Double Negative Pledges in NAV Credit Facilities: What Fund Finance Lenders Need to Know

Executive Summary

With more borrowers and lenders entering into net asset value (“NAV”) credit facilities, lenders may want to consider including a double negative pledge within the covenant provisions of NAV credit facility documentation. In this Legal Update, we explain:

• What a double negative pledge is;
• How using a double negative pledge can protect a lender’s right to seek additional collateral, deter the borrower from granting other negative pledges, and protect the lender’s place as a senior creditor; and
• Why a lender should make sure to have adequate security interests in new collateral even if a double negative pledge is included.

Background

The market for NAV credit facilities continues to grow and evolve. With their increased use, fund finance lenders should be aware of a helpful covenant provision: double negative pledges.

A negative pledge, often included in traditional loan documentation, is a covenant that prohibits the borrower from pledging assets of the borrower to another party, whether or not such assets are pledged as collateral.

The following is an example of negative pledge language in a credit agreement:

No Borrower shall, directly or indirectly, create, incur, assume or suffer to exist any Lien (other than in connection with this Agreement) upon or with respect to any of the property or assets (including the Collateral) of any kind, real or personal, tangible or intangible (including, but not limited to, the capital stock or other equity interest, as the case may be) of such Borrower.

A double negative pledge is a covenant which goes further than the standard negative pledge by also including language requiring the borrower to abstain from granting any other negative pledges to third parties. In other words, the borrower agrees to refrain from (1) granting liens on assets pledged to such lender to any other existing or prospective lender (i.e., the negative pledge) and (2) including negative pledge covenants in any loan documentation relating to other existing or prospective credit facilities.

The following is an example of double negative pledge language in a credit agreement:

No Borrower shall, directly or indirectly, (a) create, incur, assume or suffer to exist any Lien (other than Permitted Liens) upon any property or assets (including the Collateral) of any kind, real or personal, tangible or intangible, of such Borrower or (b) enter into, or suffer to exist, any agreement with any Person that prohibits or limits the ability of a Borrower to create, incur, assume or suffer to exist any Lien upon or with respect to any of the property or assets (including the Collateral) of any kind, real or personal, tangible or intangible, of such Borrower.

What You Need to Know

With NAV credit facilities becoming more prevalent in the fund finance market, lenders to private equity funds whose loan documentation permits the incurrence of other indebtedness and does not already require liens on all of the borrower’s assets to secure the facility may want to consider including a double negative pledge within the covenant provisions of its NAV credit facility documentation.

Primary Purposes

In addition to providing the protections created by a standard negative pledge, a double negative pledge has the following primary purposes in NAV credit facilities where other indebtedness is permitted to be incurred:

1. Ensures prospective creditors cannot restrict the senior lender’s ability to seek additional collateral when necessary. A negative pledge keeps the assets of the borrower, including the collateral pledged to a NAV lender, free and clear of liens in the future. A double negative pledge achieves this result as well, but goes further which can be useful in the event the NAV lender seeks to obtain additional collateral in the future. Common scenarios are where a borrower’s financial condition deteriorates and the lender requires additional comfort or where the borrower seeks additional borrowing capacity and additional security is needed to support the credit. To the extent that other debt is permitted by the terms of the NAV credit facility, the terms of that third-party credit facility could otherwise include a negative pledge on the assets of the borrower that are not already subject to the liens of the NAV credit facility, thereby restricting the ability of the borrower to provide liens on additional collateral in support of the NAV credit facility. These provisions can therefore be a helpful tool for lenders to ensure future borrowing base capacity and to bolster the credit profile of a facility.
2. Avoids issues with Acquired Asset Provisions. While NAV credit facilities are generally secured by collateral accounts into which proceeds of, and distributions from, investments are held, there is variation in other assets on which a NAV credit facility may have liens. In those facilities where it is anticipated that as assets are added to the borrowing base (or acquired by the Borrower in the future) additional liens on these assets (or liens on the equity of vehicles holding these assets) will be required, a double negative pledge will be helpful in preserving the ability to put liens on those assets.
3. Acts as a deterrent. The covenant would deter borrowers from offering multiple negative pledges to additional lenders and bolster the NAV lender’s priority position in the capital stack to the extent that additional collateral is required (or additional collateral becomes available). To the extent that other creditors emerge, the borrower would be prevented from permitting them to include such provisions, and in the event a negative pledge is requested by them from such borrower, the borrower would need to notify the other creditors of the presence of the existing debt which contains the double negative pledge restriction.

Potential Considerations

When a lender in a NAV credit facility seeks to include a double negative pledge in the loan documentation, there are a few considerations to keep in mind:

1. Double negative pledges are not a substitute for a security interest. While the double negative pledge can keep future collateral unencumbered if the lender needs to acquire a security interest in the future, the double negative pledge itself does not create that security interest. To obtain a security interest in newly acquired assets, the lender must get a pledge of those specific assets as collateral.
2. Although the double negative pledge may have the effect of putting other lenders on notice that they cannot enter into negative pledges with the borrower, this deterrent effect can be minimized if other lenders don’t have access to the facility documentation of the borrower. While other lenders may request this documentation from the borrower as part of their diligence process, there may be confidentiality restrictions on providing such documentation. Therefore, lenders may:

a. have to rely upon the borrower keeping track of their debt and collateral restrictions, including double negative pledges, and while a lender would likely have a legal claim for breach if the borrower breaches the double negative pledge, the complexities of the resulting situation can be avoided if subsequent lenders have access to all previous loan documentation, or

b. consider requesting a precautionary filing of an all assets UCC-1 financing statement that puts potential creditors on notice that assets have been pledged, even though no corresponding security interest has been created. However, in this case, lenders should also be prepared for the need to potentially modify the filing if needed and/or provide representations or other evidence to subsequent lenders that the corresponding security agreement does not exist.

3. Since double negative pledges typically operate only at, or immediately below, the level of the parties to the loan documentation, lenders in most NAV credit facilities will be structurally subordinated to liens incurred at a level at or below the underlying investment. Accordingly, lenders should keep in mind that double negative pledges may not prevent the issues that relate to subordination from subsidiary-level debt.

Next Steps

Fund finance lenders entering into NAV credit facilities with borrowers that permit the incurrence of other indebtedness may want to consider whether it would be worthwhile to include a double negative pledge in their NAV credit facility documentation. Doing so can protect the lender’s right to seek additional collateral, deter the borrower from granting other negative pledges, and protect the lender’s place as a senior creditor.