As the European funds finance market becomes more sophisticated, hybrid facilities represent an attractive solution for funds seeking a single credit facility capable of servicing its needs from cradle to grave. Furthermore, as lockdown stretches liquidity, hybrids offer an innovative solution.
Hybrids blend elements of subscription line and net asset value (NAV) facilities, lending against a large pool of undrawn capital commitments and later against a portfolio of underlying investments as those commitments are deployed. The lender will have recourse to both undrawn commitments and the investment portfolio. The form this takes for each fund is fairly bespoke as the purpose of a hybrid is to facilitate a fund’s growth, therefore its operational workability must be balanced against a lender’s ability to get repaid should matters go wrong.
In good market conditions, a hybrid facility prompts a seamless transition from initial closing to full investment.
During market turmoil, hybrids offer vital liquidity to acquire underpriced investments, aid squeezed portfolio companies and can delay unprofitable early exits from investments.
Often a lender finances a special purpose holding vehicle beneath the fund, which holds a series of portfolio companies. The facility may implement one or separate tranches to be advanced against undrawn commitments and NAV, either with different margins for the sub-line and NAV features or blended across both pools. The repayment source for the loan is usually a combination of distributions and disposal proceeds flowing up from investments and investor commitments. The facility will typically be supported by a fund guarantee, alongside security over the uncalled commitments, bank accounts into which commitments and distributions are paid, share security over asset vehicles and/or all-asset security over the investments.
This raises myriad legal considerations. Firstly, do the fund’s constitutional documents permit this financing and the security required under it? Any structural issues will need to be solved if the fund cannot guarantee or a guarantee will attract adverse tax implications. Simultaneously, does the application of any cash sweep from investment distributions impinge on the fund’s obligation to make a return to its investors?
The proposed security package should be critically analysed too. For example, if the borrower doesn’t wholly own its subsidiaries, shareholder agreements may mean that share security is not feasible without breaching those agreements.
Consider also how this structure interacts with the underlying investments and asset level financings. For instance, with credit funds, the underlying credit documents may prohibit security over the loan assets. The scope of legal due diligence should be discussed early on. In the interim, some subscription facilities include accordion features which enable an existing facility size to be increased at relatively short notice (at lender discretion).
Alternatively, liquidity may be offered directly to portfolio companies by having a “qualified borrower” concept in subscription facilities, so that they are able to borrow under that.
These options can be used prior to implementing a hybrid facility, which resolves longer-term liquidity concerns of sponsors, as asset-level credit facilities are fully drawn and credit availability for portfolio companies tightens.
By Leon Stephenson, partner, and Parisa Clovis, senior associate, at Reed Smith
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