In this Ropes & Gray podcast, finance partner Alyson Gal and counsel Patricia Teixeira discuss the use of credit facilities as an important source of liquidity and leverage for registered investment funds. They explore the regulatory landscape applicable to these facilities and review some of their key terms.
Patricia Teixeira: Hi, my name is Patricia Teixeira and I’m a counsel in Ropes & Gray’s finance practice group. Here with me today is Alyson Gal, a partner in our private capital transactions group with experience in credit facilities for registered funds. To get us started, I’m going to provide a little background on these funds and talk about why registered funds might look into entering into credit facilities.
Registered investment funds, sometimes referred to as “mutual funds,” are investment funds which are registered with the Securities and Exchange Commission under the Investment Company Act of 1940 and subject to related regulations. Debt facilities for registered funds are subject to 1940 Act-based restrictions that private investment fund liquidity facilities are not. Registered funds come in two basic types: open-end and closed-end. And the rules governing the use of debt by these two types of funds are different. Mutual funds use debt to provide a back up source of liquidity, particularly in the case of open-end funds which need to ensure that they have liquidity to finance share redemptions. They may also use debt for leverage. Both open-end and closed-end funds may use revolving credit facilities to ensure sufficient liquidity to finance share redemptions and to meet their other liquidity needs.
Patricia Teixeira: Another key constraint is that Section 18(c) of the ’40 Act prohibits closed-end funds from issuing more than a single class of indebtedness. Because debt of the same priority is considered to be a single class, a closed-end fund could have more than one credit facility, so long as they are both unsecured or are secured by the same collateral and on the same basis.
Alyson Gal: And going back to the asset coverage test imposed by Section 18, a credit facility may, depending on the risk profile of the fund’s investments, require a higher coverage percentage. We often see this as high as 400% or 500%. Open-end funds typically borrow only to fund daily redemptions and to satisfy other short-term liquidity requirements resulting in typically smaller facilities relative to the assets of the fund, and those facilities may be unsecured. In many cases, these open-end revolving facilities are seldom drawn, and serve primarily as a backstop liquidity source in case redemptions reach unusual levels. In order to save on transaction costs and unused commitment fees, multiple open-end funds, in some cases over 100 funds, with the same investment advisor may borrow separately under a single umbrella credit facility. These short-term facilities also are generally limited to 364 days to reduce capital reserve requirements for bank commitments, and thus, they will need to be renewed each year.
Patricia Teixeira: And one point to note is that since each of these separate funds has their own shareholders, it is critical that all borrowings must be on a several basis with respect to each individual series, and not jointly with the other borrowers. Where multiple funds are co-borrowers under a common credit facility, the trustees for the various funds must adopt procedures to fairly allocate borrowing opportunities and the payment of shared expenses, such as upfront fees, unused commitment fees, indemnities and obligations to reimburse lender expenses. Most often, these allocations are based either on the relative net asset value of the fund borrowers or on the anticipated relative levels of use of the facility by the different borrowers.
Alyson Gal: Now, closed-end funds tend to use leverage as a more significant part of their capital structure. Their credit facilities may be either revolving credits or term notes, and are typically secured. Because closed-end funds are limited to a single class of senior securities representing indebtedness, lending facilities that are common in other contexts can present challenges to such funds due to the regulatory restrictions on having multiple lending facilities with different pools of collateral, or differing priorities in such collateral.
So, let’s now start to get into the restrictions and covenants that these funds need to comply with in putting in place a credit facility. What are some of the covenants that these funds are facing?
Patricia Teixeira: Yes, so we know that we have the asset coverage covenants and that they can sometimes impose stronger percentage restrictions than the ’40 Act, something like 400% or 500%, but this covenant can also be tested more often than required by the ’40 Act. In some credit facilities, it is tested at all times, even though for closed-end funds, that’s only needed upon debt incurrence, equity issuance, and declaration of or payment of dividends. Lenders also often seek an immediate event of default if the asset coverage test is violated, while Section 18 provides a three-business-day cure period for an open-end fund to repay debt or to take other action needed for compliance. Borrowers obviously prefer for the credit facility to provide for the same cure period as afforded by Section 18, though not all lenders agree to this.
