Podcast: A Primer on Asset-backed Leverage Facilities
In this Ropes & Gray podcast, finance partner Patricia Lynch, counsel Patricia Teixeira and associate Douglas Hollins discuss the use of asset-backed leverage facilities by credit funds, how they can benefit the funds, and review some of its key terms.
Douglas Hollins: Hello, and thank you for joining us today on this Ropes & Gray podcast. My name is Douglas Hollins, and I am an associate in the Boston office of Ropes & Gray in the finance practice group. Joining me today are Patricia Lynch, a partner in our finance group in Boston, and Patricia Teixeira, counsel in our finance group in New York. The three of us spend a significant portion of our time advising private investment funds on various types of fund financing, including what seems to be an ever-increasing number of asset-backed leverage facilities. This podcast will focus on these leverage facilities, which are obtained by credit funds and secured by their underlying portfolios of loans and debt securities. Since the popularity of these facilities seems to be exploding, we’d like to make our listeners aware of their basic structure, some of the benefits that they offer, and some unique features to be aware of.
So, Patricia Lynch, Patricia Teixeira, could you start by explaining what these facilities are and why they may be attractive to certain funds?
Patricia Lynch: Sure. Simply put, an asset-backed leverage facility is a medium-term credit facility secured by a discreet pool of portfolio assets that a fund has invested in. These facilities “look down” the capital structure for their collateral, so to speak, as opposed to traditional subscription facilities that “look up” the structure to the investors’ capital commitments for security. The assets securing the facility are loans and other debt securities held by the fund, which are isolated in a special purpose vehicle, known as an “SPV,” much like in a securitization, so that the lender is shielded from ancillary risks at the fund itself. Those assets then contribute to a borrowing base formula that determines how much the borrower can draw at any given time.
Patricia Teixeira: These facilities usually consist of a unique three-phase lifecycle. The initial phase, lasting about one to three years, is the reinvestment period, when the facility’s regular-way fees and mechanics apply but when the borrower can invest the proceeds from drawings under the facility, as well as returns from its portfolio investments, in either additional portfolio assets or in certain pre-approved categories of assets, like highly-rated money market funds and commercial paper. Some facilities contemplate a ramp-up period that allows the borrower to accumulate assets and build its initial collateral pool more easily. During this ramp-up period, usually the first 12 months of the reinvestment period, the commitment fee is set lower than during the rest of the life of the fund, and the eligibility criteria and concentration limits with respect to the assets that the borrower can acquire are relaxed. Last, is the wind-down or post-reinvestment period, during which the borrower can neither borrow additional funds nor reinvest proceeds on investments, and has to pay down the facility with proceeds from the remaining portfolio assets.
Patricia Lynch: Our credit fund clients are finding that these facilities provide a flexible opportunity to maximize returns on their investments. The SPV structure that I mentioned translates into a relatively low cost of capital. So, the funds receive capital from these facilities, in addition to their investors’ contributions, that they can deploy to make investments in debt instruments, which investments, in turn, pay interest at rates that are meaningfully higher than the interest rates that the borrower pays on its asset-backed facility. In sum, the funds are able to deploy a larger amount of capital at a higher return using these facilities.
Douglas Hollins: To follow up on that point, the SPV structure is really what drives the utility of these products, isn’t it? Leverage facility lenders expect to be the only creditors of the borrower and to be over-collateralized. So, it’s essential that the SPV be “bankruptcy remote,” meaning that it has to be sufficiently isolated from the rest of the fund’s corporate structure that, in the event of a bankruptcy at the fund, a court would be unlikely either to consolidate the SPV with the rest of the corporate structure or to claw back any assets that the fund has transferred to the SPV.
