ESCs in Fund Employee Co-Investment Loan Programs

Executive Summary

Fund sponsors may offer their employees and other investment professionals an opportunity to invest in its funds through a co-investment program, which a lender may partially finance. While co-investment loan programs can provide various benefits, complications can arise when the co-investment program includes interests in employee securities companies (“ESCs”). In this Legal Update, we explain various options for dealing with potential complications of ESCs in co-investment loan programs.

Background

ESCs are investment entities that benefit from certain exemptions under the Investment Company Act of 1940 (“1940 Act”). The 1940 Act defines an ESC as “any investment company or similar issuer all of the outstanding securities of which (other than short-term paper) are beneficially owned (A) by the employees or persons on retainer of a single employer or of two or more employers each of which is an affiliated company of the other, (B) by former employees of such employer or employers, (C) by members of the immediate family of such employees, persons on retainer, or former employees, (D) by any two or more of the foregoing classes of persons, or (E) by such employer or employers together with any one or more of the foregoing classes of persons.”

Because of the close relationship between the fund sponsor and its employees, after applying for an ESC exemptive order with the Securities and Exchange Commission, the entity can receive a waiver of certain requirements of the 1940 Act, including many of its reporting requirements. Without ESC status, the 1940 Act generally limits privately offered, unregistered investment vehicles to those with not more than 100 beneficial owners, or whose securities are owned exclusively by “qualified purchasers.”

Employee Co-Investment Programs

Employee co-investment loan facilities are typically organized and administered by the sponsor; however, the lender extends the loans directly to participating employees and other investment professionals. The sponsor executes a master facility agreement in favor of the lender outlining the general terms and its responsibilities with respect to the employee loan program. The sponsor is responsible for negotiating the loan documentation, synchronizing borrowing requests with capital calls, and furnishing the lender with regular reports. These reports include details about the fund interests pledged by participants and information on any dividends or distributions paid in connection with those interests.

Each participating employee borrower then signs an individual short-form loan agreement specifying the terms of their individual borrowings. These employees utilize the line of credit intermittently to fulfill a portion of each capital contribution they are obligated to make from time to time. The proportion of a borrower’s capital call financed by the lender varies depending on the program, but typically the borrower is permitted to use the program to use loan proceeds to finance around 50% of its required capital contributions, with the remaining amount funded by the borrower’s available cash to ensure the borrower has enough incentive not to walk away from its repayment obligations if the equity does not perform well (i.e., “skin in the game”).

The employee’s loans are secured by a lien in favor of the lender on the employee’s equity interests in the various funds managed by the sponsor in which the employee holds an equity interest. Similar to the security structure of a fund-level NAV facility, the collateral includes the right to receive distributions and transfer such equity upon a default.

ESCs in Employee Loan Programs

To the extent an employee invests in a fund through an ESC, the sponsor and lender usually agree that the lender would be prohibited from exercising its right to transfer the borrower’s pledged equity interest in the ESC if it would result in the ESC losing its exemption under the 1940 Act. Given that the ESC’s 1940 Act exemption is limited to employees (and certain related people), the universe of potential buyers of the pledged equity is limited. Thus, lenders are not generally comfortable lending against ESC equity interests without some form of credit support to mitigate the risks presented by the ESC transfer restrictions. That credit support typically takes the form of either a sponsor guaranty or put option.

1. Guaranty. In this scenario, if an employee defaults, the lender will look to the guarantor (i.e., the sponsor or related credit-worthy entity) to satisfy the loan obligation, so a true transfer of the equity interest isn’t necessary.

2. Loan Put Option. The lender and the sponsor enter into a put option that the lender can obligate the fund sponsor to purchase the loan of a defaulting employee, usually at par.

3. Equity Put Option. Under this option, the credit support is achieved through a two-step process:

a. First, the sponsor and the employee enter into a put option that gives the employee the right to compel the fund sponsor to purchase such employee’s ESC equity interests at the notational amount or, in some cases, the then-current net asset value. The terms of the put option require that the sponsor directly deposit the purchase price into a specified account of the employee. To protect the sponsor from an employee exercising this right outside of the loan program, a condition to exercise the put option is that the employee’s loan is in default.

b. Second, the employee pledges all of their rights under the put option to the lender and agrees not to exercise any rights independently of the lender. The employee also pledges to the lender the employee’s rights to the deposit account, where the sponsor is obligated under the put option to deposit the purchase price after the option has been exercised.

No matter which of the foregoing structures is used, lenders and sponsors will need to determine the amount the lender can recover under the guaranty or put option. Specifically, at issue is whether the recovery amount is capped at the market value of the defaulting employee’s collateral (usually determined as of the date the guaranty or put option is exercised) or whether the lender can pursue the entire outstanding balance of the defaulting employee’s loan – even if the then-current market value is less than the obligations then outstanding. While lenders would prefer the ability to pursue the full amount of the outstanding obligations, tax implications that may impact the approach for certain co-investment structures.

Key Takeaways

Co-investment loan programs can provide numerous benefits to fund sponsors’ employees and investment professionals. Lenders and fund sponsors should be aware of potential complications if the co-investment program includes ESCs and consider ways to adjust documentation to ensure that the lender has adequate default recovery options without jeopardizing the exempt status of the ESC.