ISLANDS AT THE VANGUARD

7 February 2014
Feature
Offshore
ISLANDS AT THE VANGUARD
The continued and expanding
popularity of capital call facilities
to private equity funds in Cayman
is largely due to their strong
performance during the financial
crisis, with very few reported
incidents of investor defaults.
In addition, the attraction of
relatively low-priced financing
(many such facilities are advanced
on an uncommitted basis) is
appealing to borrowers and the
perceived low-risk nature of these
facilities is attractive to several
specialised lenders that operate
within this market. The Cayman
Islands has long been a domicile
of choice for private equity fund
formation and is therefore on the
cutting edge of the ever-evolving
world of capital call financing.
While traditionally utilised by
private equity funds to bridge the
period between the time notice is
served on investors instigating a
capital call and the receipt of the
resulting proceeds, such facilities
have become increasingly used as
part of a fund’s investment strategy
to make underlying investments.
Typically, a capital call facility is
secured by the granting of security
by the fund or the fund’s general
partner of security interests in: (i)
With the Cayman Islands at the
cutting edge of the capital call
facilities explosion, Rob Jackson
and Justin Hart look at the issues
for lenders and their counsels
the unfunded capital commitments
of the fund’s investors; (ii) the right
of the fund to make capital calls
upon and to enforce payment of
the capital contributions against,
such investors; (iii) the proceeds
of capital contributions; and (iv)
the subscription accounts into
which the capital contributions are
funded. A lender’s obligation to
make a loan is generally contingent
upon the fund’s compliance with a
borrowing base test, which requires
that the outstanding indebtedness
under the facility shall not exceed
the facility’s borrowing base of
eligible collateral.
In structures utilising feeder
funds and blockers the security
structure is likely to be more
complex. It may involve the
master fund granting a security
interest to the lender over its
rights to make capital calls on
its feeder fund, with the feeder
fund granting a security interest
to the master fund over the
feeder’s rights to make capital
calls on its investors. Subject to
US Employee Retirement Income
Security Act (ERISA) issues, the
feeder fund may also be required
to include a guarantee and an
acknowledgement (each in favour
of the lender) that the master
fund will assign to the lender such
security interest granted by the
feeder fund to the master fund.
The constitutional documents
Key for the lender and lender’s
counsel is to obtain a clear
understanding of the powers and
restrictions affecting a fund’s ability
to take on leverage as set out in the
funds constitutional documents. In
the case of a Cayman private equity
fund the entity will very likely be an
Exempted Limited Partnership with
a general partner and investors in
the form of limited partners.
In such circumstances the
constitutional document will be
a limited partnership agreement
(LPA) and, while it is now more
common for such agreements
to include an express right
permitting the partnership to
enter into capital call facilities, it
is incumbent on lender’s counsel
to identify a number of key
provisions that may impact on
a lender’s ability to effectively
enforce its security. These include:
• language permitting the fund
to borrow and to pledge the
unfunded capital commitments of
limited partners and related rights
in support of such borrowings;
• power for the general partner
(and therefore the lender
following an enforcement) to
make capital calls specifically to
repay bank indebtedness and for
such right to extend beyond any
investment period (similar to the
payment of other partnership
expenses);
• whether the obligation of
investors to fund capital calls is an
irrevocable and unconditional and
without any defence, counterclaim
or offset; and
• language permitting the general
partner of the fund to grant a
power of attorney (important
in the context of a financing for
the enforcement or perfection of
security arrangements following
an event of default).
In addition, LPAs can contain
provisions that could diminish
Feature
Offshore
the lender’s collateral without
providing cash control over the
contributed funds or contractual
control over the ability to make
such capital calls. These should
be highlighted by lender’s counsel
and if considered necessary
addressed in the relevant loan
documentation.
For example, LPAs generally
empower a fund or its general
partner to effect all or a portion
of a portfolio investment through
an alternative investment vehicle
(AIV). Investors are normally
required to contribute capital
directly to the AIV to the same
extent, and on the same terms
and conditions governing capital
contributions to the fund.
