Subscription Credit Facilities: Understanding Shared Blockers
Executive Summary
Private equity structures often use “blockers” to achieve certain tax benefits. In this Legal Update, we explain what blockers are, how they may be used in a subscription credit facility, and what lenders should consider when blockers are shared among multiple funds.
Background
Private equity fund structures (“Funds”) can take a variety of forms that range in complexity, depending on the investor base and sponsor. In its simplest form, the fund structure can consist of a single investment vehicle (“Main Fund”) to which the investors contribute their capital, and the Main Fund makes investments on their behalf. In its more complex iterations, a fund structure may include parallel investment vehicles (“Parallel Fund”), alternative investment vehicles, feeder investment vehicles (“Feeder Fund”), and blocker vehicles (“Blocker”). Each of these structures serves a particular function and addresses a particular investment strategy. Additionally, in the case of a Blocker, the structure achieves a particular tax effect.
What Is a Blocker and How Are They Used?
In the context of a fund structure, the constituent documents of a Main Fund or a Parallel Fund may permit the formation of a Blocker. Typically, a Blocker is a corporation or a limited liability company treated as a corporate taxpayer for US federal income tax purposes, as opposed to being a pass-through taxpayer. In this context, any US federal income tax liabilities accruing to the direct allocations or distributions received by the Blocker from the investments that sit downstream from it would be paid by the Blocker at the corporate level and would not be passed through to the investors that have a direct or indirect interest in such Blocker. In other words, the Blocker essentially “blocks” the direct US federal income tax liability of its investors, with the liability already paid at the Blocker’s corporate level.
For example, non-US investors are required to file US tax returns and pay US federal income tax if they recognize income that is effectively connected with a US trade or business (“effectively connected income,” or ECI). If investments that generate ECI are owned through a Blocker, the Blocker halts the direct US federal income liability of the non-US investors and ensures they are not required to file US federal income tax returns. Instead, the Blocker files such US federal income tax returns and pays the US federal income tax.
Another common use of a Blocker in a fund structure is the “blocking” of “unrelated business taxable income,” or UBTI. Investors that are US tax-exempted organizations, such as endowments, qualified pension plans, foundations, and the like, are generally not subject to taxation but are subject to tax on UBTI. For these tax-exempt investors, using a Blocker would generally prevent the recognition of UBTI for such investors.
What Lenders Should Consider for Blockers in a Subscription Credit Facility
How the Funds Flow Through the Blocker
In a subscription credit facility, the Blocker may be a part of the fund structure and may sit anywhere in it. Typically, Blockers do not call capital contributions directly from the investors. For example, in a case where the Blocker sits between a Feeder Fund and the Main Fund, the Feeder Fund would call capital contributions from its investors, accept the contributions at the Feeder Fund level and then contribute the capital to the Blocker for further contribution to the Main Fund.
Since capital contributions flow through the Blocker, how do subscription credit facilities account for Blockers and these funds in their security packages? There are various options for doing so:
- A Pledge and Control Agreement. The traditional approach to manage the funds flowing through a Blocker is through a pledge and control agreement. In this arrangement, the Blocker pledges to the lender (or the security trustee acting for the benefit of the lenders) the account through which the capital contributions flow. The pledge is perfected by means of a control agreement among the Blocker, the account bank, and the lender (or security trustee).
- Cascading Structures. In certain circumstances, due to ERISA or tax concerns, the Blocker cannot be in privity of contract with the lender and therefore the lender cannot receive a direct pledge from the Blocker. In such cases, a cascading security structure can be used. Similar to the typical Feeder Fund to Main Fund cascading pledge structure, the Feeder Fund pledges the capital commitments of its investors and its right to call capital to the Blocker, and the Blocker pledges these capital commitments, right to call capital and its rights as secured party with respect to the Feeder Fund to the Main Fund. Thereupon, the Main Fund can pledge these capital commitments, the right to call capital and its rights as secured party with respect to the Blocker to the lender. While the lender is not in privity with the Blocker, it still has access to the collateral that includes the capital commitments of the investors in the Feeder Fund. In all cases, lenders should review the cascading structure from the investor to the Main Fund to ensure that capital contributions flow appropriately, so the lenders achieve their expected security package.
