Equity Commitment Letters: Understanding How They Differ from Guaranties

Equity commitment letters (“ECLs”) are a type of credit support that lenders often rely on to facilitate repayment when providing financing to a private investment fund. In this Legal Update, we explain the purpose and structure of ECLs and discuss how they differ from guaranties, and specifically, limited guaranties.

A commonly used form of credit support in the fund finance market, an ECL is an agreement that documents the commitment to contribute capital or other financial support by one entity (“ECL Provider”) in favor of another entity (“ECL Recipient”). In the fund finance market, the ECL Provider is typically a parent entity or an investor in the fund, and the ECL Recipient is often a subsidiary holding or operating vehicle that is the borrower or primary obligor under a credit facility. 

ECLs may be used when the ECL Provider is unable or unwilling to enter into a guaranty. The organizational documents of the ECL Provider may include restrictions or limitations on the incurrence of indebtedness that prevent the entry into a guaranty, or the ECL Provider may prefer that the obligation be reflected on its balance sheet as a contingent contractual obligation to make an equity contribution via an ECL rather than as debt in the form of a guaranty. The ECL is used to demonstrate to a lender that the ECL Recipient—the borrower in the credit facility—has additional resources and liquidity options to meet its repayment obligations under the credit facility if its assets are at some future point in time insufficient to meet those obligations.

The obligation to provide capital runs in favor of the ECL Recipient, not the lender, so only the ECL Recipient can enforce the terms of the agreement; however, the ECL Recipient and ECL Provider can specifically designate the lender as a third-party beneficiary under the ECL.  The ECL Recipient may also collaterally assign its rights under the ECL to the lender under a credit facility. From a lender’s perspective, the collateral assignment by the ECL Recipient of its right to enforce and receive the ECL Provider’s capital commitment essentially mirrors the collateral provided in a subscription credit facility, with the enforcement and receipt of the ECL Provider’s funding obligation filling the role of a fund’s third-party investors’ unfunded capital commitments associated with a typical subscription credit facility collateral package.

Key Terms and Provisions of an ECL

An ECL in connection with a fund financing will usually include the following key terms and provisions:

• Waivers of defenses, counterclaims, and offset rights: A waiver by the ECL Provider of the defenses of Section 365(c)(2) of the Bankruptcy Code, suretyship-related defenses, counterclaims, and offset rights that may be available to an ECL Provider under applicable law.
• Third-party beneficiary: A provision naming the lender in a credit facility as a third-party beneficiary of the ECL Recipient’s rights under the ECL, which is also intended to permit the lender standing to assert a contractual claim in the event of a breach of the terms of the ECL. This also provides evidence of the lender’s reasonable reliance on the ECL Provider’s obligation to fund capital, which relevant courts have indicated is the standard required in upholding a lender’s right to enforce similar capital commitment obligations.
• Lender consent to amendments: Prohibitions on any modification to or termination of the ECL without lender consent.
• Pledge by the ECL Recipient: An acknowledgment of the pledge granted under a credit facility by the ECL Recipient in favor of the lender of its rights to receive capital from the ECL Provider under the ECL, which is intended to permit the lender standing to assert a contractual claim in the event of a breach of the terms of the ECL. 
• Acknowledgment of lender’s reliance: A specific acknowledgment of the lender’s reasonable reliance on the ECL Provider’s obligation to fund capital, which relevant courts have indicated is the standard required in upholding a lender’s right to enforce similar capital commitment obligations.

Key Enforceability Differences Between ECL and Guaranties

ECLs and guaranties are common forms of credit support used in the fund finance market, but there are some key differences between the two with respect to enforcement rights.

Parties to the Agreement

In the fund finance market, a guaranty is most commonly executed by a fund in favor of a lender to support the obligations of a subsidiary or portfolio company that is a borrower under a credit facility. However, a guaranty may also be executed by a sponsor, feeder fund, or portfolio company to support the repayment of an obligation by the fund. A guaranty creates a direct contractual relationship between the lender and the guarantor, with the guaranty running directly in favor of the lender and allows the lender to enforce the guaranty directly against the guarantor and independent of any rights of the borrower.

Conversely, an ECL is typically executed by a parent entity in favor of a fund or a special purpose vehicle and runs in favor of the ECL Recipient, with the lender as a designated third-party beneficiary and a collateral assignee of the ECL Recipient’s rights under the ECL. The collateral assignment of the rights of the ECL Recipient under the ECL will enable the lender to enforce the terms of the ECL on behalf of the ECL Recipient and not in the name of the lender. Lenders can view the collateral assignment of the ECL Provider’s obligation to fund capital to the ECL Recipient in parallel to the collateral assignment of third-party investors’ obligation to fund capital commitments to a fund in a typical subscription credit facility.

Defenses to Enforceability

Guaranties are generally considered sureties, which include a common law defense to enforceability (such as the defense that no changes to the underlying debt obligation may be made without notice to the guarantor). To avoid these potential defenses, many lenders include detailed and extensive waivers and releases of the defenses and common law restrictions on enforceability in the guaranty. Because ECLs are a contractual obligation that are intentionally structured to not be a guaranty,  both the right of subrogation and suretyship defenses arguably should not apply. However, notwithstanding that the contractual obligations that arise under the ECL are different than those under a guaranty, an ECL will ideally include these same waivers of defenses in the event the ECL is recharacterized by a court to be tantamount to a guaranty in an enforcement proceeding.

Enforceability Challenges in Bankruptcy

Under Section 365(c)(2) of the Bankruptcy Code, a debtor cannot assume or assign any executory contract to make a loan or extend other debt financings for the debtor’s benefit. Because an ECL gives the ECL Recipient the right to obtain funds from the ECL Provider in exchange for debt or equity, there are potential enforceability challenges in the event of a fund’s bankruptcy.

Due to concerns regarding a bankruptcy of the ECL Recipient, lenders should require that (i) they be named a third-party beneficiary of the ECL, (ii) the ECL include an express waiver by the ECL Provider of Section 365(c)(2) defenses, (iii) the lender have a contingent right to repayment directly by the ECL Provider if the ECL is deemed unenforceable, and (iv) the ECL include a specific acknowledgment that the lender is relying on the ECL Provider’s obligations in connection with the lender’s decision to provide financing to the ECL Recipient.

In addition, because the equity commitment would be considered “property of the estate” in an ECL Recipient bankruptcy, a lender would need to seek relief from the automatic stay that arises upon a bankruptcy filing to enforce its rights as a third-party beneficiary and/or as collateral assignee.  By contrast, a guaranty could be enforced directly against a non-debtor guarantor without the necessity of such relief.

Conclusion

 Guaranties and ECLs are similar but distinct forms of credit support in the fund finance market and should not necessarily be viewed as interchangeable. During times of market uncertainty, we expect funds to hold portfolio investments for longer, resulting in increased interest in obtaining back-leverage for such investments. ECLs provide fund finance lenders that offer such back-leverage an important source of credit support and ECLs may be the preferred form of credit support for funds that are seeking financing without an impact on any applicable debt limitations to which such funds are subject.