However, capital contributions
made to an AIV often reduce the
unfunded capital commitments
of the investors to the fund as if
such capital contributions were
made to the fund itself, yet they
are funded into an account of the
AIV instead of the fund’s pledged
subscription account.
Fund LPAs may also allow an
investor’s capital call obligations
to be satisfied ‘in kind’, namely by
securities or other assets valued
at fair market value. Such noncash capital contributions would
not be funded to the pledged
subscription account and there
are no cash flows from capital
calls readily available to repay
outstanding loans.
General partner as a party
The LPA may provide that it is
the general partner of a fund
(rather than the fund) that has
the right to make the capital calls
to the limited partners. In light
of this, there is some debate in
Cayman as to whether the right
to make capital calls is a right of
the general partner rather than a
right of the fund and accordingly
debate whether the general
partner itself must be party to the
security agreement (together with
the fund) under which the general
partner grants security over its
right to make capital calls.
Currently lenders should
push to ensure that the general
partner is a party to the security
agreements, although there are
various changes proposed to
the Cayman Islands Exempted
Limited Partnership Law, which
are expected to be enacted in
2014 and seek to clarify that
such right to make capital calls
is an asset of the partnership
(rather than an asset of the
general partner), which will be
helpful in the context of capital
call financing.
Notice to limited partners
As the right to call for capital
contributions from the limited
partners of a Cayman fund are
derived from a Cayman Islands
law governed LPA, the priority
and perfection of security granted
over such capital call rights will
be determined by Cayman Islands
law. Under Cayman Islands
law (and subject to certain
exceptions), priority between
successive assignees is decided
according to the order notice
is given to the relevant debtor
or obligor based on the English
decision in Dearle v Hall (1828)
3 RUSS 1, which is persuasive
authority for the courts of the
Cayman Islands.
The timing of delivery and
form of such notice are matters
for negotiation between the
lender and the fund, although
the preferred approach for a
lender generally would be for the
notice to describe the security
interest in detail and to be
delivered no later than closing.
From the fund’s perspective, this
is an investor relation issue and
so the preferred approach for a
fund is often for the notice to be
short and less legalistic and to
be delivered together with, for
example, quarterly reports that
are sent out to the investors on a
regular basis.
There are no specific
requirements concerning the
form such notice is to take or who
must give it. What is key is that
the recipient has, in some way,
been made sufficiently aware
of the nature of the security
so that a reasonable person
would act upon the information
and regulate their conduct
accordingly. At a minimum, the
notice should contain a short
statement confirming the name of
the security document, its date,
the parties to the document and
that the security comprises an
assignment of the call rights and
the related proceeds. The notice
should also explain to whom the
obligations are owed, especially
once there is an event of default.
The relationship between
and relative bargaining power
of the counterparties to the
loan documentation as well
as practicalities (namely the
number and sophistication of
the limited partners of the fund)
will often influence how delivery
is effected. Many funds now
upload reports and information
to investors via portals.
Provided that the uploading
of documents to the portal is
permitted under the relevant
LPA (and this is becoming more
common), the uploading of
the notice of grant of security
interest should be sufficient to
constitute delivery of the notice
to the limited partners. At times,
some financial institutions have
required that limited partners
acknowledge receipt of the notice
of grant of security interest.
Such acknowledgement is not
necessary to regulate ranking
point in priority or to perfect the
security interest, but, in instances
where the limited partner is an
affiliated feeder fund or where
there are few investors, the
fund may be open to seeking
acknowledgement from the
limited partners.
As the volume of capital call
financing transactions continues
to rise and capital call financing
continues to evolve, we will no
doubt see further trends and
structures develop in this area.
Rob Jackson is a partner and Justin Hart
is an associate in Walkers’ finance and
corporate group in the Cayman Islands.
Reprinted with permission by The Reprint and Licensing Centre. (www.rl-centre.com / 0207 501 1085).
Not to be reproduced without authorisation.

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