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Understanding Fund Finance: Key Considerations for Subscription Credit Facilities and Net Asset Value (NAV) Facilities

As private equity funds and other alternative investment vehicles increasingly turn to fund finance solutions to optimize liquidity and maximize returns, it is critical for sponsors, investors, and lenders to understand the key legal and structuring considerations involved. This article, provides an overview of the two most common types of fund finance facilities - subscription credit facilities and net asset value (NAV) facilities - including the typical structures, key legal documents, due diligence processes and hot topics that arise.

Subscription Credit Facilities

Subscription credit facilities, also known as capital call facilities, are loans made to a fund that are secured by the unfunded capital commitments of the fund's limited partners. These facilities are typically used as a bridge to capital calls, allowing the fund to quickly access capital to fund investments or expenses before calling capital from investors.

Structure

In a typical structure, the fund establishes the facility at the main fund vehicle, and may also have a parallel fund vehicle that participates in the facility. The fund's limited partnership agreement (LPA) and investors' subscription agreements outline the contractual framework governing the fund and its relationship with investors. The general partner, as manager of the fund, has the authority under the LPA to call capital from investors to repay borrowings under the facility.

Key Documents

The three key fund documents that lenders focus on when conducting due diligence for a subscription facility are:

1. Limited Partnership Agreement (LPA): The LPA is the most critical document as it governs the relationship, rights and obligations between the fund, the general partner and the limited partners. Lenders review the LPA closely to confirm it contains provisions permitting the incurrence of the debt, the granting of security over uncalled capital commitments, and the ability of the general partner to call capital to repay debt, including after the investment period. The LPA should also grant the lender third party beneficiary rights to enforce capital calls and exercise remedies against defaulting investors.

2. Subscription Agreements: Subscription agreements and related subscription booklets document each investor's commitment to the fund and representations regarding its ability to fund capital calls. Lenders review subscription documents to verify basic information like commitment amounts match the fund's records, the correct investor entity is committing, and the agreement is properly signed. Lenders also diligence investor suitability, looking at the type and jurisdiction of investor, any special terms, and information like ERISA or tax status that can impact creditworthiness.

3. Side Letters: Side letters are agreements between the fund and specific investors that supplement or modify fund terms with respect to that investor. Provisions in side letters, if not addressed, can significantly impact the lender's rights and collateral. These include things like restrictions on providing investors' information to lenders, ability to cease funding capital calls in certain circumstances, sovereign immunity and most favored nation (MFN) provisions. Lenders need to identify any problematic side letter terms and work with the fund to navigate these issues, such as expressly permitting disclosure to lenders and ensuring lenders are third party beneficiaries.

Due Diligence and Hot Topics

In addition to the core fund documents, lenders often review other diligence items like the fund's marketing materials (private placement memorandum), the fund's track record, and background on the investment manager. Lenders also conduct varying degrees of know-your-customer (KYC) and background diligence on investors directly. An emerging trend, especially for first-time funds or new lender relationships, is for lenders to conduct more robust individual investor diligence, including verifying commitment amounts directly with investors.

A recent SEC enforcement case has highlighted the risks of the "fraud" scenario - a bad actor on the manager side fabricating investor commitments and subscription documents to obtain a larger credit facility. This has led some lenders to enhance their processes around diligencing investors and in some cases requiring a "seeding" capital call to verify the investor base before closing the facility. 

From a documentation perspective, trends in the subscription credit facility market include more comprehensive LPA provisions addressing the specific requirements of these facilities and more flexibility to accommodate what has become a common liquidity tool used by funds of all sizes and strategies. Standardization of these "market" terms has helped streamline the diligence and documentation processes as the market has matured.

Net Asset Value (NAV) Facilities

NAV facilities, also referred to as asset-backed facilities, are loans made to a fund and secured by the fund's portfolio assets or the cash flows generated by those assets. While subscription facilities look "up" the capital structure to the uncalled investor commitments, NAV facilities look "down" to the fund's underlying investment portfolio. These facilities are typically used later in a fund's life cycle once a pool of assets has been assembled.

Structure 

The most common NAV facility structure establishes the facility at a special purpose holding company owned by the fund, which in turn owns the fund's portfolio companies or assets. The loans are secured by a pledge of the equity interests in the portfolio companies, or in some cases a pledge of the cash flows generated by the assets. Security is generally not granted directly over the underlying assets. Variations of this structure include facilities directly at the fund level or alternatively at individual portfolio company entities.

Due Diligence

Compared to subscription facilities, the due diligence process for NAV facilities is more expansive given the need to diligence and underwrite the actual underlying assets rather than just the fund documents and investor capital commitments.

On the legal due diligence side, this means reviewing the governing documents and material contracts for each portfolio company proposed to be included in the borrowing base. Key issues include:

- Restrictions on pledging equity interests or transferring cash flows

- Change of control and other consent rights triggered by the pledge and/or foreclosure

- Contractual priming issues where lenders need to ensure the NAV facility claims will not be subordinated to other obligations

- Holding company and cash flow structuring matters to ensure cash can be efficiently transferred to the borrower and lenders

In addition, because NAV facilities are often structured with a special purpose borrower entity, lenders typically require SPV/bankruptcy-remote provisions in the borrower's organizational documents (such as the operating agreement of an LLC borrower) addressing separateness covenants, independent directors, and non-petition language.

On the credit underwriting side, NAV lenders and their advisors conduct an appraisal of each portfolio company to determine its enterprise value and run downside cases to establish a borrowing base and advance rates. Lenders look at financial metrics like EBITDA, debt ratios and asset coverage as well as qualitative factors like the company's business, competitive position, and management. The diligence process often involves a mix of onsite meetings, management interviews, customer diligence, and third party appraisal reports.

Hot Topics

With NAV facilities, there is more variation in structures and terms compared to the relatively standardized subscription facility market. An emerging trend is the increased use of hybrid facilities that combine features of traditional subscription facilities and NAV facilities, allowing funds to transition more seamlessly between the two products as they move through their life cycle. These hybrid facilities are often structured as a single facility with an "accordion" feature allowing the fund to toggle back and forth between a subscription facility borrowing base and NAV-based borrowing base.

Another development has been the increasing number of sponsors exploring NAV facilities for a broader range of fund types beyond the initial private equity model. Funds focused on private credit, real estate, infrastructure and secondary strategies are more frequently using NAV facilities as an additional source of liquidity. This expansion requires lenders, funds and their respective counsel to tailor the diligence and structuring considerations to the specific underlying asset class.

Finally, a key trend from the fund sponsor side has been building in greater flexibility in fund LPAs to accommodate NAV facilities from the outset, rather than relying solely on retrofitting older vintage funds. This means addressing items like pledge restrictions, debt limitations, cash flow waterfalls and overcall limitations that may need to be modified to implement an efficient NAV facility.

Conclusion

As the fund finance market continues to grow and evolve, it is important for participants to stay abreast of the latest structuring trends and hot button issues in both the subscription credit facility and NAV facility arenas. While the two products share the common theme of providing efficient liquidity solutions to facilitate fund investment activities, they differ meaningfully in their structuring, diligence and documentation requirements. Understanding these key distinctions - and how they impact the rights and obligations of funds, investors and lenders - is critical to successfully navigating the fund finance landscape.