Alyson Gal: That’s right, and credit facilities will also have the standard set of negative covenants. It’s customary, for example, for these agreements to impose restrictions on the amount of debt and liens that can be incurred by the fund for both open-end and closed-end funds. In negotiating these covenants, borrowers will want to make sure that they include enough exceptions to permit the various credit-type obligations that the fund might incur in the ordinary course, such as hedging exposure, securities lending, reverse repos, and the like, while the liens covenant should include segregated assets that cover these obligations for the purposes of Section 18. This can be a particularly tricky covenant as a fund may need to project their usage of these products as many credit facilities limit these obligations to a certain percentage of fund assets.
Patricia Teixeira: Another noteworthy covenant is that lenders to a registered investment fund often do not want the borrower to pay dividends on its equity or to repurchase shares of equity if an event of default exists. For open-end funds that are subject to daily redemptions and may seldom have outstanding borrowings, flexibility takes the form of this restriction applying only when the particular fund has outstanding loans. In addition, since registered funds must generally distribute to shareholders at least 90% of their net investment income in order to maintain tax pass-through status as a “regulated investment company,” restricted payment covenants ideally contain an override exception that permits restricted payments to the extent necessary for the fund to maintain its status.
Alyson Gal: Another covenant to consider is that lenders often prohibit registered fund borrowers from creating subsidiaries to hold portfolio assets that do not become guarantors under the credit facility. However, open-end and closed-end funds will sometimes want to transfer portfolio assets to a special purpose subsidiary which obtains independent debt financing that is non-recourse to the parent fund. Open-end and closed-end funds may also create subsidiaries to hold futures and commodities investments to avoid excess non-qualifying income which would arise if these investments were held directly by the fund itself. If credit facilities do permit subsidiary drop-down structures, the covenants will typically impose limitations on the amount of portfolio assets that can be contributed to non-obligors and on the level of debt which can be incurred at that level given that the holders of such debt will have structural priority on the assets of those entities.
Patricia Teixeira: Also, because the lender bases its credit analysis on a fund’s Fundamental Investment Policies, credit facilities for registered funds will restrict the ability of the fund to alter these policies. Any change in such policies that is sufficiently material to require shareholder approval under the ’40 Act will likely require consent of the lenders under the credit facility.
Alyson Gal: Similarly, the identity of the fund’s investment advisor and custodian is also central to the lender’s credit analysis. Lender consent must be obtained before either the investment advisor or custodian is changed other than to an affiliated entity. In thinking about the custodian, secured credit facilities for closed-end funds and, when applicable, open-end funds, involve special issues. The ’40 Act generally requires all funds to keep portfolio assets with a bank custodian. As a result, in order to have a perfected security interest in such assets, the secured lender must either be the custodian itself or enter into an account control agreement with the custodian.
Patricia Teixeira: And that control agreement may look different depending on the types of assets that the fund maintains. For example, funds that invest in limited partnership interests in private equity funds may not have the ability to freely pledge such assets, due to general partner consent requirements that often apply to such investments. For such investments, workarounds will need to be considered.
Now, thinking of how these products have evolved over time, they are certainly not immune to the recent rise in interest rates. As rates have risen, I’ve noticed an uptick in borrowers seeking uncommitted lines which allow discretionary access to liquidity at lower fees. I’ve also noticed a stronger emphasis by borrowers on the operational aspects of a breach. Perhaps it was the lower valuations during the pandemic, but borrowers have increasingly asked banks to consider longer cure periods for borrowing base or other valuation-type breaches. We have seen very detailed provisions on borrowers providing specific cure plans to the banks if valuations drop below expected levels, allowing the business and operations teams at these funds a bit of breathing room to cure a potential default. I think this really underscores the importance of these credit facilities for fund borrowers, especially in times of financial stress.
Alyson Gal: Yes, overall, these credit facilities can be an important source of liquidity and leverage for registered funds. The regulatory landscape that applies to registered investment funds and their lenders is always evolving, so while we’ve provided an overview of some of the issues that are presented by these credit facilities, there’s always more to consider, and we definitely are always needing to consult and coordinate with our ’40 Act colleagues.
Patricia Teixeira: Thank you, Alyson, for joining me today for this interesting conversation, and thank you to our listeners. For more information on credit facilities for registered funds or other topics of interest to private investment funds, please don’t hesitate to contact one of us or visit our website at ropesgray.com. You can also subscribe and listen to other Ropes & Gray podcasts wherever you regularly listen to your podcasts, including on Apple and Spotify. Thanks again for listening.
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