Lenders and funds continue to explore innovative ways to include a wider pool of investors in the borrowing base. But care should be taken to understand the provisions of a fund’s constituent documents and side letters when considering such an approach.
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.
One increasingly negotiated point in recent subscription facilities is whether to include in the borrowing base the unfunded commitments of investors that have the right to pre-fund their allocable share of borrowings. This article provides an overview of borrowing pre-funding rights and related considerations for lenders in subscription facilities.
Overview of Pre-Funding Rights
An investor’s right to “pre-fund” its capital contribution is typically set forth in an investor’s side letter but may also appear in the fund’s partnership or other operating agreement.
Generally, a pre-funding right provides the investor with the option to fund its pro rata capital contribution to the fund at a time before a capital call notice is delivered to the investors to repay a debt obligation of the fund.1
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.
Alternatively, the general partner may have the right to elect to treat an investor as a pre-funding investor and call capital from such investor in lieu of borrowings being made on behalf of such investor. The fund may expressly acknowledge in the partnership agreement or side letter that the amounts pre-funded by the investor will be treated as a capital contribution. The general partner may also have broad authority to adjust the partnership agreement provisions to accommodate the pre-funding of capital contributions.
Purpose of Pre-Funding Rights
Investors may seek, and sponsors may agree to, a pre-funding right for several reasons, such as avoiding potential adverse tax consequences. Tax exempt investors, sensitive to unrelated business taxable income (UBTI), may seek provisions to avoid recognizing unrelated debt-financed income (DFI), which is treated as UBTI for federal income tax purposes. Specifically, a portion of such investors’ gross income derived from or on account of “debt-financed property” is treated as gross income from an unrelated trade or business, which, after certain deductions, is taxable to investors in the same manner as UBTI.2
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.
Some types of investors, such as governmental entities or endowment plans, may have provisions in their constituent documents, side letters or investment policies that restrict or prohibit using their capital commitments as credit support to secure the debt obligations of the fund. Side letters can specify that an investor is not obligated to honor a capital call made by a lender (which typically results in outright exclusion from the borrowing base).
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.
Addressing Borrowing Pre-Funding Rights in Subscription Facilities
Pre-funding investors may be addressed several ways in the borrowing base of a subscription credit facility.
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.
One approach is to include the pre-funding investor in the borrowing base until it funds its allocable share of the applicable loan within the time period agreed upon in the fund’s partnership agreement or the investor’s side letter (as applicable) and to require a dollar-for-dollar repayment of the borrowings under the subscription facility to which the pre-funding election relates as the pre-funding investors capital contributions are received (regardless of whether a mandatory prepayment would otherwise be triggered under the subscription facility).6 This prepayment mechanism addresses the fact that the pre-funding investor will not be making a capital contribution when capital would be called from the investors generally to repay the borrowing, but permits the fund to borrow against the pre-funding investor’s unfunded capital commitment prior to and during the period between when the fund draws on the line and the point when the pre-funding investor makes its related capital contribution (or fails to make a capital contribution and is deemed an excluded investor). A subscription facility with these features will typically include enhanced notice requirements whereby the fund is obligated to alert the lender if any investor elects to pre-fund borrowings, so the mandatory prepayments and exclusion event may be monitored.
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
In addition to considering the borrowing base impacts of a pre-funding investor, the fund’s partnership agreement must be reviewed to determine how the pre-funding rights and mechanics work generally and how any overcall provisions may impact the analysis. Limitations (or ambiguity resulting from silence) on such overcall rights may restrict the ability of a fund or a lender to call capital from pre-funding investors to make up any capital contribution shortfall resulting from the default (or excuse) of other investors. This issue can be heightened if the pre-funding investor also has the right to opt-out of capital calls to repay borrowings.
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.