Subscription Credit Facilities: Considerations for Addressing Recallable Capital

Executive Summary

Recallable capital has become an increasingly common concept in subscription credit facilities. In this Legal Update, we explain the concept of recallable capital and its role in subscription credit facilities, as well as considerations for fund sponsors, lenders, and investors interested in including recallable capital as part of the facility’s borrowing base calculation. The inclusion of recallable capital in a subscription credit facility’s borrowing base requires a careful analysis of the fund documentation and tailored drafting of the subscription credit facility’s loan documentation.

Background

At the heart of a subscription credit facility are investors’ capital commitments to a private equity or similar type of fund (the “Fund”), any remaining unfunded amounts, and the ability of the Fund and its general partner to require the investors to make capital contributions to the Fund within a certain timeframe pursuant to a capital call. These obligations, and the corresponding amounts, are the crux of the collateral package and borrowing base for a subscription credit facility. Any fluctuations in the amount of the investors’ capital commitments or their unfunded capital commitments must be carefully tracked by a lender to ensure compliance with the facility’s borrowing base and to maintain adequate over-collateralization.

There are various reasons the amount of an investor’s remaining unfunded capital commitment might fluctuate over time. For instance, it might change due to a commitment increase or a partial/full investor transfer or because the Fund has called capital from the investors. Additionally, recallable capital can change the amount of an investor’s remaining unfunded capital commitment.

A Fund’s limited partnership agreement (“LPA”) may contemplate multiple potential sources of recallable capital, but, generally, recallable capital includes:

• Unused capital contributions (i.e., capital contributions that have been funded by the investors but were not deployed by the Fund for the intended purpose or within a defined period of time).
• Principal and/or interest distributions that the investors receive from the Fund as proceeds from the Fund’s investments or liquidity event proceeds from realized investments.
• Returned capital issued to the existing investors of the Fund in connection with subsequent investor closings.

In each case, under the recallable capital construct, the Fund returns or distributes (as applicable) the recallable capital to its investors. The investors’ remaining unfunded commitments to the Fund are treated as being increased by the amount of recallable capital that they received, which ultimately results in increased availability of uncalled capital upon which the Fund and its general partner can call. Since recallable capital is part of an investor’s unfunded capital commitment, it can be called (again) by the general partner pursuant to a capital call as if it had never been called previously. Of course, while these are the customary mechanics for recallable capital, they need to be carefully reviewed in the course of performing a diligence check on a Fund’s LPA to make sure it is indeed set up to function in this manner.

The recallable capital concept has become increasingly popular in LPAs as the fund finance market has evolved and is today commonly included under the terms of a Fund’s LPA. Recallable capital provides a Fund with increased flexibility to plan for its liquidity needs and a method to call additional capital in a relatively short timeframe. This additional source of capital is another option in a Fund’s liquidity toolkit that can be particularly useful to a Fund during challenging market conditions. For instance, a well-documented recallable capital construct that a lender can get comfortable lending against may enable a Fund to better maximize the potential of its borrowing base under a subscription credit facility and capital availability, which can in turn be especially useful to a Fund when there is a liquidity crunch in the broader market or the Fund needs additional capital given dwindling exit opportunities for the Fund’s portfolio investments, a slowdown in distribution streams from the Fund’s investments, or increased liquidity needs for its portfolio companies.

As the fund finance market has matured, we have seen an uptick in the number of Funds that request borrowing base credit for recallable capital under their subscription credit facilities, as well as in the number of lenders open to the request.

What You Need to Know

LPA Mechanics for Recallable Capital

For lenders to get comfortable giving borrowing base credit to recallable capital, it is essential to fully understand the mechanics of recallable capital in the Fund documentation. Among other considerations, lenders must be certain that, under the Fund’s LPA, recallable capital will, in fact, increase the investors’ unfunded capital commitments, be recallable, and can be called to repay indebtedness (including principal, accrued interest, and other costs) under the subscription credit facility. These criteria require a careful analysis of the LPA and other Fund documentation, as well as tailored drafting of the subscription credit facility’s loan documentation.

From a lender’s perspective, the mechanics of recallable capital must be explicit in the Fund’s LPA and other applicable Fund documentation because the mechanics will directly impact the calculations of the subscription credit facility’s borrowing base.

The mechanics must also be clear to the Fund’s investors so they understand that recallable capital will increase their uncalled capital commitments and is recallable for any purpose permitted under the LPA, including the repayment of a credit facility. Making the terms of recallable capital abundantly clear under the LPA will mitigate the risk to the lenders of an investor failing to fund a capital call to repay indebtedness under the subscription credit facility on the (mistaken) belief that the investor has already fully contributed such amount and does not need to re-contribute such amount.

Drafting Considerations

If an LPA includes recallable capital provisions, for purposes of a subscription credit facility, the LPA should specifically and clearly state that the return of any recallable capital will increase an investor’s uncalled capital commitment and may be called again by the Fund for, among other purposes, the repayment of debt obligations of the Fund. While recallable capital provisions are often included within the LPA’s definition of “uncalled capital commitments,” the terms may also be located in the LPA provisions outlining capital call procedures or recycling procedures.

