Regulated ’40 Act funds and business development companies are turning to credit lines for greater flexibility in handling liquidity requirements.
Khizer Ahmed runs Hedgewood Capital Partners, a New York-based fund finance advisory business. He has spent a large portion of his career in investment banking, and he now assists borrowers on the finer points of negotiating these loans. Here’s what borrowers, administrators and transfer agents need to know when they engage lenders for revolving lines secured by fund assets.
What are the first things borrower need to consider when arranging these loans?
Khizer Ahmed: Fund borrowers need to be very clear about the motivation for seeking a revolving credit facility. The most common ones are:
- Providing instantly available investment capital;
- Meeting redemption requests at a point in time when free cash flow is tight;
- Paying fund expenses.
Funds need to track periodic capital flows and undertake careful cash budgeting to ensure they have sufficient cash to meet redemption requests. Simultaneously, they must avoid a large build-up of cash. Cashflow projections highlighting flows of cash and any potential shortfalls must be undertaken regularly. A well-run cash management process typically requires close interaction between the fund sponsor’s operations team and service providers, especially the administrator.
What do banks consider when they make these loans?
KA: Usual considerations of counterparty credit risk and collateral are the basic assessments that all lenders will undertake when considering making a loan. Beyond risk assessments, the capital cost of a loan is a particularly relevant consideration for lenders. These types of credit lines are generally expensive from a capital perspective. The higher the utilization, the more economically sustainable the provision of such a facility is for a lender and, therefore, the more competitively priced a loan can be.
One mechanism lenders use to improve the economics of making revolving lines of credit is to split the total size of the facility between ‘committed’ and ‘uncommitted’ portions. The lender contractually undertakes to provide only the ‘committed’ part of the facility for the borrower to take down, and to make the remainder of the line available on a ‘best-efforts’ basis. The capital charge savings that this structure generates can be shared with the borrower.
What are other considerations a borrower needs to keep in mind?
KA: The key consideration is what assets will be pledged as collateral and the structure of any pledge arrangements. At a high level, collateral for revolving credit lines for funds falls into two categories. A fund of funds borrower can offer up LP interests in individual underlying funds as collateral. Single strategy funds that invest directly in underlying assets will offer up ownership stakes in such underlying investments. Also, most transactions involve a security interest in the borrower’s bank accounts. Determination of which assets will be pledged as collateral, their identification and location, valuation, maintenance and disposal are all issues that require careful attention and may require service providers like administrators and custodians to make operational adjustments.
So what exactly is the main consideration here then?
KA: It’s all about perfecting the lender’s security interest. The nature of the collateral pool drives several unique structuring considerations. Lenders generally have a strong view on the mechanism for perfecting their security interest. Lenders to fund of funds may require the borrower’s sponsor to obtain explicit consent from the GPs of underlying funds for a pledge of their fund interests as collateral by the owner fund of funds. Lenders may also require that underlying fund LP interests that are subject to such consent are segregated and held separately by the borrower in a fully owned subsidiary/SPV to distinguish them from other LP interests that are not backed by underlying GP consents.
Sounds like a lot of work…
KA: Absolutely. For a borrower and its service providers, obtaining such consents can be a time-consuming process. Furthermore, there are significant legal, administrative and operational considerations involved in the creation of a wholly owned subsidiary/SPV and transferring LP interests from the parent to such an entity. The further layer of operational and administrative burden and cost all require a careful evaluation on the part of the sponsor and a concerted effort to ensure an efficient and timely completion of all necessary steps in this regard.
What kind of information do borrowers need to provide to secure the loan?
KA: For collateral composed of LP interests, borrowers are typically required to provide detailed information about their investments in underlying funds – amounts, strategy identification, geographical focus, vintage year, committed capital, called-down capital, and distributions. Lenders use this information to evaluate the risk of the underlying collateral portfolio. Often, lenders or their lawyers go through constitutional documentation of underlying funds during their legal due diligence. The borrower will likely have to answer questions that arise during this process and there will be significant time spent on this by both borrower and lender.
How do lenders shape the covenants that govern the loan?
KA: Most fund of funds lenders use standardized haircut models to determine how much a given borrower can borrow on an on-going basis. At a high level, these models incorporate exposure limits across multiple dimensions for risk evaluation, monitoring and control purposes. These dimensions include diversification, concentration and may include minimum asset coverage ratio requirements. Borrowers must carefully evaluate the haircut methodology to make sure that any limits are not unduly restrictive given their operational requirements. What’s more, non-utilization fees are generally paid by reference to the maximum notional amount made available by the lender and does not change with the maximum ‘borrow-able’ amount as calculated by reference to a haircut model. Watch out. A borrower can end up paying a non-utilization fee for a significantly larger facility than what is available to draw down in practice, making the facility much more expensive than it should be.
What about when the loan is outstanding?
KA: There are significant operational and administrative arrangements relating to a credit facility that borrowers must confront from an early stage. Considerations such as the number of draws on, and repayments of, the facility in any given period and associated notification requirements, presentation of compliance certificates and other documentation required by the lender for each draw and repayment, processes for generation of ad-hoc draw requests and checking lender calculations of fees and expenses. Although routine in nature, these activities nevertheless require coordination between the administrator and the sponsor’s operations team and form the administrative and compliance burden of entering into a transaction of this nature.
What about compliance with loan covenants during the life of the loan?
KA: Monitoring compliance with terms of the facility is typically shared between the administrator and the sponsor’s operations team. Monitoring covenants in a credit facility is very important, since their breach can cause significant difficulties for the borrower and can lead to the facility being withdrawn. Generally, it is a very good idea for a borrower to point out any potential issues or difficulties with covenant compliance and to highlight these to the lender at the earliest possible opportunity. Keeping surprises to a minimum and early communication of potential issues is always appreciated.
What can happen should financial market stress cause liquidity conditions to tighten?
KA: No crisis is like the previous one but there are certain themes that continue to rhyme from one stress episode to another. They are:
- For part committed facilities, expect that the uncommitted part of a facility will not be made available for draws until such time as market conditions stabilize.
- During extended periods of financial market turbulence, lenders can seek to re-price facilities to reflect the higher cost of financing for their own balance sheets. Perhaps it is better to pay more than to be without such credit during such financial market stress.
- Lenders like borrowers who engage in frequent and meaningful communication during periods of market stress. Sponsors and their administrators should attempt to provide frequent updates to enable better management of loan portfolios on the part of lenders.
Khizer Ahmed is founder and managing member of fund finance advisory business Hedgewood Capital Partners, LLC in New York.