- A Blocker Acknowledgment. In other instances, a Blocker will sign an acknowledgment that acknowledges and agrees, among other things, to remit capital contributions downstream to the applicable Funds within a certain period, typically one business day, of receipt. Since there is no use of a pledge and control agreement at the Blocker level, this is sometimes considered “unsecured” at this level. However, a Blocker acknowledgment is usually only used in the case where capital contributions are permitted to skip the Blocker (i.e., a foreclosing subscription lender would not be obligated to call capital through the Blocker, but instead could directly route the capital contributions from the Feeder Fund to the Main Fund). Otherwise, a direct pledge or cascade with respect to the Blocker would be used.
Unique Considerations in the Context of a Shared Blocker
Due to their utility as a tax-efficient fund structure, Blockers often appear as a matter of course when a Fund aims to achieve specific tax objectives. However, Blockers are not without their inherent costs, including establishing and maintaining the Blockers’ separate corporate identity throughout the life of the Fund to achieve the intended tax benefits. Thus, as a cost-saving measure during the fund formation stage, there has been a rise in the use of Blockers where they are shared across fund families, one of which is party to a single subscription credit facility, but the other fund families are not parties to the same subscription credit facility, hence the term “Shared Blockers.” However, the complexity of commingling funds in a Shared Blocker should be weighed against their use.
When using Shared Blockers, lenders should consider the following:
- How funds flow through the Shared Blocker. Shared Blockers add a layer of complexity to how funds flow through them since Blockers do not typically call capital contributions from the investors, but, nevertheless, serve as a conduit through which their capital contributions flow. When fund families use a Shared Blocker where one fund family is party to a single subscription credit facility and the other fund families are not, lenders should pay additional attention to covenants regarding how funds flow through the Shared Blocker to ensure that the capital contributions from one fund family are separate from the capital contributions related to another fund family.
- Lack of lender visibility to other creditors of the Shared Blocker. Lenders to one fund family under a single subscription credit facility that uses a Shared Blocker will generally not have visibility to other lenders and/or creditors of another fund family that uses the same Shared Blocker but are not party to the same subscription credit facility. While, as a contractual matter, capital contributions attributed to one subscription credit facility may be made separate and distinct from the capital contributions with respect to another subscription credit facility, both of which use the same Shared Blocker, this distinction has not been tested in the event of a bankruptcy involving a Shared Blocker. Additionally, the lack of visibility between lenders to a Shared Blocker means that lenders will not be able to fully assess the risk of the other lenders’ claims with respect to such Shared Blocker.
Furthermore, Shared Blockers are created to be special purpose vehicles. As such, except for the lenders to it, there ought not to be other unknown creditors. Nevertheless, care should be taken to ensure that the organizational documents of a Shared Blocker incorporate the appropriate special purpose vehicle covenants and corresponding covenants be reflected in any subscription credit facility agreement whose fund structure involves a Shared Blocker.
Key Takeaways
Like other Blockers, Shared Blockers are created to be special purpose vehicles to achieve certain tax benefits in a cost-efficient way. However, in the case of Shared Blockers, since they are shared across multiple fund families, lenders to one fund family under a single subscription credit facility should take care to ensure that the appropriate covenants are incorporated in the credit documents to separate the funds of one fund family from another as they flow through the Shared Blocker and that the organizational documents of a Shared Blocker incorporate the appropriate special purpose vehicle covenants to minimize the possibility of non-lender creditors to the Shared Blocker. Certainly, the complexity of inserting a Shared Blocker into a fund family under a subscription credit facility should be carefully evaluated, as the issues inherent in their use may outweigh the initial cost savings they might bring.
