Subscription Credit Facilities: Understanding The Collateral

Subscription credit facilities, commonly referred to as "sub-lines" or "capital call facilities," are a cornerstone of private equity finance. These facilities are secured by a bespoke collateral package that protects lenders in the event of default. Because the collateral structure directly impacts the fund's borrowing capacity via a borrowing base derivative of the facility's collateral structure, an understanding of the collateral framework is essential to grasp how these facilities operate.

What Defines a Subscription Credit Facility?

A subscription credit facility is, at its core, a loan to a private equity fund (the Fund), underwritten primarily on the strength of the investors' capital commitments (Capital Commitments).¹ These commitments are contractual obligations for investors to contribute capital to the Fund when requested. Unlike immediate capital contributions, investors commit funds that are drawn down gradually through capital calls, aligning with the Fund's investment needs. This staggered approach allows investors to keep their capital invested elsewhere or readily available until required by the Fund, thereby optimizing efficiency. By reducing idle capital while ensuring the Fund has access to resources when necessary, this structure reflects the operational and financial efficiency central to private equity investing.
The collateral for these facilities consists of several key components:

• Capital Call Rights: The Fund, through its general partner (GP), pledges the contractual right to issue capital calls to investors for their uncalled Capital Commitments. This pledge enables lenders to step into the Fund and/or its GP's shoes and issue capital calls if the Fund defaults on the credit facility. This right ensures that the lender can directly access uncalled Capital Commitments without the need to liquidate other assets of the Fund, which might be illiquid, operationally tied up, or pledged as collateral to another lender under a different financing.
• Capital Contributions: Beyond the right to call for contributions, the lender is also secured by the right to receive the actual funds contributed by investors in response to those calls. This ensures that any funds collected from investors under the pledged rights flow directly to the lender, further securing the loan's repayment.
• Collateral Account: The bank account designated to receive investor contributions is another key part of the collateral package. By securing an interest in this account, lenders ensure they have control over the funds once deposited, preventing misuse or diversion of the contributions in a default scenario.
• Enforcement Rights: The GP's authority to enforce investor payment obligations forms another critical component of the collateral. This includes remedies for investor defaults, such as pursuing legal action or imposing penalties as defined in the Fund's governing documents. Without these contractual enforcement rights, a lender might be hard-pressed to collect on its collateral—as without any contractual penalty, investors might balk at making their required contribution.

Thorough Diligence: A Foundation for Structuring Collateral

Proper diligence on the Fund's structure and investor base is essential for lenders to fully understand the quality and enforceability of the collateral. This diligence encompasses:

• Investor Credit Evaluation: Assessing the financial strength and creditworthiness of the Fund's investor pool is paramount. Lenders often review audited financial statements, credit ratings, and historical funding performance to gauge the likelihood of timely and full payment of Capital Commitments.
• Limited Partnership Agreement (LPA): The LPA is the Fund's governing document and a critical source of authority for the collateral arrangements. Lenders scrutinize the LPA to confirm that it authorizes:
  • The pledge of collateral and the enforcement of investor obligations.
  • The Fund to establish borrowing arrangements.
  • Any relevant remedies in case of investor or Fund default.²
  • Key provisions around the enforceability of the Capital Commitments and their ability to serve as collateral.³
• Subscription Agreements: These agreements outline the specific terms of each investor's obligation to contribute capital pursuant to the LPA. Lenders examine these agreements to confirm that investor obligations are binding and that no unusual terms could impair the enforceability of their commitments.
• Side Letters: Investors frequently negotiate side letters with the Fund that amend or supplement the terms of the LPA and/or the subscription agreements. These can include limitations on liability, conditions for funding, or withdrawal rights, all of which may impact the collateral's value or enforceability. Lenders must carefully identify and evaluate any such provisions.

Key Collateral Documentation

The collateral package is formalized through several key agreements. Each serves a specific purpose in securing the lender's rights and ensuring enforceability:

• Security Agreements: These agreements govern the pledge of collateral by the Fund and its GP. Key provisions typically include:
• • • The grant of rights to call, receive, and enforce capital commitments.
    • Default remedies that outline the steps a lender may take in response to non-payment.
    • An irrevocable power of attorney that allows the lender to act on behalf of the Fund and its GP in issuing capital calls or pursuing enforcement actions.
  • UCC-1s: In the United States, the subscription facility collateral (other than the collateral account, which is explored below) is classified as a "general intangible" under the Uniform Commercial Code, necessitating the filing of UCC-1 financing statements to "perfect" the security interest.⁴
  • Investor Notices: In certain jurisdictions, an additional step to achieve "perfection" involves ensuring that investors are aware of the pledge. This is because some legal systems require that investors have knowledge of the pledge to perfect the security interest. Accordingly, lenders often require that investor notices are sent, informing investors of the pledge and, in some cases, securing their acknowledgment.
• Collateral Account Pledges: These agreements secure the bank account where investor contributions are deposited. The pledge ensures that any funds received are subject to the lender's security interest, safeguarding the funds from competing claims.
• • Control Agreements: To perfect a lender's interest in the collateral account under the Uniform Commercial Code, control agreements are essential. These agreements grant the lender (or administrative agent) authority over the account in a default scenario, providing a clear path to access deposited funds.
  • Depositary Bank / Lender: While a control agreement is often employed to perfect the lender's lien in the collateral account, in certain structures, perfection can be achieved without a control agreement when the bank maintaining the account also serves as the secured party (i.e., the lender or collateral agent).

Why the Collateral Package Matters

The collateral package is more than just a collection of legal documents—it is the backbone of a subscription credit facility's risk management. By securing capital call rights, contributions, and collateral accounts, lenders create a robust framework for repayment. Moreover, careful diligence and precise documentation minimize the risk of disputes or unenforceability, ensuring clarity for all parties involved.⁵

Conclusion

Subscription credit facilities are underpinned by the strength of their collateral framework, which provides lenders with confidence in their ability to mitigate risks and recover funds in default scenarios. By carefully structuring and documenting the collateral—including capital call rights, investor contributions, and enforcement mechanisms—lenders create a robust foundation for secured lending. However, achieving this requires careful diligence and a deep understanding of fund structures, investor obligations, and legal frameworks. As the private equity landscape evolves, staying attuned to these complexities is essential.

Footnotes

1. See Beginner's Glossary to Subscription Finance for a beginner's glossary on fund finance terms.

2. See Understanding LPA Default Remedies for a further discussion regarding LPA default remedies.

3 .For a detailed discussion on these provisions and model LPA language, see Model LPA Provisions for Subscription Credit Facilities.

4. Security interests may be perfected or unperfected. A "perfected" security interest establishes a priority interest in the property against other creditors. Perfection is achieved in different ways depending on the type of collateral, but it is generally established by providing other creditors notice of the security interest.

5. For information on the foreclosure process in Subscription Credit Facilities, see Default Remedies under Subscription Credit Facilities: Guide to the Foreclosure Process.