Subscription credit line lenders are increasingly looking beyond LPs’ contractual capital call funding obligations to get comfortable with their exposures, even as credit performance remains resilient.

“That’s one thing that has come out of this coronavirus crisis,” says one sub line banker. “Subscription lenders, who used to care only about the borrowing base, are now also looking at the assets as a theoretical secondary source of repayment.”

As the crisis stretches on, subscription credit line lenders are looking to other metrics, sources of repayment and safety nets to ensure they are repaid. Net asset value covenants, which come in a variety of formats, are one such metric.

“This condition that never used to exist, now exists, where you have to call 10 percent or 5 percent, or whatever within the first year”

Anonymous banker

Generally, if the NAV of a portfolio, or even an individual asset, falls below a certain threshold, lenders can demand a quick repayment of drawdowns; a stop on further drawdowns, or and event of default on a fund’s SCF.

“The big thing we’re seeing is the insertion of some type of NAV covenant into deal documents,” says Zachary Barnett, co-founder and managing partner of Fund Finance Partners. Where a breach in such covenants triggers a repayment, it is often within 12-15 business days, he says.

Jeff Johnston, head of asset management at Wells Fargo, says: “Certainly where there’s more question around valuations or prospective valuations in the future, lenders are focused on making sure that the fund still has adequate invested capital to motivate an LP to fund a commitment or motivate a secondary buyer to purchase a defaulting commitment if that was to be the case.”

“We live in the real world, not in a binary world”

Anonymous banker

NAV covenants have been increasingly used in the past five years or so, he adds. In some cases, lenders use such covenants as a “catalyst to have a discussion,” says a second fund finance banker, adding that the bank rarely uses them, but most often in cases where it is making loans with extremely high advance rates and a borrowing base that includes non-institutional investors. Should a borrower trip the covenant, the bank assesses the situation, and if satisfied that LPs are still supportive, often lowers the threshold.

“So long as the NAV covenant is set at an appropriate level, it’s not the end of the world for our clients,” says Barnett, adding that given the collateral and the contractual obligation of investors to honor capital calls, the necessity of NAV covenants is arguable.

Mary Touchstone, head of Simpson, Thacher & Bartlett’s fund finance practice, says that, because of expected volatility, borrowers should try to negotiate out of them before signing a deal. “You don’t want to have to go back to the banks for waivers or amendments if there’s some significant fluctuation in those asset values,” she says.

LP skin in the game

Subscription credit lines often only require repayment at maturity and have relatively flexible use-of-proceeds, as opposed to so-called ‘capital call lines’, which have regular clean-down periods and are primarily used to bridge capital calls. The first banker says subscription line lenders are increasingly asking for “LP skin in the game,” even for lines with no clean-down requirements.

“This condition that never used to exist, now exists, where you have to call 10 percent or 5 percent, or whatever within the first year,” that banker says. “That concept is starting to creep into deals from the bigger lenders.” He adds he is “absolutely looking at the assets” as potential sources of repayment outside of LPs’ uncalled capital and is scrutinizing funds’ leverage strategies.

Barnett says there is also a greater push to include an amortization component in some of the lines he has arranged.

In a largely bespoke market where there is no standardized approach to structuring and underwriting, the variations on LP skin in the game, NAV covenants and even alternate sources of repayment outside of LP uncalled capital, will be numerous. Lenders are thinking harder about their existing exposures as well as new lending.

A third banker says that, if they aren’t already, lenders should be looking at every kind of risk they can think of. He adds that funds should consider reputational risk on new loans, given the charged atmosphere around socio-economic issues that has only intensified in the pandemic. If a lender has to call capital from a large pension in a state whose economy has been severely hit by covid-19, for example, does it want to?

“People don’t think about that, but they should, because we live in the real world, not in a binary world,” the third banker says.