Recent reports have caused fund finance lenders to re-evaluate their understanding of the risks of subscription lines of credit. These credit facilities are commonly used by closed-end funds and are secured by the commitments of the limited partners of those funds. Traditionally, the risks to the lender were thought to encompass “known unknowns” such as the creditworthiness of limited partners, the investment prowess of fund managers, the strength of legal documents and the particulars of contract and statutory law in relevant jurisdictions.
Over the past few weeks, fund finance lenders have focused on risks of the “unknown unknown” kind: how do they know the facts that are presented to them are true, and how do they evaluate the trustworthiness of their borrowers?
Some lenders are focusing their attention on the highest end of the market: funds sponsored by blue chip institutional managers who are household names, and typically have assets under management greater than $50 billion. Others are lending only to repeat clients with whom they have a prior relationship. More still are uncertain how to proceed, and how to modify their existing practices and procedures.
In evaluating due diligence procedures, lenders should consider the constellation of service providers retained by a fund or its manager: attorneys, auditors and fund administrators.
A good legal firm will ensure that limited partnership agreements are properly drafted and executed. Auditors provide checks on a fund’s internal controls and procedures, as well as a review of the accuracy of financial statements. Fund administrators calculate net asset values, produce capital calls, publish communications from a fund and its limited partners, effectuate transfers of cash and may provide ancillary products such as enhanced middle office, risk, tax, depositary or treasury services.
Lenders should confirm that their fund borrower is represented by a known, reputable fund counsel. Legal firms with large fund formation and fund finance practices conduct reputational, anti-money-laundering and know-your-client processes on their clients, providing one more safeguard that one is dealing with an institutional-quality borrower.
Similarly, the audit should be conducted by a reputable firm, such as one of the “Big Four.” Firms with institutional procedures and reputations are likelier to provide a rigorous audit that does not cut corners on procedure. Lenders may consider contacting the auditor directly to confirm the relationship with the client.
Lastly, the fund administrator should be of reputable, institutional quality. Reputable fund administrators enjoy large, institutional, transnational practices that have the benefit of longevity in trustworthiness and track record. A fund administrator typically has a multi-year relationship with established investment managers, and institutional procedures which generate the funds’ books and records.
When onboarding a new prospect, a fund administrator will review the manager, including performing a background and Securities and Exchange Commission registration check. Generally, the administrator’s leads arrive via qualified channels, though deeper due diligence is often performed when no known connections can be established. During onboarding, the investor relations team typically reviews and sets up each LP as part of the normal AML and KYC processes. This includes checks against what is already known by the administrator in relation to an LP who subscribes to funds of other clients.
Once a client has been onboarded, the day-to-day activity of fund administration begins. The IR team verifies and reconciles funding by and distribution to LPs in order to maintain proper books and records. Capital call requests are often sent directly to LPs by the IR team. The administrator oversees NAV calculation and produces client fund financial statements, offering transparency into the financial health of funds, independent of the audit function.
Service providers often work together. For example, the auditor’s professionals are likely to physically occupy a conference room at the fund administrator’s premises, and these firms will share information in order to generate audited financial statements upon which lenders rely.
Of course, none of these service providers can provide a substitute for a lender’s basic confirmatory due diligence. Whenever possible, lenders should endeavor to have direct contact with investors, in the form of notices (as are customary in security agreements under UK law), letters of acknowledgement (increasingly uncommon) or simple telephone or email checks. Similarly, as part of due diligence, lenders should consider obtaining formal verification of the audit and fund administration relationships.
The quality, reputation and longevity of a fund’s counsel, auditor and administrator should be considered when lenders are evaluating new fund finance clients. Verifying that borrowers have retained reputable service providers is one more safeguard against the risk of an unknown unknown.
Shiraz Allidina is director of capital markets, Citco Capital Solutions, Inc.