The current environment and impact of covid-19 has led some funds to consider their liquidity requirements and explore options to meet potential current and future liquidity needs. Liquidity options may include calling on undrawn (or otherwise callable) capital commitments or, where available, raising additional equity either at the fund or portfolio investment level.
In addition, funds considering raising additional liquidity (either for the fund or underlying investments) increasingly look to the credit markets and the products offered by different market participants, which are often tailored to the specific needs of the fund. Outlined below are some of the different liquidity options available to funds from the credit market.
Subscription facilities secured on uncalled capital commitments
Facilities secured on uncalled capital commitments have become the norm for an increasing number of funds, providing them with flexible liquidity and an ability to expedite execution of deals in competitive transaction environments.
For those funds seeking additional liquidity in the current environment, extension options or incremental facilities under existing subscription facilities may provide a bridge for any anticipated liquidity shortfalls. For funds with uncalled capital, this may be the preferred option because of speed of execution, familiarity of the existing lenders with the fund structure (and limited partners) and subscription facility pricing. However, funds should engage with their lenders early in this process to ensure an expeditious execution process.
Additional borrowers/qualified borrowers
As an alternative to portfolio level debt, some subscription facilities permit funds to add certain subsidiary entities as additional borrowers under their facilities, thereby providing liquidity to underlying portfolio companies.
The main advantages of this financing, particularly in the current market, are: potentially lower pricing, as this structure allows the portfolio company to borrow at the subscription facility margin (rather than the potentially more expensive portfolio company margin); and, speed of execution – borrowing using the qualified borrower mechanic tends to be a reasonably quick process and can remove the need to negotiate a separate facility for the portfolio company.
Usually the fund guarantees such borrowings and so the documents need to be reviewed to ensure the guarantees are not restricted. However, there may be restrictions in the limited partnership agreement or the underlying subscription facility that limit the length of time these loans can be outstanding and so this alternative may not be a permanent solution for the portfolio company’s financing requirements.
Portfolio investment level debt
To the extent financing solutions at the fund level are not available or desirable, an alternative option for raising capital by certain funds may be to raise debt at the portfolio company level directly. To the extent the portfolio company has existing indebtedness, any additional indebtedness will need to be permitted within the restrictions of the existing facilities and the underlying documentation will need to be carefully reviewed.
Alternatively, such indebtedness would need to be sufficiently structurally subordinated so as to fall outside the restrictions on the borrower group under the documents governing the existing financing. Depending on the nature of the underlying cashflows (or restrictions under the underlying documents), bespoke facilities which do not require cash pay interest may be required for such subordinated debt. Market appetite, pricing and underlying performance considerations may dictate the extent to which portfolio level financing is appropriate.
Net asset value facilities are increasingly being considered by funds as another option to meet liquidity requirements. Whereas subscription facilities “look up” to the uncalled capital of a fund’s investors, NAV facilities “look down” to the underlying assets of the fund (ie the amount that can be borrowed will be based on the NAV of the underlying portfolio).
These facilities can be used to provide liquidity for a range of purposes, including providing cash to meet the funding needs of an underlying portfolio company (whether for short-term operational cash requirements, for value accretive capex, or otherwise) or making investments.
An understanding of the structure of a particular fund and how its assets are held is crucial to structuring NAV facilities. Other key considerations include the mechanics around valuation of underlying assets, which assets will be “eligible assets” (used to calculate NAV) and what the appropriate financial covenants should be.
At Fried Frank, we are seeing both an uptick in interest from funds in these facilities, as well as lenders taking an increasingly innovative approach to their structuring and terms, which makes them attractive to a greater number of funds.
In a preferred equity transaction, the preferred equity holder typically invests in a vehicle below fund level and receives a certain level of preferred return in respect of any distributions.
Preferred equity structures can provide funds with liquidity but often without many of the covenants traditionally built into debt instruments. For example, there is usually no interest or principal payable and typically no guarantees or security are required. Whether preferred equity is an option for a fund considering its liquidity requirements will depend upon a number of factors, including pricing and the underlying fund documentation.
There are a range of options for fund managers looking to raise liquidity. From vanilla subscription facilities to innovative preferred equity and NAV line products, the credit markets offer a spectrum of tailored products that funds may consider in detail as they assess their financing and liquidity needs as they look at the impact (and potential opportunities) arising from covid-19 and beyond.
Kathryn Cecil and Jons Lehmann are partners at international law firm Fried Frank