Investor Pre-Funding Rights In Subscription Credit Facilities

As the market for subscription-backed credit facilities, also known as capital call or subscription facilities, continues to mature, co-mingled private investment funds are seeking higher advance rates and inclusion of a wider pool of investors in the borrowing base. As such, banks and lenders extending credit to a fund under a subscription facility must carefully determine the eligibility criteria regulating which uncalled capital commitments of investors in the fund will be included in the borrowing base.

Overview of Pre-Funding Rights

An investor’s pre-funding right is often limited to circumstances in which the fund intends to borrow money. The fund’s general partner will typically agree to provide an investor with timely notice of the fund’s intention to borrow and give the investor an opportunity to pre-fund its allocable share of any such borrowing. The investor may have the right to elect to pre-fund (or not pre-fund) a capital contribution on a loan-by-loan basis.

Investors in limited partnerships generally recognize their share of the partnership’s income and deductions,3 and the tax character is determined as the income or deductions were realized by the investor directly.4 Absent certain exceptions, debt incurred by a fund could cause its investments to be debt-financed property for UBTI-sensitive tax exempt investors. Pre-funding rights are intended to prevent the allocation of fund-level debt to the applicable tax exempt investor to prevent recognition of DFI.

In addition to addressing tax, regulatory and policy considerations, pre-funding investors may also receive the economic benefit of pre-funding contributions. To the extent an investor pre-funds a capital contribution in lieu of a borrowing, and the fund agrees to treat the contribution as made prior to the time when the capital contributions of other investors are required, pre-funding investor benefits with respect to calculating the preferred return.5 The investor may be spared what would otherwise be its pro rata share of the cost of borrowing. As such, any adjustment made to accommodate a pre-funding investor will be highly negotiated, although it is common for a pre-funding investor to be treated similarly to a non-pre-funding investors for purposes of preferred return calculations and distributions.

Historically, lenders often excluded the capital commitment of pre-funding investors from the calculation of the borrowing base altogether. More recently, lenders giving borrowing base credit to the capital commitment of pre-funding investors subject to certain parameters has been a trend.

Another way to address a pre-funding investor is to include its unfunded capital commitment in the borrowing base but adjust the borrowing base calculation to subtract the amount of capital contributions the pre-funding investor pre-funds. With this approach, a lender may require more robust ongoing borrowing base reporting, and with each request for borrowing, a detailed listing of which pre-funding investors have elected, declined or not responded to a request to verify their plans to pre-fund any given borrowing to properly calculate the borrowing base and resulting line availability.7

As the fund finance market evolves, lenders and funds continue to explore innovative ways to include a wider pool of investors in the borrowing base. Subject to certain parameters, more lenders are willing to consider inclusion of the unfunded capital commitments of pre-funding investors in the calculation of the borrowing base. Care should be taken in reviewing and understanding the applicable provisions of a fund’s constituent documents and side letters when considering such an approach.