Subscription Credit Facilities: Concentration Limits

In a subscription credit facility, the borrowing base is typically calculated by applying reductions, commonly referred to as concentration limits, to the uncalled capital commitment of each eligible investor (i.e. an investor whose uncalled capital commitments are included in the calculation of the borrowing base) and then multiplying the aggregate uncalled capital commitments (as reduced by concentration limits) of each eligible investor by the applicable advance rate. Concentration limits are included in the calculation of the borrowing base as a way for a lender to diversify its risk by capping the amount of exposure to a particular investor or group of investors it is willing to lend against.

While many people conceptualize concentration limits as a percentage of the borrowing base itself or as a percentage of the entire investor base of the fund, the most typical approach is to apply the haircut to that amount of an individual investor’s uncalled capital in excess of a specified percentage of the uncalled capital commitments of all eligible investors included in the borrowing base (e.g., all “Included Investors” and “Designated Investors”) without taking into account the investor’s particular advance rate, the advance rate of any other eligible investors or the uncalled capital commitments of any investors which are excluded from the borrowing base. 
Concentration limits are usually assigned via a risk rating system—with strong “Rated Included Investors” having the most relaxed concentration limits and “Designated Investors” having the most stringent. Additionally, concentration limits can also be applied to some classes of investors in aggregate (e.g., all “Non-Rated Included Investors” and/or all “Designated Investors” may be subject to a concentration limit).

Most Common Way Advance Rates and Concentration Limits Are Used to Determine Borrowing Base

While advance rates vary among lenders and depend on the composition of the borrowing base, large syndicated facilities in the market usually use 90% for so-called “Rated Included Investors” and “Non-Rated Included Investors” and 65% for so-called “Designated Investors.”

Typically, the borrowing base is determined through a calculation involving both concentration limits and advance rates, such as the following:

Borrowing Base means, at any time of determination, the sum of (a) 90% of the aggregated uncalled capital commitments of the Included Investors and (b) 65% of the aggregate uncalled commitments of Designated Investors, in each case as such uncalled capital commitments are first reduced by all applicable concentration limits.

It is important to note that the order of application of concentration limits and advance rates can significantly impact the overall borrowing base under the facility. Typically, concentration limits are applied before the advance rate, as this formulation more accurately addresses the risks a lender seeks to minimize. Because advance rates will vary among the fund’s investor base, if the concentration limit haircut were to be calculated second, such haircut would be applied to an investor base that no longer reflects the true concentration of each investor in the borrowing base.

Key Nuances

The following are some key nuances that can have a significant impact on the borrowing base:

Aggregating Affiliates to Calculate the Concentration Limit

Concentration limits are intended to reduce a lender’s risk by ensuring a diversified borrowing base, which protects the lender in case an issue arises that would impact an investor’s ability to fund its capital commitments. Thus, when calculating concentration limits, an investor and its investing affiliates’ uncalled capital commitments will typically be aggregated as though they are a single investor. When a group of affiliated investors whose businesses are linked invest together in a fund, an issue that impacts the ability of one investor to fund its capital commitments is likely to impact its affiliates which share the same ultimate credit support.

Although aggregating affiliates is an effective strategy to mitigate risk, there may be certain instances where the affiliated investors have diversified businesses with differing means of ultimate credit support, such a set of two affiliated investors, one of which invests in commercial real estate and one of which invests in distressed debt. In these cases, aggregating the affiliates for concentration limit calculations only reduces the borrowing base without providing a corresponding risk reduction for the lender.Therefore, rather than mechanically aggregating affiliates, borrowers and lenders should review the link between the affiliated investors' source of repayments to determine whether aggregation would reduce the lender's exposure to specific risks. If not, the parties may want to draft specific carve-outs to separate affiliated investors with diversified sources of capital.

Concentration Limit Holidays

A fund may enter into a subscription credit facility at various life stages, ranging from its inception to after its investment period has ended. Concentration limits can be particularly challenging for a fund in its early stages when its investor base may be highly concentrated. A fund in this situation may negotiate a delay in the implementation of concentration limits—a so-called concentration limit holiday—to ensure that adequate capital is available under the facility to allow the fund to grow.

When a concentration limit holiday is agreed, the concentration limits will spring into effect upon a triggering event, such as a pre-determined date (often the earlier of the fund’s final investor close and one year from the facility's closing).

Concentration limit holidays may only be applied to only a subset of investors within the borrowing base. For example, lenders may agree to a concentration limit holiday for “Rated Included Investors” but apply the concentration limits to the rest of the borrowing base. In exchange for a concentration limit holiday, lenders may require tighter constraints on the borrower under the facility. For instance, because lenders face greater exposure to each investor with a concentration limit holiday, the lender may require a more diverse investor base or tighter covenants relating to the incurrence of indebtedness.

The “1-Minus Test”

The “1-minus test” is another twist on concentration limits that is usually implemented in situations where there is one particularly large capital commitment included in the borrowing base. It is specifically designed to protect the lender from relying on any one particular investor to be repaid in full. In other words, the 1-minus test can be used to haircut the borrowing base so the lender will still be paid in full even if the largest investor in the borrowing base fails to fund its capital contribution, as long as all the other investors in the borrowing base do fund. When this test is implemented, the borrowing base is generally determined to be the lesser of:

(a) uncalled capital commitments (as adjusted by advance rates and concentration limits), and

(b) the product of (i) 100% of the aggregate uncalled capital commitments of all investors multiplied by (ii) the percentage equal to (A) 1.00 minus (B) a fraction—the numerator of which is the aggregate uncalled capital commitments of the investor (or group of investors that are affiliates) with the largest capital commitment and the denominator of which is the aggregate uncalled capital commitments of all investors.

