A limited partner (“Investor”) in a private equity fund (“Fund”) will often enter into a letter agreement (“Side Letter”) with the Fund that modifies the terms of the Fund’s limited partnership agreement (“LPA”) as they apply to the specific Investor. Through an LPA or a Side Letter, a Fund may grant an Investor rights in connection with certain investments made by the Fund that conflict with the Investor's internal investment policy restrictions. These rights may allow an Investor to disapprove of or exclude itself from Fund investments that the Investor is restricted from participating in. A Fund may also protect its own investment interests by negotiating for certain requirements or requests for Investors to be included in its LPA or Side Letter provisions to ensure compliance with applicable laws and regulations. Such LPA and Side Letter provisions may impact an Investor’s capital commitment and contribution obligations to a Fund and, thus, may impact such Fund’s subscription credit facility (“Facility”) with a lending institution (“Lender”). Two common examples of potentially problematic investments include (i) investments in banks and bank holding companies and (ii) investments in media companies. This Legal Update will touch upon some of the restrictions Investors and Funds face relating to investments in banks, bank holding companies and media companies; the effect these restrictions have on capital commitments to a Fund and on a Facility; and, ultimately, why Facility Lenders should carefully review LPA and Side Letter provisions relating to these types of investments.
I. Investments in Bank Holding Companies
When a Fund or Investor invests in a bank or a bank holding company, the interest in the entity will be viewed as either controlling or non-controlling under the Bank Holding Company Act of 1956 (“BHCA”).1 Concerns arise when any entity acquires direct or indirect control of a bank through a bank holding company. If a Fund or Investor has a controlling interest in a bank or a bank holding company, the Fund or Investor itself (assuming not a natural person) may be considered a bank holding company that is subject to regulation under the BHCA as discussed below. Further, if an Investor’s commitment to a Fund that is invested in a bank or a bank holding company equals or exceeds a certain percentage of the aggregate commitments of the Fund, even if the Investor itself is not directly invested in such bank or bank holding company, the Investor may indirectly have control over such entity and be subject to the BHCA and its restrictions.
A bank holding company is defined as a company that has control over a bank or over a company that is or becomes a bank holding company.2 Under the BHCA and the Board of Governors of the Federal Reserve System’s Regulation Y, an entity is deemed to have control over a bank or a company when either (i) it directly or indirectly owns, controls or has power to vote 25 percent or more of any class of voting securities of the bank or company; (ii) it controls the election of a majority of the directors or trustees of the bank or company; or (iii) the Board of Governors of the Federal Reserve System determines that the company directly or indirectly exercises a controlling influence over the management or policies of the bank or company.3 The third prong of the definition typically requires an analysis of the particular facts and circumstances related to the investment, including business relationships, contractual powers, the number of directors and the percentage of ownership of a class of voting securities.
Bank holding companies are subject to significant regulation under the BHCA, including activities restrictions (e.g., only engage in financial activities), consolidated supervision and examination, reporting and an obligation to serve as a source of strength to its bank subsidiaries. Investors and Funds seek to avoid these restrictions and any other potential regulatory issues. In connection with Funds investing in banks or bank holding companies, one way Investors attempt to avoid BHCA regulation is by structuring their investment in a manner to avoid controlling the entities or limiting or restricting a Fund in its ability to invest in banks and bank holding companies. One example of a limiting LPA or Side Letter provision is an excuse right pursuant to which an Investor may opt out of participating in and funding a capital call relating to a Fund’s investment in a bank or bank holding company. Additionally, if an Investor has sufficient bargaining power in Side Letter negotiations with a Fund, its rights could also include preventing the Fund from investing in a bank or bank holding company altogether or requiring the Fund to gain the Investor’s consent prior to investing in a bank or bank holding company.
Funds also wish to avoid regulatory restrictions and issues relating to Investors that are separately invested in banks and bank holding companies and, as a result, subject to the BHCA. One way Funds accomplish this is through Investor voting rights. Through an LPA, a Fund may require that a portion of such Investor’s voting interest in the Fund that exceeds a certain percentage of the total interests of all Investors in such Fund (usually 4.99 percent) be treated as non-voting interests. Also, a Fund may require that such Investor partially withdraw from the Fund to the extent necessary to maintain its investment at a level below a threshold percentage of the Fund’s total capital commitments.4
These rights may restrict access to the capital commitments of a Fund and prevent a Fund from using all or part of an Investor’s capital contributions to fund an investment in a bank or bank holding company. Moreover, an Investor who is excused from funding a capital call may not be obligated to fund the repayment of a prior draw on a Facility used to acquire an investment in a bank or a bank holding company. To avoid this, Facility credit agreements will often exclude the capital commitments of such Investors from a Facility’s borrowing base if the proceeds of the borrowing will fund an excused investment. As a result, the Fund’s maximum borrowing amount under a Facility is reduced.
