Guest comment: Reed Smith

There was a significant increase in the number of subscription line credit facilities and other debt facilities to Luxembourg-based private debt funds during 2015.

This is partly due to the fact that Luxembourg has won over the private debt world as the European jurisdiction of choice, while the rapid rise of the fund finance market generally in Europe must also take some of the credit.

The explosive growth in the use of fund finance in Luxembourg is expected to continue in 2016 and beyond. There are a large variety of fund finance instruments: subscription line facilities secured against the fund investors’ undrawn commitments; net asset value (NAV)/asset-backed facilities secured against the portfolio of loans assets of a private debt fund; as well as co-investment or manager/GP support facilities secured against the management fee and other fee income paid to the manager or principals of a fund.

There are also certain hybrid facilities that package together some or all of these individual types of facilities.

The trend raises questions, including why lenders are opting for Luxembourg, what issues the jurisdiction raises around fund finance and where the market is headed in 2016?

WHY LUXEMBOURG?

Funds are attracted to Luxembourg due to its competitive tax rates, recognised stock exchange for listing, consistent regulation and expertise of service providers. However, perhaps the most important reason is linked to the fact that private debt funds prefer to have a lending vehicle for their underlying debt transactions that is incorporated in Luxembourg.

In order to avoid potential dual regulation and withholding tax issues (which may be the case if the fund was established in say Guernsey or Jersey) it makes sense to also establish the fund vehicles themselves in Luxembourg. Furthermore, investors are familiar and comfortable investing into Luxembourg which they view as an established “onshore” jurisdiction. Luxembourg allows for a number of different feeder fund vehicles to be set up into which the investors may contribute their capital in a tax efficient manner.

These feeder fund entities may sometimes be securitisation vehicles that are bankruptcy remote providing certain advantages, including giving the fund access to capital at a reduced cost and facilitating the mechanism by which the investors contribute their commitments to the fund without the need to issue more shares.

Various different types of fund entity exist under Luxembourg law (including the FCP, SICAV, SICAF), but the recent trend is for the special limited partnership (SCSp) to be utilised. The SCSp was only recently created under Luxembourg law in 2013 and was modelled on the typical limited partnership vehicles seen in Anglo-Saxon jurisdictions such as England, Guernsey, Jersey and Delaware.

Often, separate SCSp entities are set up as parallel vehicles denominated in different currencies with a Luxembourg master fund sitting underneath them. This allows investors to invest into the fund using different currencies, but also ensures that the parallel vehicles co-invest together into the master fund which will then make the relevant investment.

The private debt fund manager’s decision to establish the feeder funds, the main parallel funds, the master fund and the holdco lending vehicles all in Luxembourg, usually avoids any risk that the fund could be regulated by more than one jurisdiction.

However, this does not of course avoid the requirement for the investment advisor of the fund to be regulated in the jurisdiction where investment advice is given.

CHALLENGES

Although there has been a substantial increase in the number of fund finance transactions involving Luxembourg fund entities, execution of financing transactions, in particular as it relates to granting of security to lenders, can often be challenging.
The reasons relate to an array of restrictions set out in Luxembourg legislation. For example, unlike under English law, powers of attorney (even if stated to be irrevocable) may be revoked at any time. There is also uncertainty under Luxembourg law about the ability to give Luxembourg law-governed security over purely contractual rights (such as the rights to draw down from investors).

Questions also arise as to whether Luxembourg security can be validly granted over future receivables that arise from drawdown notices sent to investors. This has all produced differing views from Luxembourg legal counsel on the best way to structure fund finance transactions. Lenders and their legal counsel have had to structure their security package around these potential issues recognising commercial demands while at the same time ensuring that risks are protected against or mitigated.

It is important for funds and their lenders to work with law firms who have experience in executing fund finance transactions in Luxembourg to ensure that issues are identified at an early stage and solutions provided.

THE RISE OF FUND FINANCE

There has been a dramatic increase in the number of fund finance transactions in recent years and a lot more lenders are entering this market.

Private debt funds are now using fund finance facilities, not only for bridging drawdowns from investors, but also to provide leverage to their funds. A number of lenders are providing debt facilities secured against the underlying portfolio of loans in the fund in addition to having such facilities secured against the commitments of investors.

These “hybrid” facilities are set to increase substantially in frequency in 2016 and we have seen more and more lenders seeking advice on such instruments. Of the 40-45 fund finance transactions Reed Smith advised on during 2015, a large proportion involved Luxembourg vehicles.

Finally, it is worth mentioning the importance of hedging to private debt funds.
Alternative lenders may be receiving commitments from investors in one currency while lending out in another. This has allowed banks to provide hedging facilities in addition to subscription line and capital call facilities.

Establishing a master Luxco entity that sits below the fund vehicles themselves has made it much simpler to put hedging facilities in place as the master Luxco will generally not be subject to borrowing limits set out in the main fund limited partnership agreement.

Private debt funds can then, through this master Luxco or a separate SPV vehicle sitting underneath the fund, leverage up its loan portfolio by borrowing further amounts from lenders providing NAV or asset-backed facilities.

It is fair to say that this movement from “offshore” to “onshore” is set to continue as Luxembourg positions itself as the go-to jurisdiction for the establishment of private debt funds.

This, combined with the growing number of bank lenders offering these facilities, suggests that the trend established in 2015 will continue to accelerate through 2016 and beyond.

Leon Stephenson, a partner in the Financial Industry Group of Reed Smith is the head of the Reed Smith European fund finance practice. Leon provides specialist advice on capital call and subscription line facilities, NAV/Asset Backed funds facilities, GP and manager support and co-investment facilities to private equity and debt funds.

Reed Smith is a global law firm with more than 1,800 lawyers in 26 offices throughout Europe, the Middle East, Asia and the United States. The firm represents leading international businesses from FTSE 100 corporations to mid-market and emerging enterprises. Its lawyers provide litigation and other dispute resolution services in multi-jurisdictional and high-stake matters, deliver regulatory counsel, and execute the full range of strategic domestic and cross-border transactions. Reed Smith is a preeminent advisor to industries including financial services, life sciences, health care, energy and natural resources, advertising, technology and media, shipping, real estate, manufacturing, and education.