Subscription funding: rated note feeder funds and debt capital commitments

Insurance company investors are increasingly seeking to invest in private equity and similar private equity funds through debt capital commitments (as opposed to traditional equity capital commitments) in order to take advantage of better treatment of regulatory capital, including under the risk-based capital system established by the United States. National Association of Insurance Commissioners (the “NAIC”). Fund sponsors have responded to this demand by using a rated note feed structure, in which a feeder fund issues notes under a note purchase agreement to an investor (rather than requiring a commitment traditional equity) and obtains a high credit rating on these notes which results in a much more favorable risk-based capital treatment from the NAIC.

As discussed in our previous legal updates, debt capital commitments have always been classified as ineligible for inclusion of the debt base in underwriting facilities. This is due to the uncertainty as to whether these loan capital commitments would be enforceable under Section 365(c)(2) of the United States Bankruptcy Code if the relevant fund were subject to legal proceedings. of bankruptcy.1 The concern is whether the commitment of debt capital would be considered an “enforceable contract” to “make a loan, or grant other debt financing or financial arrangements to the debtor or for the benefit of the debtor “. If so, the obligation could be rendered unenforceable by the fund or its trustee in bankruptcy (and therefore unenforceable by the fund, its trustee in bankruptcy or the fund’s lenders).

In an attempt to address this concern while meeting the market need for debt commitments presented by insurance companies, some sponsors have begun to use hybrid debt/equity commitments which begin as an equity commitment of borrowing but “switch” to a commitment of equity upon the occurrence of an event of default or similar triggering event under the underwriting facility (such as bankruptcy or insolvency of the fund). Although this type of conversion feature has not been tested in litigation, there are concerns that a bankruptcy court may find it unenforceable under Section 365(e) of the US Bankruptcy Code. United States, which provides for a contractual agreement that terminates or modifies an enforceable contract conditioned on or triggered by the occurrence of insolvency, the opening of a bankruptcy case, or a similar event is not enforceable in bankruptcy proceedings (this concept is often referred to as “ipso facto prohibition”). As a result, many underwriting lenders have resisted the “conversion approach” for a hybrid debt/equity commitment. There are, however, two approaches that are gaining traction in the market that do not raise the same ipso facto prohibition issues: first, a “day one” equity commitment approach and, second, a feeder fund approach. remotely in the event of bankruptcy. We explore both of these approaches below.

“Day-One” equity commitment

At a high level, the day one equity commitment approach provides for the investor to subscribe to a shared equity/debt capital commitment on “day one”. This shared capital commitment can be called as debt through a note purchase agreement or as equity through a traditional capital call at the option of the underwriting fund or lender, and any debt or equity financing will reduce the shared capital commitment on a dollar-for-dollar basis. Because the capital commitment includes a “day one” equity component – ​​and does not convert from one form of capital commitment to another form of capital commitment in the event of a bankruptcy-type event – this day one equity commitment approach is not likely to raise the same level of potential Ipso Facto ban issues as the conversion approach described above.

The day one capital commitment approach works for insurance company investors because the NAIC’s risk-based capital treatment is determined by the actual investments financed. Thus, the mere possibility that the capital commitment is financed by equity would not adversely affect the treatment of the regulatory equity of the investor, unless the investor actually contributes equity. To assure the investor that, in the normal course of business, the preferential treatment of regulatory capital will be achieved by calling debt, the organizational documents of the rated feeder fund may even be structured with conditions precedent to make a capital call. clean. For example, an equity call could be conditional on (1) the occurrence of an event of default under the underwriting facility, (2) an investor’s inability to effectively fund the loan capital and/or the fund’s inability to call the capital commitment debt, or (3) the fund is insolvent and/or subject to bankruptcy proceedings.

Remote rated debt feeder funds in the event of bankruptcy

While the day one capital commitment approach focuses on structuring the capital commitment to be enforceable in bankruptcy proceedings, the second approach focuses on minimizing the risk that the fund feeder fund is subject to bankruptcy in the first place by structuring the feeder fund as a non-bankruptcy special purpose vehicle (an “SPV”). In other words, an SPV structure does not seek to address the bankruptcy legal risks associated with debt capital commitments, but rather aims to reduce the likelihood of a feeder fund bankruptcy proceeding occurring having a impact on investors’ debt capital commitment. . Important features of an SPV include, among others, provisions in its organizational documents which (1) require an independent director or independent manager of the feeder fund to explicitly approve any bankruptcy filing by the feeder fund or other significant actions that could give rise to insolvency proceedings, (2) limit the securities transactions of the feeder fund (including indebtedness other than obligations to the lender) and require it to maintain social separation relative to the underlying master fund, and (3) prohibit changes to the organization documents without the consent of the independent administrator/manager and the consent of the underwriting lenders while the obligations of the underwriting facility are outstanding . Subscription lenders will also seek express acknowledgment that feeder fund investors and other lenders (if any) will not seek to initiate or support any bankruptcy or insolvency proceedings of the feeder fund. While these types of customary SPV arrangements may add additional costs to the creation of the SPV (including legal structuring costs and the expense of notices that must be rendered in connection with the closing of the advisor’s underwriting facility formation of funds to the feeder fund) and maintaining the structure at a distance from bankruptcy (including the annual fees of the independent director/manager), such SPV protections are well established in the field of structured finance and are frequently invoked in structured finance transactions. To the extent that it is able to obtain these protections, an underwriting lender may be willing to include debt capital commitments in the borrowing base due to the reduced likelihood of feeder fund failure.2


As more investors seek to invest through debt capital commitments, we expect the market to adopt the “day one” capital commitment approach as the preferred approach for inclusion. of the borrowing base. Similarly, given that many subscription lenders are familiar with bankruptcy remote vehicles given their familiarity with structured finance transactions, we expect more subscription lenders to start giving loanable value to pledges. of loan capital as long as the feeder fund is structured as a remote bankruptcy vehicle. Accordingly, sponsors should seriously consider employing one or, ideally, both techniques in order to unlock more loanable value on their subscription facilities.

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