Earlier this week we pondered a thought experiment: what would happen if a fund released its investors from their capital commitments without notifying the lender to the fund? How would the lenders’ rights under a typical capital call facility structure hold up in such circumstances?
No loan, no worry…?
The starting point is the state of the facility at the time. Has it been drawn? If there are no outstanding loans, then the lender can simply cancel any commitment to lend and walk away whole with any arrangement and accrued commitment fees.
The contracts hold up?
So, if there are existing borrowings, what next? (Yes – we know it is stretching credulity to release fund investors without dealing with the credit facility. It is a thought experiment…!)
Well, there will generally be restrictions around what a fund can do by way of releasing or canceling investor commitments without lender consent under a well-drafted facility, notwithstanding that such rights may exist under the partnership documents.
This right would be subject to compliance with the facility financial covenants measuring the collateral cover provided by the capital call rights against the borrowings outstanding. We’re thinking here of collateral tests measured by LTV ratios or included/ excluded investor criteria.
A facility breach would certainly occur if all investors are released, since their commitment obligations to the fund constitute the primary collateral for a typical capital call facility. Such a breach triggers an event of default and activates the lender’s right to enforce the security package, including the security interest over the general partners’ right to call on investor commitments.
But the commitments have already been released. So, what next?
Does security triumph over all?
Can the lender simply rely on its status as a secured creditor to ‘reverse’ the investor releases? Does its security interest over contractual rights trump what the two contractual parties may decide to do with those rights? That would be great (for lenders). But the answer is no.
The lender takes security over the right of the general partner or the manager to call on the capital commitments of investors. The security sits ‘on top’ of those contractual rights, but does not replace or vary them.
The security will always be subject to the general partners’ or manager’s discretion to deal with the capital call rights, as described in the fund agreement (and any investor side letters). The fund agreement will give the general partner or manager discretion to deal with investors (e.g. by releasing an investor from its capital commitments). These rights are distinct from its obligations under the finance documentation to limit its exercise of such rights.
The lender will have a clear contractual breach under its facility documents, but this cannot be used to ‘clawback’ those capital commitments into the hands of the fund. A capital commitment must be held by someone. If the commitment is released, so is the benefit of the security interest over that commitment.
Hence the golden rule for secured lenders – protect your secured assets. The finance documents provide the initial framework (e.g. including properly drafted borrowing base and prepayment mechanics), but the monitoring of the borrower provides the ongoing protection.
So, if pushed, what would be your next step? Part two of this two-part article, continuing our thought experiment on lenders’ rights under capital call facilities will be available from Monday 12 March.