Shariah in the spotlight IV: Fund finance
By Emily Fuller, Deborah Low, Ellen McGinnis and Emma Russell, Haynes and Boone – If an investor in a private equity fund is subject to Shariah, or committed to making ESG investments, then such investor might seek to be excused from participating in certain investments that are non-compliant with its investment guidelines. In the context of fund finance, such restrictions can pose problems for lenders, as in capital call facilities the lender is providing short term liquidity for the fund to acquire investments that is backed by the unfunded capital commitments of the fund’s investors, and, frequently, loans are advanced when the investment is first made without a simultaneous capital call and opportunity for investors to review and, potentially, raise excuse rights with respect to, the investment.
If an investor later rejects the investment, unless the investor has made further agreements for the protection of the lenders (for example, that the investor will not exercise its excuse right for a capital call made the purpose of repaying debt), the lenders may not have recourse to the unfunded commitment of that investor for repayment. In order for the lender to get comfortable lending against the capital contributions of a fund’s investors, the lender will seek assurances (which are often contained in the fund’s partnership agreement) that the investor is obligated to fund its capital contribution without defence.
Therefore, if the lender advances loans for the purposes of acquiring an investment and an investor has a defence to its obligation to fund its pro rata share of such investment, then the lender may be left with a shortfall in the available capital contributions needed to repay loans made to acquire such investment.
In order to mitigate these risks, if a fund is looking to include unfunded capital of either a Shariah-compliant investor or an investor with a strict ESG investment policy in the calculation of its borrowing base, the lender will need to perform additional diligence to understand the investor’s investment limitations, get comfortable that the fund will not invest in prohibited investments, and build out provisions of the loan documents that enable the lender to exclude all or part of the investor’s capital commitment from the calculation of the borrowing base with respect to any prohibited investment, or, to include it with the proper structure and assurances.
An investor’s prohibition on investments will be most commonly found in such an investor's side letter, which is a side agreement between the investor and the fund’s general partner that amends the provisions of the partnership agreement applicable to such investor. When conducting due diligence on the fund documentation, the lender's counsel will conduct a detailed review of all investor side letters and determine if any investors have excuse rights that could limit their agreement to fund capital contributions without defence.
If an investor is restricted from investing in certain products or industries, such investors will be considered to be ‘Excused Investors’ in relation to a capital call made for the purpose of funding an investment in any of these prohibited assets, and as such will not receive any returns from that investment.
Typically in fund finance facilities, at any time in which the fund seeks to draw down on the credit line to acquire or service an investment, the conditions to the making of a loan will include delivery by the fund of an updated borrowing base calculation, and a certification from the fund that no investor has any rights to be excused from participating in the investment to be acquired or serviced by the requested loan.
If an investor has a right to be excused from funding capital contributions in relation to such investment, the fund must inform the lender of the nature of the excuse and the amount of capital contributions impacted by such excuse right will be carved out of the calculation of the borrowing base. It is worth noting that an excused investor may remain in the borrowing base in relation to the proportion of its commitments which is not excused, represented as the amount that can be called from that investor to fund a non-prohibited investment.
It is also possible that investors will specify that all or a specified percentage of their capital
contributions only be used to fund Shariah or ESG compliant investments. In such a situation, there will not be a need to excuse investors from participation in an investment, but lenders will need to get comfortable that the fund is complying with any of these mandates. Though these requirements may be potentially onerous on a fund, ideally any such restrictions would be aligned with a fund’s investment strategy.
It would be detrimental to a fund if they accepted a capital commitment under terms in which they were not able to fulfil. Additionally, funds themselves often impose investment limitations to limit risk and diversify their portfolio, and therefore, should have mechanisms in place to accommodate limitations from investors. From a documentation standpoint, the credit facility will typically include provisions requiring the fund to comply with its partnership agreement and other constituent documents, in which any such investment restrictions will be included.
Though excuse rights and investment limitations may seem daunting from a lender perspective,
lenders can take some comfort in the fact that it is in the best interest of investors and funds to
minimize the number of excused investors. For an investor, it is inefficient to deploy capital into a fund that cannot meet its investment guidelines. Investors will perform significant diligence on the fund’s investment strategy when making the decision to invest, and for investors with stringent investment protocols, they are unlikely to invest in a fund that is not able to abide by their investment policy.
Likewise, as discussed above, a fund will not want to be in a position where their ability to make
investments is constrained by an inability to call down committed capital. In addition to the underlying investments, the investor documentation and corporate structure of a Shariah-compliant investor itself will need to be in compliance with Shariah law principles, and, as a result, the requirements to structure such an investor’s investments may be more complex than the average institutional investor.
The need to uphold certain contractual requirements and ensure that all investments relate to real assets often means that the investment will be structured through a series of SPVs. A detailed explanation of such structures is outside the scope of this article, but ultimately lenders may require additional KYC and credit linkage documentation to get comfortable with the structure of the Shariah-compliant investor.
In summary, there are many similarities between Shariah-compliant investors and investors that
adhere to ESG investment policies. While Shariah-compliant investors have been investing in the market for some time, the increasing prevalence of ESG is causing additional institutional investors to rethink their investment policies and impose additional investment restrictions.
Ultimately, in underwriting investors in fund finance facilities, ESG and Shariah-compliant investors may be treated similarly when a lender is evaluating whether they can be included in the calculation of a borrowing base. Both lenders and funds need to be prepared for increased scrutiny on investments, and should incorporate strategies to effectively monitor investment restrictions and any applicable excuse rights.
This is particularly important in light of the current pandemic climate, as a tightening in fundraising has enabled large investors to negotiate favourable terms. It can therefore only be seen as a strength if fund managers and lenders alike understand the needs of different categories of investors.