Patricia Teixeira: That’s right, and that bankruptcy remoteness is achieved in a number of touchpoints throughout the structure and process. There’s a documentary aspect for one thing: The SPV borrower’s organizational documents and the credit agreement include separateness covenants to ensure the borrower is a third party, distinct from the fund. In addition, the borrower’s management includes an independent director whose consent is required for material actions, including any insolvency filings or a dissolution. The transaction documents also include non-petition provisions that prevent a third party from dragging the borrower into a bankruptcy proceeding before the end of the applicable preference period.
Patricia Lynch: Another aspect of maintaining bankruptcy remoteness has to do with how the portfolio assets that secure the loan are transferred to the SPV. The fund initially acquires or originates these assets, then sells or contributes them to the SPV at the closing of the facility and/or from time to time thereafter pursuant to a purchase agreement. It’s important that these sales or contributions of portfolio assets constitute what are called “true sales” or “true contributions,” and a major factor in that analysis is whether the relevant transaction essentially shifts the risks and benefits of ownership of the assets from the fund to the SPV. So, it’s critical that, under the purchase agreement, the fund not remain liable for any debt or receive any surplus in respect of the transferred portfolio assets. It also should not guarantee the collectability of any portfolio asset or accept any risk of loss. And anyone contemplating an asset-backed leverage facility should be aware that lenders typically require borrowers’ counsel to deliver “true sale” opinions with respect to these transactions, which are quite fact-intensive and can require a good amount of lead time to prepare.
Douglas Hollins: Yes, it is very important to plan ahead for those. Let’s stay on the topic of collateral for a moment since that is obviously a key feature of these leverage facilities and, accordingly, a highly negotiated one in our experience. In this type of facility, what does the collateral consist of, and how do the parties determine what collateral is and isn’t eligible for inclusion in the borrowing base?
Patricia Teixeira: Sure. Some facilities give the administrative agent approval rights over assets purchased by the borrower during the life of the loan on a case-by-case basis, but many include pre-negotiated eligibility criteria so that the borrower doesn’t need to go back to the agent for approval in connection with every investment. The collateral usually consists of various types of debt instruments: loans, bonds, structured debt obligations, etc. Apart from that, eligibility criteria can include whether the asset is secured, the frequency of interest and principal payments on it, term to maturity and credit rating, to name a few, in addition to more bespoke, deal-specific requirements.
Patricia Lynch: As in any asset-backed loan, in addition to eligibility criteria, concentration limitations are also a key collateral consideration. These limitations can be based on any of the eligibility criteria that Patricia mentioned, but also frequently include restrictions on the proportion of the overall collateral pool that can consist of obligations that are issued by the largest individual obligors or groups of obligors. They can also include restrictions on loans to obligors with certain S&P or Moody’s industry classifications, the proportion of obligors affiliated with the fund, the proportion of distressed loans or the amount of obligations that have an unfunded commitments to lend additional amounts in the future, for example, under a delayed draw term loan commitment.
Douglas Hollins: The possibilities are virtually endless here. So, once everyone agrees what the collateral can consist of, another key point of negotiation is how that collateral is valued for purposes of the borrowing base. I think we find that specific mechanics can vary quite widely, though they do follow a common framework.
Patricia Teixeira: That’s right. Typically, when a portfolio asset is acquired by the borrower, the agent simply values it at its purchase price, or at par if purchased above market value, disregarding any de minimis original issue discount. After the initial acquisition, there are often certain circumstances that allow the agent to reassess the value of an asset. These can include the measurement date for any monthly collateral reports, borrowings or repayments by the borrower, reinvestments of proceeds from portfolio assets and sales of portfolio assets. Some facilities only allow the agent to revalue assets in connection with certain adverse events at the level of the assets, such as payment defaults or insolvency events with respect to the obligor on the underlying asset, defaults in the obligor’s financial covenants, its failure to deliver periodic financial statements and material changes to certain key terms of the underlying loan documents. In the case of any of these revaluations, the agent usually calculates the value by multiplying an asset’s market value, as a percentage of par, by its outstanding principal balance.