II. Investments in Media Companies
Funds and Investors face similar hurdles when investing in media companies. If a Fund or Investor is found to have sufficient control of a media company, the Fund or Investor will be subject to the US Federal Communications Commission’s (“FCC”) local media cross-ownership rules.5 For a Fund that holds a controlling ownership interest in a media company, an Investor may be found to hold an interest in the Fund sufficiently large to fall under the scope of the FCC's regulations. This is the case even if such Investors are not themselves directly invested in such company.
As used herein, a “media company” refers to an entity that, directly or indirectly, owns, controls or operates, or has an attributable interest in, a broadcast radio station, television station and/or a daily newspaper within the same local market. Investment in such media companies is subject to the local media ownership or also known as local media cross-ownership restrictions set forth in the United States Communications Act of 1934, as amended (“Communications Act”) and in the FCC’s regulations and policies.6 Under its local media cross-ownership rules, the FCC limits the number of media companies that a single entity may own or control in a local market.7 The FCC's media attribution rules establish various criteria for determining if an entity has an attributable interest and/or whether such interest violates or would violate the Communications Act and the FCC's rules.8
Funds and Investors must consider carefully the regulations associated with holding attributable interests in media companies to ensure FCC compliance. One means to avoid implicating the local media cross-ownership rules would be for a Fund or an Investor to negotiate favorable LPA or Side Letter rights that would limit or restrict the Fund or Investor’s exposure. Such rights may include documenting restrictions or prohibitions on using capital contributions for the purpose of investing in a media company or making an investment that would result in attributing an interest in a media company to a given Investor.
Another option would be to obtain an opinion from counsel that the anticipated ownership interest in a media company would not be attributed to an Investor by virtue of the Investor’s status as an investor in the Fund. Additionally, documentation might also include a representation by the general partner of a Fund confirming that the Fund does not expect to invest in media companies.
Furthermore, when a Fund is subject to the FCC's local media cross-ownership rules, the Fund may restrict an individual Investor from being materially involved in the Fund’s media-related activities to ensure that the FCC media ownership rules are not attributed to the Investor. For example, the general partner could restrict the Investor from acting as an employee of the Fund if the Investor’s functions relate to the media enterprises of the Fund.
For a Fund that is invested in media companies, the general partner of the Fund may require an Investor also invested in other media companies to provide certain information and assistance necessary to allow the Fund to make any filing before and/or to discuss with the FCC whether the Fund and its media companies are in compliance with the FCC’s rules and regulations. In such circumstances, such requirements are typically found in the Fund’s LPA or the Investor’s Side Letter.
Finally, we note that rights that limit or restrict an Investor’s exposure to investments in media companies may diminish or eliminate the amount the Investor may contribute toward a Fund’s investment in media company investment activities. Such provisions would have an effect on the total capital commitments of and contributions to a Fund, similar to the effect of restrictions with respect to investments in banks and bank holding companies.
Investments in banks, bank holding companies and media companies are subject to regulations that determine whether a Fund or Investor is deemed to have “control” over such entity, as defined under the BHCA or the FCC’s local media cross-ownership and attribution rules. The resulting regulatory burdens on an individual Investor or a Fund may be mitigated by identifying and negotiating certain separate rights through an LPA or Side Letter. Such rights may affect an Investor’s capital commitment and contribution obligations to a Fund and such Fund’s Facility. Therefore, Facility Lenders should carefully review any BHCA and FCC provisions in a Fund’s LPA and Side Letters and consider the effect the provisions may have on the borrowing base under a proposed or existing Facility.
1 Investments in banks may require analysis under the Change in Bank Control Act, and investments in federal savings associations and savings and loan holding companies would require analysis under the Home Owners’ Loan Act. A discussion of these laws is beyond the scope of this Legal Update.