In this Ropes & Gray podcast, finance counsel Patricia Teixeira and asset management associate Jeanna Simeone discuss hybrid facilities as an alternative option for private investment funds to combat the economic impact of COVID-19. In today's market climate, hybrid facilities offer a unique solution for sponsors to inject cash into portfolios that are in need of liquidity. Throughout this podcast, Patricia and Jeanna explain how hybrid facilities work, why they might be of interest to fund managers and if we should expect them to increase in popularity.
Transcript:
Jeanna Simeone: Hello, and thank you for joining us today on this Ropes & Gray podcast. My name is Jeanna Simeone, and I am an associate in the Boston office of Ropes & Gray in our asset management practice group. Joining me today is Patricia Teixeira, a counsel in our finance group in New York, who regularly advises private investment funds on subscription facilities and other types of fund financing. In recent weeks, as the economic consequences of COVID-19 have left many businesses in need of liquidity, sponsors are looking for alternative ways to inject cash into their portfolios. In today's podcast, we will be focusing on hybrid facilities for private investment funds as one tool available to fund managers. Patricia, to start us off, could you provide us with an overview on what hybrid facilities are and why they might be of interest to fund managers?
Patricia Teixeira: Sure, Jeanna. Funds usually have subscription facilities, sometimes called capital call facilities, which have a borrowing base composed of unfunded capital commitments from its investors. The borrowing base under these facilities goes down over time as the fund calls capital to fund its investments. At the end of the investment period, when unfunded capital commitments have been exhausted, funds might replace the subscription facilities with a separate NAV facility, which stands for net asset value facility. NAV facilities have a borrowing base that is based on the net asset value of the fund's portfolio and are generally better suited for end-of-life funds, credit funds and open-end funds. Now, to answer your question, the idea behind a hybrid facility is to combine both a subscription facility and a NAV facility under one documentation.
Jeanna Simeone: Thanks, Patricia. That makes a lot of sense. So how does a hybrid facility actually work in comparison to a standalone subscription facility or a standalone NAV facility?
Patricia Teixeira: There's not one-size-fits-all in hybrid facilities. Generally speaking, they tend to have a longer duration than either a capital call facility or a NAV facility. Some facilities treat the subscription facility and the NAV facility as separate items under one single document. The fund would then borrow under the subscription facility until a point in time in which the facility flips from a subscription facility to a NAV facility. The GP would decide at which point to switch from uncalled capital to NAV borrowing base, usually when the uncalled capital left in the fund is so low that it would no longer support the facility. From that point on, the fund then relies on the net asset value of its portfolio for borrowings. Another approach, which is probably more common, is for facilities to have a more gradual transition where the two lines would overlap. In those situations, the borrowing base could be based, let's say, seventy percent on uncalled capital and thirty percent on net asset value of the funds' portfolio. As the amount of the uncalled capital decreases, the lenders then rely more heavily on the net asset value of the fund.
One of the issues that comes up in connection with hybrid facilities is the difficulty of negotiating the terms of the NAV portion (such as advance rates or concentration limits) years before the fund has acquired any assets. That's why for private equity funds, NAV facilities are more common for mature funds that are past or towards the end of their investment period. For credit funds, on the other hand, we see NAV facilities in early stages since the underlying assets can be easily categorized and advance rates can be agreed early on based on well defined asset classes (such as first-lien or second-lien, single-B or double-B rated). Credit funds with a hybrid facility from the outset strictly rely on the uncalled commitments only briefly as they build up their portfolio and then switch to a NAV borrowing base relatively quickly.
Jeanna Simeone: Thanks, Patrica – that's helpful background. Can you tell us a bit more about what lenders expect in terms of collateral for these types of facilities?
Patricia Teixeira: There's also not one answer when it comes to hybrid facilities. You would typically see the uncalled commitments as part of the collateral as you do in subscription facilities, but fund sponsors may resist pledging the underlying investments (for example, because doing so may require third party consents). There seem to be two ways of structuring the facility when the investments are not part of the collateral initially. In the first ones, the lender never has security over the investments and is secured only by the uncalled capital, in which case the bank will want the right to approve the switch to the NAV borrowing base at the time that it occurs. The second way is to have an obligation to create a security interest over the investments that takes effect if the uncalled capital falls below a certain level (in which case the borrower may switch to the NAV borrowing base at its discretion). As you can imagine, if the investments are not part of the collateral, the percentage of the net asset value used to calculate the NAV borrowing base is pretty low.
Jeanna Simeone: I would think that having a facility that can be outstanding for longer periods of time than the usual subscription facility or NAV facility would be attractive for fund managers. We don't come across hybrid facilities as often as you would expect, though. Why do you think the main reasons for that are?
Patricia Teixeira: That's right. Despite the theoretical appeal of such facilities, they are still relatively rare for two primary reasons. First, since lenders have very different approaches to evaluating these two potential sources of payment, there's only a limited number of banks that are actually capable of doing capital call facilities and also handling the assets the fund is investing in, both in terms of valuation upfront and enforcement in a default scenario. Even if a single lender can handle both, in practice, banks do not have a single credit team that can lend against both types of collateral. As a result, sponsors usually have more financing options, and thus can negotiate better terms, if they opt to obtain a subscription facility at the beginning of the fund's life and a separate NAV facility towards the end of the fund's life. Second, and we have touched on this before, particularly in the case of private equity funds, it can be difficult to negotiate the terms of a hybrid facility that apply to the fund's assets before the fund has made significant investments. In addition to that, the economic terms of the NAV portion of the facility are negotiated years before they become effective, so you could see situations in which the terms are way off-market by the time the facility switches to a NAV borrowing base, in which case the borrower might as well prefer to terminate or renegotiate the facility at that time, eliminating some of the benefits of having a hybrid facility in the first place. Other points to consider are cost and timing. Given the complexity of hybrid facilities, they usually come with higher upfront costs in terms of the attorney fees and take a bit longer to put together.
Jeanna Simeone: Given where we are today, do you expect that we will see more hybrid facilities being done?
Patricia Teixeira: It's always hard to predict the future. I think it's particularly hard right now when we are all still trying to understand what COVID-19 means to the financial markets. That said, sponsors having been reaching out looking for ways to get access to more liquidity at the fund level and many funds are turning to NAV facilities to achieve that. There are some indicators in the market that support the increase in the use of NAV facilities. For one, funds are holding onto their portfolio companies longer, often beyond the period in which they can call capital from their investors to support their assets. With that, we have seen private equity sponsors using or contemplating using NAV facilities for legacy funds to provide additional capacity to make follow-on investments or to refinance asset-level debt. From the lender-side, banks are looking at NAV facilities to provide higher returns as pricing pressure on subscription facilities continue. Having the ability to provide both facilities also means the lender can build deeper relationships with certain sponsors. I think once the market gets more comfortable with NAV facilities in general, in particular if these facilities are being provided by the same lenders that provide the subscription lines, we could see at least one of the obstacles of successfully getting hybrid facilities done, which is the ability to find a bank both capable and willing to provide both types of financing, going away.
Jeanna Simeone: Well, thank you, Patricia, for joining me today for this discussion. And thank you to our listeners.
Originally published by Ropes & Gray Podcast, April 2020
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