To enhance a Fund’s ability to enter into a subscription credit facility and obtain favorable terms (including the inclusion of recallable capital in the borrowing base), sponsors and fund formation counsel are advised to bear these considerations in mind, along with the robust set of other subscription credit facility provisions that the fund finance market has developed.¹

LPA Restrictions on Recallable Capital

The Fund’s ability to recall recallable capital from the investors may be subject to certain caps or other restrictions under an LPA, such as:

• A requirement that an investor’s pro forma/increased unfunded capital commitment cannot exceed the investor’s initial capital commitment.
• A percentage cap connected to the aggregate amount of investor capital commitments.
• A requirement that the investors be notified that the returned amount is recallable.
• A limit on the timeframe during which the Fund may recall capital (i.e., a sunset provision).
• A limit on the Fund’s permitted use of proceeds for the recallable capital.
• A limit tied to the suspension or termination of the Fund’s investment/commitment period.

To optimize the borrowing base, Funds should consider including as few limitations on recallable capital under their LPAs as possible. Lenders should carefully review the LPA documentation to determine whether any of the above-mentioned restrictions are included. If so, corresponding restrictions should be hardwired into the credit agreement’s borrowing base calculation.

Potential for Confusion Due to Similar Concepts

If the drafting considerations for recallable capital outlined above are satisfied in the LPA and the credit agreement is tailored accordingly (as discussed below), recallable capital may appropriately be included in the borrowing base for a subscription credit facility. However, the borrowing base should explicitly exclude amounts tied to certain similar concepts:

• Investment proceeds that are not recallable under the LPA’s terms.
• Retained capital: unused capital contributions or investment proceeds that the Fund’s general partner elects to retain but treat as if distributed to the investors and subsequently recalled. Since retained capital is retained by the general partner, it technically is not subject to being recalled. Thus, it is not appropriate to lend against in the context of a subscription credit facility as, in an enforcement scenario, the lender would not be able to call this amount from the investors and would be forced to rely on the general partner to cooperate.
• “Givebacks”: the ability of the Fund to recall capital from the investors to satisfy certain types of obligations or liabilities, such as indemnity obligations. Usually, givebacks are not treated under an LPA as capital contributions and do not change the amount of the investors’ unfunded capital commitments. Moreover, givebacks are not typically subject to the customary subscription credit facility LPA provisions and lender protections that the fund finance market has developed.

Credit Agreement Provisions for Recallable Capital

If a lender determines that a Fund’s LPA includes sufficient mechanics for recallable capital to merit its inclusion in the borrowing base, the credit agreement’s definitions and covenants should be precisely drafted to appropriately contemplate recallable capital.

First, the credit agreement’s definition of unfunded capital commitments should specifically include recallable capital. Additionally, the credit agreement should include covenants requiring the Fund to:

• Promptly notify the lender in writing of the return of recallable capital to the investors.
• Deliver copies to the lender of return capital notices sent by the Fund to each of the investors. Ideally, these notices will clearly indicate the exact amount of the recallable capital that is being returned to the investor, state the amount of the pro forma unfunded capital commitment of the investor, and explicitly remind the investor that the returned amount is recallable.
• Deliver to the lender a capital return certification that, among other things, confirms the pro forma amount of the uncalled capital commitments of the investors and certifies to the lender that the recallable capital is treated under the LPA as if those funds had never previously been called pursuant to a capital call and is therefore recallable.
• Track the return of recallable capital and the resulting changes to the capital commitments and uncalled capital commitments in periodic reports delivered to the lender (such as updated borrowing base certificates or compliance certificates).

From a timing perspective, under the credit agreement’s terms, the investors’ unfunded capital commitments should be deemed to exclude the distributed recallable capital for purposes of the borrowing base until the lender has received these items, at which point, the borrowing base will increase.

Takeaways

Recallable capital has become increasingly prevalent in subscription credit facilities, and it often also plays a role in the borrowing base or loan-to-value covenants for hybrid facilities and net asset value (“NAV”) facilities. It is vital for all parties – including lenders, sponsors, and investors – to understand how the amount of the investors’ unfunded capital commitments is impacted by recallable capital. The inclusion of recallable capital in the borrowing base requires careful drafting and diligence of the fund documentation and precise tailoring of the credit agreement. If a Fund’s LPA contemplates recallable capital but lacks the clear and explicit mechanics outlined above, the credit agreement’s borrowing base formulation should expressly exclude recallable capital.

Finally, it is imperative for lenders and their counsel to keep recallable capital on their diligence checklist and not lose sight of it under any circumstances, including when undertaking a refinancing (or otherwise establishing a new facility for a mature Fund) or implementing a facility for a Fund where the loan documentation will be based on that of a predecessor Fund. Recallable capital mechanics may materially differ from one Fund’s LPA to the next. It is also possible that a prior lender may not have carefully reviewed the LPA’s recallable capital provisions to ensure an appropriate treatment of recallable capital in the borrowing base. We have witnessed challenges for both sponsors and lenders alike when it comes to how to calculate and address recallable capital. A sponsor and lender must each ensure they have a good understanding of the LPA’s and credit agreement’s recallable capital mechanics, in order to avoid the potential pitfalls of the sponsor miscalculating and misrepresenting to the amount of available uncalled capital (due to a misunderstanding of how recallable capital works under the LPA) and/or a lender lending against amounts that are not, in fact, available to be recalled to repay the credit facility.

¹ For additional information, see our article on Model LPA Provisions for Subscription Credit Facilities.