and have the role of providing certain reports. A third-party account bank is often responsible for managing the disbursement of funds pursuant to the waterfall on each Payment Date. A separate third party might act in the capacity as custodian or collateral agent in order to perfect the Lenders' security interest in the Loan Assets. In each case, these third-party agents would not typically act as Lenders in the facility.
Conclusion
Private credit portfolio back-leverage transactions provide a source of financing to support the fast-growing direct lending market. These transactions help direct lenders optimize their capital structure and support the continued growth of direct-lending products. Securitization techniques are central to these structures and market participants will need to be familiar with those techniques and have a sense of the market to effectively negotiate and deploy these strategies in the growing market.
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