Key issues for lenders in providing acquisition finance and liquidity finance to Cayman vehicles in the alternative investment space
August 2013 | PROFESSIONAL INSIGHT | BANKING & FINANCE
Financier Worldwide Magazine
Lenders face several challenges when providing acquisition finance for the purchase of private equity interests on the secondary market.
The secondary market started 15 years ago and transaction volumes have been rising, especially in recent years. In 2012, there were around US$26bn worth of secondary transactions. This level is likely to reach $30bn in 2013. Also, fundraising for secondary funds is on the increase. AXA raised US$7.1bn in 2012 which is one of the highest fundraisings in several years. The forecast is for activity levels in the secondary market to continue and possibly grow further during 2013.
Reasons why interests are sold
Some investors are looking to rebalance their portfolios and diversify in terms of vintage years. Frustration with the lack of exit opportunities has fuelled sales. Some investors are exiting in order to rationalise their relationships with general partners. There are regulatory pressures such as Solvency II, which have forced the hand of some institutions, such as insurers, to reduce their private equity holdings. In recent years, the price expectation gap between buyers and sellers has narrowed sufficiently to get sales moving as the discount on NAV is attractive at around 9-10 percent. For buyers, purchases are also a way to buy into funds managed by better performing general partners which were oversubscribed. The secondary market has become a core strategy for investors in its own right; a far cry from the days when it was only associated with distressed sellers looking to exit their investments and regain liquidity.
Specific issues in providing secured acquisition financing for secondary market transactions
In the Cayman Islands, interests in private equity funds usually take the form of interests in exempted limited partnerships. The general partner has a key role in relation to transfers of interests and the taking of security over them.
Lenders take security by entering into a charge and assignment by way of security over the limited partnership interest. Partnership agreements usually provide that no transfers or charges over interests can be made without the prior consent of the general partner. Lenders should ensure that the general partner’s consent, and all other requisite consents, are obtained and procedures followed to ensure that the borrower purchaser acquires the interest and that the general partner approves the grant of security over it in favour of the lender. If the transfer of the interest to the borrower purchaser is ineffective due to lack of general partner consent, the security will fail as the borrower purchaser then has nothing to charge to the lender. The security may also fail if the general partner does not consent to the charge.
Lenders should ensure that notice of the charge together with a copy of the charge document is served at the registered office of the fund as the timing of service establishes priority under Cayman statute. Before taking security, the register of limited partnership interests, which is required to be maintained by the general partner under statute and which is open to public inspection, should be checked to make sure that there is no existing charge registered over the interest. An existing charge could take priority over the lender’s security.
When a lender enforces its security, it will usually exercise its powers under the charge to acquire or sell the interest to its nominee or to a third party purchaser. This is yet another transfer which would require the prior consent of the general partner. However, it is one unlikely to be provided at the time of acquisition. This leaves lenders facing risks on enforcement.
According to Samantha Hutchinson, a partner in Dentons’ London office, leverage finance in private equity secondary transactions is on the increase. “At a time when financial institutions are heavily focused on risk, these products offer an attractive risk/reward profile – a diversified private equity investment portfolio (of mostly mature interests), usually coupled with some recourse to the capital commitments of a diversified investor base consisting mainly of pension funds, SWFs and other institutional investors, which together provide strong down-side protection and attract a healthy return. The opportunities for lenders in this market are plentiful – the ones ahead of the game will be those looking at how to adapt their products to the wave of new secondary players that we have seen come into the market, including direct investors and SWFs,” she says.
Specific issues in providing credit facilities to hedge funds
Hedge funds generally use bank lending for leveraging investments and for additional liquidity to assist in meeting cash redemption payments. Usually, these are short term facilities secured against interests in offshore funds and other fund interests held by the fund.
These loans are mostly structured as revolving credit lines. In providing these facilities, the maximum amount banks will lend is usually set at a percentage of the total market value of the fund’s assets. This percentage will vary depending on the nature of those assets, including liquidity, risk profile, extent of diversification and volatility. The pricing of the loan will depend on the risk profile of the fund and the quality of the security being taken; a lower risk profile and more liquid security will result in a lower price.
As for taking security over the fund’s assets, particular issues arise in the fund of funds context. The underlying assets of the fund are interests in other funds which are not freely transferable, requiring the consent of the issuer to any transfer or grant of security over them. Also, legal title to those underlying fund interests is usually held not by the fund borrower but instead by a custodian in a custody account on behalf of the fund. Typically, the fund charges its beneficial interest in the custody account in favour of the lender and the lender takes a fixed and floating charge over the fund’s interest in the custody account. The lender does not take security directly over the underlying fund interests for a number of reasons which are largely practical. The grant of security would require the prior consent of each issuer of interests which poses challenges. The assets of the fund likely constitute multiple interests issued by different issuers and, as the fund trades each asset in the custody account, each issuer would have to be approached to release the asset from the security.
The lender also takes an assignment by way of security over the fund’s contractual rights against the custodian under the custodian agreement. Notice of such assignment should be given to the custodian to ‘perfect’ the security and to establish priority. Lenders should ensure that assets held in custody do not form part of the custodian’s bankruptcy estate but are clearly held for the benefit of the fund borrower. The custodian agreement and standard terms of custody should be checked. Lenders should also have a good understanding of any sub custody arrangements and be able to identify which entity actually has custody of the assets.
To minimise risks in providing acquisition financing and fund of hedge fund financing in Cayman, lenders will need to identify and address some specific issues. The Cayman Islands is the offshore jurisdiction of choice for alternative investment funds and also a creditor friendly jurisdiction based on the English legal system. Such an attractive combination explains why lenders are increasingly active in lending to Cayman vehicles.
Richard Addlestone is a partner at Solomon Harris. He can be contacted on +1 (345) 949 0488 or by email: firstname.lastname@example.org.
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