Subscription Credit Facilities: Temporary Increase Tranches

Executive Summary

As the subscription credit facility market continues to evolve, temporary increase tranches have become increasingly common because they enable funds to quickly adjust the facility size in response to changing investment opportunities and capital requirements. While temporary increase tranches offer several benefits, they also introduce complexities in voting rights, consent processes, and payment allocations that require careful negotiation and documentation.

The Mechanics of Temporary Increase Tranches

Temporary increase tranches may complement or substitute traditional permanent increase options. When this option is included in a subscription credit facility, the temporary increase option usually allows borrowers to request an increase in the maximum commitment for a brief period, typically 90 days or less and generally less than a year. Loan agreements for temporary increase tranches may specify that the increases are available on either a committed or uncommitted basis.

Loans under a temporary increase are usually structured as separate tranches from those under the permanent facility, with each temporary increase tranche distinct from others. These tranches are renewed or extended independently. Because there is typically not a requirement to make pro rata draws across the permanent and temporary tranches, borrowers can choose the specific tranche – permanent or temporary – they wish to access for each drawdown request.

The obligations associated with temporary increase tranches are considered part of the overall facility’s obligations, secured by the same collateral and ranking pari passu with all other loans under the facility in terms of security and priority. This parity extends to foreclosure scenarios, where obligations under both permanent and temporary tranches share equal priority for repayment from collateral accounts, investor capital contributions, and any other secured assets.

For loan availability calculations relevant to future draws, the principal obligations of both permanent and temporary increase tranches are combined. While the terms of temporary increase loans generally mirror those of the permanent tranche, their tenor and pricing are often subject to individual negotiation for each temporary increase request.

Benefits of Temporary Increase Tranches

Temporary increase options offer several benefits, including:

• Flexibility. Borrowers can scale their facility up to meet surging funding needs, such as when facing multiple large investments in a short time frame, and scale down during quieter periods.
• Optimizing facility usage. Borrowers can ensure that the permanent facility tranche is “right sized,” avoiding long periods of unused commitments, thereby saving borrowers on unused commitment fees throughout the facility’s life.
• Lender portfolio allocation. By reducing the size of permanent facility tranches, lenders can reallocate capital that would have otherwise been committed but unused more efficiently within their portfolio.
• Expanded lender pool. If temporary increase tranches are structured as term loans, borrowers might attract insurance company lenders.¹
• Streamlined consent process. Pricing of temporary increase tranches are negotiated directly with the lenders participating in the temporary increase, bypassing the need for consent from all or a majority of the permanent facility’s lenders and allowing borrowers to more swiftly expand the facility size.

Navigating Potential Complexities Created by Temporary Increase Tranches

When incorporating a temporary increase tranche into a subscription credit facility, lenders should consider the potential impact on voting rights, consent processes, and payment allocations so they can carefully negotiate and document possible solutions and risk mitigation strategies.

Voting Rights and Consent Processes

Integrating temporary increase tranche lenders into the voting process for amendments to credit or security documents is one challenge posed by temporary increase tranches. Although these lenders commit to the facility as permanent tranche lenders do, temporary increase tranche lenders’ risk exposure may be significantly less due to the shorter tenor and typically smaller commitment size. Some permanent tranche lenders have expressed a concern that borrowers could manipulate the required lender consent for amendments or waivers by engaging temporary increase tranche lenders sympathetic to their cause.

To address this concern, one market approach is to simply exclude temporary increase commitments from the calculation of required lender consent. This approach mirrors the broader loan markets’ traditional approach to secured hedge providers and heavily favors the permanent tranche lenders. Another approach is to use a bifurcated required lender test, which stipulates that required lenders constitute both 50% or more of the total commitments (including temporary commitments) and 50% or more of the permanent commitments.

In addition to standard voting rights concerns, an open question in the market is whether an exercise of remedies after an event of default (including a full foreclosure) can be initiated by a simple majority of the outstanding obligations, irrespective of tranches. For example, in a scenario where only the temporary increase tranche has loans outstanding (e.g., because the borrowers have prepaid all outstanding principal on the permanent tranche in full), if an event of default has occurred and is continuing, and the administrative agent has not exercised remedies, the temporary increase tranche lenders may have to rely on the permanent tranche lenders to direct the administrative agent to foreclose. In this scenario, the permanent tranche lenders might not be incentivized to do so because they have no principal obligations exposed, and the borrower would be prohibited from incurring new loans during the continuance of the event of default.

While voting issues are nuanced, the market is aligned that the consent of temporary increase tranche lenders should be required for any amendments or waivers that affect their specific loans, such as alterations to the pricing or duration of the temporary increase tranches.

Payment Allocations.

Structuring temporary increase mechanisms requires a clear strategy for allocating borrower payments between permanent and temporary increase tranches. This need becomes particularly acute when a temporary increase tranche expires, leaving only the permanent tranche active. Under normal circumstances, borrowers can decide how repayments are applied between the permanent and temporary tranches. However, the borrower typically loses this right when the loan’s status deteriorates, a measure designed to preserve the pari passu treatment among the tranches. In these instances, repayments must be divided pro rata, calculated on outstanding obligations rather than existing lender commitments.

While the market is settled that pro rata repayment is equitable when a loan’s status has deteriorated, ambiguity remains around the appropriate triggering events for pro rata distribution of borrower repayments. For example, the triggering events could include any event of default and/or potential defaults (or a subset thereof) and/or a borrowing base deficiency. The market is trending toward setting the trigger to leverage the traditional “cash control event” concept frequently used in subscription facilities.

Key Takeaways

The adoption of temporary increase tranches in subscription credit facilities represents a significant evolution in the subscription finance market, offering enhanced flexibility and efficiency for both borrowers and lenders. These mechanisms address the dynamic needs of funds by providing the ability to swiftly adjust the facility size in response to changing investment opportunities and capital requirements. While these innovations bring clear benefits, they also introduce complexities in voting rights, consent processes, and payment allocations that require careful negotiation and documentation. As the market continues to mature, the development of standardized practices and terms for managing these temporary tranches will be crucial for maintaining their utility and ensuring equitable treatment among all participants. The ongoing dialogue between borrowers and lenders will be key to navigating these challenges and fully realizing the potential of temporary increase options.

 

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¹ Note: Certain structural accommodations may also be required by insurance company lenders, such as obtaining a rating for the term tranche from a rating agency. Please see Mayer Brown’s The Benefits of Term Debt Tranches in Fund Finance Products – and What to Consider When Utilizing Term Debt.