Patricia Lynch: When an asset is sufficiently liquid, that market value is determined by reference to bid prices published by independent valuation firms, like LoanX/Markit or Loan Pricing Corporation. If an asset is not sufficiently liquid, the agent usually determines the value of an asset on its own using its commercially reasonable discretion and acting in good faith. In those cases, it’s important that a borrower have the right to challenge that valuation, which it can usually do either by reference to observable market prices, by submitting third-party bids or by obtaining a valuation from an independent valuation firm.
Now, taking all of these points together, what this means is that the amount that a borrower can draw at any time under these facilities is determined by specifying an advance rate with respect to each type of collateral, and multiplying the value of the collateral pool by the applicable advance rates to determine the borrowing limit. One thing to note is that the revaluation mechanics in an asset-backed loan can cause the borrowing limit to fluctuate more frequently than under a borrowing base construct in a traditional subscription facility.
Douglas Hollins: That’s certainly helpful to keep in mind. Now, finally, what would you say are some other features of this type of facility that potential borrowers should be aware of but might not be as familiar with if they’re more used to a traditional subscription facility structure?
Patricia Teixeira: One thing is certainly the waterfall mechanic. This will be familiar to anyone who has experience with securitizations as it’s a by-product of the borrower’s bankruptcy-remote structure. Since the borrower’s only assets are the collateral pool that secures the facility, there’s a payment waterfall that carefully directs the use of any proceeds of the portfolio assets to prevent leakage of those proceeds to the fund before the lenders have been paid. The waterfall requires principal and interest payments on the portfolio assets to be paid to a collection account that’s pledged to the lenders. The borrower is then required to periodically run collections on the portfolio assets, along with proceeds of any other permitted investments, through the waterfall. The steps in the waterfall are usually, first, fees and expenses due to the agents, then, other third-party administrative expenses, then, interest or margin due to the lenders, then, any amortization payments. During the reinvestment period of the facility that I mentioned earlier, any excess interest proceeds can generally be distributed to the fund as long as there is not an event of default, and excess principal proceeds can be reinvested in additional assets, subject to the facility’s concentration limits. However, lenders usually require the borrower to maintain a reserve account holding a sufficient amount of cash to cover any revolving or delayed draw loan commitments. And during the “wind down” phase of the facility, all excess proceeds have to pay down the loan.
Patricia Lynch: There are also certain unique events of default that, again, are driven by the borrower’s bankruptcy-remote status. Failure to maintain the bankruptcy remoteness of the borrower often triggers an event of default, as does the failure to maintain a perfected lien on the collateral or to properly maintain any collateral accounts. Remedies for events of default are the same as in any customary credit facility, but the nature of the collateral pool means that the administrative agent generally has some additional rights. For example, during an event of default, the borrower is prohibited from purchasing further portfolio assets or investing any funds that it has on hand, and the agent can seize and distribute cash in any collateral accounts according to a default waterfall described in the credit agreement. To forestall these remedies, a fund can sometimes negotiate the right to contribute assets to the borrower or to sell assets. And a borrower can also sometimes require the lenders to seek bids for any portfolio assets being sold in order to avoid a fire sale. Finally, a fund may request a right to match the highest offer for portfolio assets being sold or to have a last look right at those assets.
Douglas Hollins: It’s definitely important to think through these distinguishing challenges when putting one of these leverage facilities in place. Thank you both. I’m sure that’s all useful information for our listeners to be aware of. And I think we can safely expect these structures to continue to grow in popularity given their utility and flexibility. Thank you to our listeners for joining us. For more information on other topics of interest to private funds or institutional investors, please visit our website at www.ropesgray.com. And of course, if we can help you navigate any of these areas, please do not hesitate to contact any of us. You can also subscribe and listen to other Ropes & Gray podcasts wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.
For more information on this topic, please click here to access a chapter in Global Legal Insights: Fund Finance Laws and Regulations 2022 authored by Patricia Lynch, Patricia Teixeira and Douglas Hollins.