Providing loan facilities to investment funds is certainly nothing new and it has been a lucrative business for a number of banks here in the Cayman Islands for many years. With single manager funds obtaining their finance at brokerage level, the primary market for Cayman banks are fund of fund vehicles (usually formed as Cayman Islands exempted companies) to which they provide both bridge and leverage finance. The model for these financing arrangements is reasonably simple. Generally, the bank lends to the fund via a revolving loan facility agreement and as security takes a fixed and floating charge over the assets of the fund. In the case of fund of funds the assets are primarily the investments in the underlying single manager funds. Usually the bank, or an affiliate of the bank, also acts as the custodian of these investments which gives the bank an additional level of security and control.
While this continues to be a strong source of business for local banks, even in the current challenging markets, there is also a growing trend to lend to private equity funds. Like hedge funds, private equity funds also from time to time face a mismatch between receiving monies from their investors and making the investment into their underlying target company. Private equity funds, which are an ever increasing and developing industry in the Cayman Islands, are generally formed as exempted limited partnerships under the Exempted Limited Partnership Law (2007 Revision). Unlike hedge funds, private equity funds generally do not require that their investors invest their monies into the fund from the initial launch. Instead, investors are required to commit to investing up to a set amount of money in the fund over the investment period of the fund. This is commonly referred to as a capital commitment. Once the private equity fund has a sufficient level of capital commitments, it will then hold one or more closings where, having identified a suitable investment, it will draw down on the capital commitments of the investors in one or more tranches. On each such closing date the investors are required to invest all or a portion of the amount that they have committed to invest into the fund. Once the fund receives the cash it is then in a position to make the underlying private equity investments.
From time to time private equity funds, like fund of funds, find themselves in a situation where they are required to make the underlying investment in advance of being able to draw down on the capital commitments. In these circumstances, they need bridge financing to allow them to make the investment pending receipt of the investors’ cash. This is where the banks are able to step in to provide a well secured loan.
Like the model for lending to fund of funds, this is again a reasonably simple structure that can be achieved by entering into a loan agreement with the private equity fund, secured by a fixed and floating charge over the assets of the fund. There are, however, a number of significant differences in the two models. Firstly, when lending to a fund of funds, the bank or an affiliated entity will often act as the custodian of the underlying investments of the fund of funds. This gives the bank a greater level of control over the assets of the fund of funds and allows them to act very quickly in the event of a foreclosure. However, given the nature of the underlying investments of private equity funds (which are obviously private in nature) banks do not generally act as the custodian of such investments and as a result they lose this level of control.
Secondly, and more importantly, such private investments by their very nature are not particularly liquid. In the event of a default, the bank may very well have difficulties realising its security through the sale of these investments.
Hence, a mechanism is required to ensure that in the event of a default, the bank is able to act quickly to recover the amounts owed to it. The first level of protection is that, as discussed above, the fund has the right to draw down on the capital commitments and this right, in addition to the existing portfolio of investments, can also be made subject to the fixed and floating charge to be granted in favour of the bank. By doing this, in the event of a default by the fund, the bank will have the ability to proceed directly against the investors to recover losses up to the limit of capital commitments.
There is an additional level of security and control that is available under the Property (Miscellaneous Provisions) Law (2001 Revision) which provides in Section 5(1) that:
“any absolute assignment by writing under the hand of the assignor (not purporting to be by way of charge only) of any debt or thing in action, of which express notice has been given to the person from whom the assignor would have been entitled to claim such debt or thing in action, is effectual in law to pass and transfer from the date of such notice-
(a)the legal right to such debt or thing in action;
(b)all legal and other remedies for the same; and
(c)the power to give good discharge for the same without the concurrence of the assignor”
Accordingly, relying on Section 5(1), the bank is able to further secure the loan to the private equity fund by entering an agreement of cession or assignment of the fund’s right to receive the capital commitments. By entering into such agreement with the fund, the bank then has the right to receive the capital commitments directly from the investors and to give discharge for same.
Hence, by using these two mechanisms in conjunction, the bank can be satisfied that it has excellent security not only over the existing assets of the Fund, but also over the capital commitments owed to the fund by the investors.
There is a practical issue here in that the section requires that “express notice” be given, which is often a sticking point for the managers of the funds who are not always keen to give such notice. In our experience, one of the main reasons for this reluctance is that given the nature of investors in private equity funds, they tend to want to become involved in negotiating the terms of the loan and security agreements with the bank. This is obviously very cumbersome for both the fund and the bank and hence to alleviate this concern, the bank can agree to enter into the assignment agreement, but further agree that it shall not give notice until an event of default happens. However, should they elect to go down this route, the bank does need to be aware that any other creditor who may take an assignment of the capital commitments after the bank, but who gives notice to the investors thereof before the bank, would have a priority claim in respect of those capital commitments. This is therefore a risk based decision for the bank.
There are some additional areas for concern with regard to such lending and security arrangements. Firstly, the general partner of the fund must have the capacity to grant security over and assign the capital commitments. This is usually expressly dealt with in the relevant limited partnership agreement of the fund wherein the general partner is usually empowered to borrow money and to grant security over the assets of the fund including over the capital commitments. However, every fund is different and careful consideration will need to be given to the limited partnership agreement, both in terms of the powers given to the general partner in this regard as well as in respect of any restrictions on the powers of the general partner.
Secondly, and perhaps a more significant issue, is whether a new investor investing into the fund after the loan and security documentation has been put in place will be bound by these lending and security arrangements. Again, the limited partnership agreement is key here. In general terms, a new investor coming into a partnership will, in respect of the interests being bought by them, be bound by any loans existing prior to them becoming a partner. However, as the agreements were signed prior to them becoming a partner, there is some question as to whether they will be liable for future drawdowns under pre-existing revolving loan and security agreements since at the time the general partner entered into these arrangements they were not partners and accordingly the general partner had no authority to bind them. That being the case, if the nature of the loan agreement is such that it is a revolving facility, it is important to ensure that the limited partnership agreement provides that any incoming limited partners are subject to and agree to be bound by the existing loan and security agreements at the time that they become a partner.
In conclusion, there is certainly a growing need to provide financing to private equity funds in the Cayman Islands and while there are some practical issues that may arise, there is an excellent model for providing such loans in a very well secured fashion allowing banks to provide such facilities on a risk controlled basis.