The following two hypotheticals show how the standard calculation method and the "1-minus test" can yield different results when a large investor is in the pool.¹

Hypothetical #1: Fund of $10,000,000 in uncalled capital commitments, with four investors, each with similar uncalled capital commitments:

Calculation of Borrowing Base using the Standard Application of Concentration Limits and Advance Rates: First, the concentration limit would be applied to each individual investor as follows:

• LP 1: UCC after application of concentration limit (15% of $10,000,000): $1,500,000²
• LP 2: UCC after application of concentration limit (15% of 10,000,000):  $1,500,000
• LP 3: UCC after application of concentration limit (10% of 10,000,000):  $1,000,000
• LP 4: UCC after application of concentration limit (10% of 10,000,000):  $1,000,000

Then, the advance rate would be applied to the uncalled capital commitments as follows:

• 90% of $3,000,000 = $2,700,000
• 65% of $2,000,000 = $1,300,000

Accordingly, the total amount of the borrowing base with this method would be $4,000,000.

Calculation of Borrowing Base with “1-Minus” Test: First, the borrowing base would be calculated using the standard application of concentration limits and advance rates, as shown above. Then, the applicable fraction would be determined with the uncalled capital commitment of the investor with the largest capital commitment as the numerator and the aggregate uncalled capital commitments of all investors as the denominator. In this case, that fraction would be $3,000,000/$10,000,000.

Finally, 1.0 minus the result of such fraction (1.0 – 0.3 = 0.70) would be multiplied by the aggregate uncalled capital commitments ($10 million).

Here, the test would yield a borrowing base of $7,000,000.

In this scenario, the 1-minus test doesn’t provide any additional haircut and the standard concentration limits would apply. However, this hypothetical assumes an investor base that is relatively evenly split. The result could vary significantly in situations with an investor base that includes a very large investor. Consider the following hypothetical:

Hypothetical #2: Fund of $10,000,000 in uncalled capital commitments, with four investors, including one very large investor:

Calculation of Borrowing Base using the Standard Application of Concentration Limits and Advance Rates: First, the concentration limit would be applied to each individual investor as follows:

• LP 1: UCC after application of concentration limit (15% of $10,000,000): $1,500,000
• LP 2: UCC after application of concentration limit (15% of $10,000,000): $1,000,000³
• LP 3: UCC after application of concentration limit (10% of $10,000,000): $1,000,000
• LP 4: UCC after application of concentration limit (10% of 10,000,000): $1,000,000

Then, the advance rate would be applied to the uncalled capital commitments as follows:

• 90% of 2,500,000 = $2,225,000
• 65% of 2,000,000 = $1,300,000

In this calculation method, the total amount of the borrowing base would be $3,525,000.

Calculation of Borrowing Base with “1-Minus” Test: First, the borrowing base would be calculated using the standard application of concentration limits and advance rates, as shown above. Then, the applicable fraction would be determined with the uncalled capital commitment of the investor with the largest capital commitment as the numerator and the aggregate uncalled capital commitments of all investors as the denominator. In this case, that fraction would be $7,000,000/$10,000,000.

Finally, 1.0 minus the result of such fraction (1.0 – 0.7 = 0.30) would be multiplied by the aggregate uncalled capital commitments ($10 million).

In this case, the “1-minus test” would yield a borrowing base of $3,000,000 ($10 million x 0.30). Accordingly, to ease concerns that the standard concentration limits do not accurately reflect the true diversification risk, the borrowing base would be calculated using the “1-minus” haircut.

Conclusion

The borrowing base construct is essential to the credit underwriting of any subscription financing. A key part of that calculation is how concentration limits apply and that they accurately reflect the issues raised by the investor base at hand. In some cases, the “standard” borrowing base is overly punitive, while in other cases, it is overly lenient. In either of these circumstances, it makes sense for both lenders and borrowers to use sensible variations—and, to the extent the facility will be syndicated, variations that have been historically accepted in the market—such as those identified above.

Note: In the below hypotheticals, we assume that each investor is an eligible investor.  In a real world investor base, there are likely to be certain investors in a fund whose uncalled capital commitments are excluded in the calculation of the borrowing base.

Note: In this hypothetical, the concentration limits reduce each investor’s uncalled capital commitments included in the borrowing base, as the investor base is size reduced for simplicity. In a real world investor base, the concentration limits are less likely to reduce each investor’s uncalled capital commitment as there will often be a much larger investor base than shown here.

¹ Note: In the below hypotheticals, we assume that each investor is an eligible investor.  In a real world investor base, there are likely to be certain investors in a fund whose uncalled capital commitments are excluded in the calculation of the borrowing base. 

² Note: In this hypothetical, the concentration limits reduce each investor’s uncalled capital commitments included in the borrowing base, as the investor base is size reduced for simplicity. In a real world investor base, the concentration limits are less likely to reduce each investor’s uncalled capital commitment as there will often be a much larger investor base than shown here. 

³ Note here that the UCC of this investor is less than what would be permitted by concentration limits, so it remains unchanged by the application. LP 3 and LP 4’s UCCs are similarly unchanged by the application of the concentration limit as their uncalled capital commitments match their concentration limit caps.