When we think of the parties to a subscription credit facility (the “Facility”), all eyes are usually on the fund and the general partner (the “GP”), but the investment manager (the “Manager”) is also a part to Watch. For the reasons explained here, the role of the manager may vary from transaction to transaction and, depending on the terms of the fund documents, may create risk for the lender of the facility in an underwriting transaction. Here, we’ll break down those risks and how incorporating certain terms into your credit agreement can mitigate those risks.
In a typical US fund structure, a fund will have a GP and a manager. The GP is generally delegated extensive rights with respect to the fund pursuant to the fund’s limited partnership agreement (or other governance agreement) (the “LPA”) to do all things deemed necessary or desirable by the GP within the powers, objectives and purposes of the fund. These rights include the right to delegate some of its responsibilities with respect to the management of the fund’s assets to the manager. The relationship between the General Partner and the Manager with respect to the Fund is governed by a management agreement or investment advisory agreement (the “Management Agreement”).
The management agreement is entered into by and between the fund and the manager. The rights delegated to the manager are generally limited to identifying investment opportunities, buying, monitoring, evaluating and selling fund assets, and exercising any voting rights. or consent in respect of such assets, in each case subject to the terms and conditions set forth by the GP and/or the APL. In an atypical situation, the rights granted to the Manager in the Management Agreement go beyond those aforementioned rights or the grant language in the Management Agreement is ambiguously drafted. Such ambiguity could lead to the wording being interpreted as granting the manager broader rights, which could potentially negatively impact the rights of the facility lender.
The facility will generally include covenants in the loan documents which are intended to protect the interests of the facility lender by limiting the rights of the fund and the general partner to take certain actions which could adversely affect the security of the facility. These include, but are not limited to, the following: (i) the prohibition of additional liens on the security of the facility; (ii) limitations on the amount of other debt the fund may incur; (iii) restrictions on the cancellation, curtailment, excuse or reduction of an investor’s capital commitment; (iv) limitations on distributions; (v) prohibition to withdraw funds from collateral accounts at certain times; and (vi) restrictions on capital calls in the event of default (the “Restrictive Covenants”). Covenants help to mitigate warranty risks.
In a typical subscription agreement, the covenants generally only apply to the fund and the general partner as a party to the facility loan documents. In the ordinary course, the manager is not a party to the facility, except with respect to the recognition of a standard covenant which obliges the fund to subordinate any payment or advance of any kind to any debt or obligation due to the manager. Since the Manager is not otherwise a party to the Facility Loan Documents, the Manager is not bound by the covenants and the Facility Lender has no recourse against the Manager pursuant to the Loan Documents. ease if the manager should take actions that conflict with or violate the Covenants. A concern for the facility lender is that if the manager is not subject to the facility loan documents, the manager may issue a capital call to investors in the Fund and direct the proceeds of this capital call to an account other than the collateral account pledged to the facility lender. This is often called collateral leakage.
To help protect against leakage of collateral, the servicer may be attached to the credit agreement as a creditor party. The manager would be treated the same as the general practitioner. The Covenants and certain other relevant covenants, representations and warranties would apply to the Manager. The Manager would be subject to remedy for breach of its contractual obligations under the Facility Loan Documents or for any fraud, willful misrepresentation or willful misappropriation of Facility proceeds. In addition to becoming a credit party to the Credit Agreement, the Manager would also pledge all rights it has in respect of the Collateral to the Facility Lender. These are minor changes to the facility loan documents that can serve to strongly protect the interests of the facility lender without affecting the manager’s day-to-day operations and means of managing the fund.