Subscription Secured Credit Facilities Gaining Traction in Real Estate Transactions

Subscription secured credit facilities are a niche lending product oriented to the liquidity needs of real estate and other private equity funds. These facilities are attractive to funds because they allow them to transact quickly on investment opportunities in a competitive marketplace and provide return-enhancing leverage. They appeal to lenders because of their favorable risk profile.

After providing a brief overview, this article highlights five of the most important issues confronting lenders and borrowers in connection with entering into a subscription-secured facility:

• Lender Diligence

• Loan Documentation – Addressing the Borrower’s Fund Structure

• Investor Letters

• Investor Transfer and Withdrawal Rights

• Facility Defaults

What Are Subscription-Secured Credit Facilities?

Subscription-secured credit facilities are revolving lines, drawn upon to make acquisitions and then paid down from capital calls and asset level borrowing. Typically, their terms are for about three years, with brief extensions—not beyond the “investment period” during which capital can be called. The collateral is—as the name indicates—a pledge of investors’ capital commitments to the fund, the fund’s rights to call that capital and enforce the investors’ capital funding obligations, and the accounts into which capital is funded. In most instances, the “borrowing base” is limited to 90 percent of the amount of unfunded capital commitments of creditworthy investors (called “Included Investors”). Thus, subject to the credit line’s maximum loan amount, the amount a fund can borrow grows as more Included Investors are closed into the fund, and then ultimately shrinks as more capital is called over time.

Subscription lines usually are put in place amidst a series of fundraising closings and are sized accordingly. The lead lender(s) will first do a “bridge facility” that in due course is replaced by a larger, “permanent facility” as the fund reaches the necessary size and syndicated co-lenders are added. As a fund acquires assets and matures, typically it will obtain an unsecured credit line as well that can be tapped to manage liquidity needs as the subscription line tails off. Often there is considerable overlap in the lending consortiums that provide subscription, asset-based and unsecured facilities for a fund as its sponsors cultivate and manage their banking relationships.

Lender Diligence.

As in any secured loan, the subscription line lender must be able to realize upon collateral in the event of a default. Because the collateral is the right to call capital, it is imperative that investors have no defense to a capital call that might be made by the lender in place of the general partner after the fund has defaulted on the loan. The lender’s counsel will scrutinize the fund’s organizational documents to confirm that the fund is authorized to enter into the credit facility and that investors will fund capital without defense, counterclaim, or set-off. In addition to the fund’s partnership agreement, the lender’s diligence will include a review of investors’ subscription agreements and side letters entered into with the fund’s general partner. In general, fund documentation prepared by experienced fund formation counsel has evolved over recent years to anticipate subscription secured credit facilities and avoid many of the concerns and language issues that might otherwise arise, including those potentially created by “most favored nation” clauses in side letters.

Investor Letters.

Because lenders are not parties to the fund documents themselves, they have traditionally required, at least in real estate funds, that borrowers deliver “investor letters” from each investor in which the investors acknowledge, among other items, that their capital commitment is being pledged to the lender and they will only fund their capital contributions into an account in which the lender has a perfected security interest. Investor letters also include a waiver by governmental investors of their sovereign immunity, an issue that can lead to additional negotiation and documentation.

A number of practical solutions and innovations have taken hold over the years as subscription secured lenders, fund sponsors, investors, and their respective counsel have become familiar with each other, the fund and loan documentation, and the issues that have tended to arise in repeated instances, especially those particular to specific investors. Recent streamlining trends include incorporating the substance of the investor letter into the fund limited partnership agreement rather than having a separate document, especially where certain foreign and other institutional investors lack the necessary familiarity or administrative capability to provide a separate investor signature easily. Especially for successive funds where lender relationships will continue, it can even be advantageous for fund formation counsel to seek input from lender’s counsel on the proposed fund documentation before fundraising efforts begin.

Documentation: Addressing the Borrower’s Fund Structure.

As with other credit facilities, loan documents generally consist of a credit agreement and one or more security agreements. While there are numerous terms subject to negotiation, the immovable object in subscription secured facilities tends to be the borrower’s fund structure itself. Loan documents must accommodate a wide range of ever-changing fund structures driven by unique investor tax issues and fund investment strategies. While the issues and the tools of the trade to address them tend to come up in fund after fund, the results are usually unique to each fund and often quite complex. The use of real estate investment trusts (REITs), other unrelated business income tax (UBIT) blockers, and alternative investment vehicles in a fund’s structure can generally be accommodated with guaranties (in the case of an upREIT), back-to-back pledges of the right to call capital (in the case of a downREIT), and the inclusion in the credit agreement of multiple borrowers (in the case of alternative investment vehicles). Because each fund’s structure is different, a sophisticated understanding of applicable tax structuring and Employee Retirement Income Security Act (ERISA) issues is essential to properly arrange and document the credit facility.

Investor Transfer and Assignment Rights.

Naturally, investors’ transfer or withdrawal rights—including those in side letters—are a particular concern to lenders whose collateral is based on the creditworthiness of transferring or withdrawing investors and who may interpret transfers or withdrawals as a sign of trouble between a fund and its investors. Lenders retain the right to approve the inclusion of new investors and transferees in the borrowing base. Unapproved transfers, withdrawals, or failures to fund will trigger default if a safety margin is exceeded, often measured at a cumulative 15 percent of the remaining capital commitments. Default will also arise, of course, if the facility becomes overdrawn as a result of a reduction in the borrowing base caused by a transfer or withdrawal.

Facility Defaults.

The subscription secured credit facility product seems to have survived the recent economic downturn well. The enforceability of the lender’s collateral—its right to call capital from investors—appears uncontroversial and generally accepted on both statutory and contract law grounds, although there is very limited case law on point and it does not address every defense an investor might raise. The paucity of case law supports anecdotal information from funds and lenders indicating that even though a number of investors faced liquidity and other issues and some reduced their holdings in a variety of funds, credit facility defaults seem not to have arisen from investors’ failure to fund.

There may be a practical mechanism at work—funds simply were not likely to transact and draw on their subscription lines if they were aware that one or more of their investors might not fund their capital contributions. Either way, however, lenders, funds, and investors can all take comfort in the result.

Looking ahead, subscription secured facilities will continue to be attractive to funds that are able to fundraise successfully and to lenders who have developed or can access the necessary expertise and understanding of the fund market and the evolving investor base globally.