Documentation and terms in the fund finance markets have evolved differently in the United States, Europe and Asia based on various factors particular to each market, with each market having its own strengths, innovation and trends. Previously, we noted the convergence of certain terms and techniques between the United States and United Kingdom markets in a Legal Update and the growth of second lien financing in the United States in another publication,1 so it is with interest that we are now observing increased interest from European and Asian market participants in second lien subscription financings.
An opportunity for growth
The term "fund finance" now refers to an array of financial products, but, in many respects, the market staple remains the subscription credit facility (for the purposes of this Legal Update, a "Facility," and collectively, "Facilities"), whereby lenders make available to private funds (each, a "Fund") a Facility for the purpose of bridging the Fund's investment and other activities in lieu of capital being drawn from the investors in the Fund (the "Investors"). As collateral for a Facility, the Fund, its general partner and/or manager will grant in favor of the lenders or a security trustee (a "Security Agent") security over the Investor commitments and the rights to issue capital call notices to the Investors (and receive the proceeds thereof), as well as over the bank accounts into which the proceeds of such capital calls are required to be paid (this security package, the "Security"). The Security is often accompanied by a negative pledge prohibiting the Fund from granting security over certain of its assets to any party other than the Security Agent.
Facilities can be overcollateralized given that the borrowing base that lenders use to assess availability under a Facility often does not include all Investor commitments a Fund has access to, but the Security granted does extend to the right to call on all Investor commitments and not just the commitments of those Investors in the borrowing base. This can be frustrating for Funds with an appetite for incurring a higher level of Facility debt. The past year in particular has seen a push by Funds for increased levels of liquidity; some market participants have sought this by way of "NAV" or "hybrid" facilities (and sometimes even preferred equity solutions), but this liquidity push has also increasingly focused both Fund and lender attention on the opportunities provided by "second lien" financing.
What do we actually mean by "second lien" or "2L"?
From the perspective of the wider European and Asian loan markets, there is certainly no novelty to the idea of layered debt. Structures with super senior, senior, mezzanine, junior debt and unitranche facilities are commonplace. Likewise, there is no special magic to the term "second lien." Use of "lien" in United States legalese is broadly equivalent to "charge" or similar terms in the United Kingdom. What "second lien" means, in its simplest form, therefore, is "second charge"—i.e., a debt layer that is subordinated to or ranks below the senior or "first lien" debt, either with two, stacked, security packages (i.e., the "first lien" and the "second lien") or a shared security package with an agreed payment waterfall in respect of proceeds from the same ("shared lien"). Although this Legal Update notes some key differences between the two structures, for ease we have referred to both in general terms as "first lien"/"second lien" financings.
Scope for second lien lending (or alternative structures)
Inherent in the sizing of Facilities is not only the appetite of lenders to lend against particular Investor commitments but also (often tighter) aggregate borrowing caps imposed by the Fund's limited partnership agreement and other fund documents. That caveat aside, we look below at some of the structural options available for a Fund looking to "top up" its financing package with an additional Facility from a second lender. The risk exposure of a second lender in any of these structures is of course greater (as compared to the first, secured, lender), and second lenders will look to price their facilities accordingly.
A second lender may elect to provide a Facility on an unsecured basis, relying on the cushion of Investor commitments that constitutes the overcollateralization of the first Facility and should therefore be available as a source of repayment of the second Facility. Although its unsecured nature can make this option less appealing to prospective second lenders, it may be appropriate for relationship-driven financings, and we have often seen this used as a mechanism to obtain a temporary increase in leverage. The lack of security makes intercreditor arrangements less complicated or even unnecessary, but to the extent the first Facility prohibits or limits the incurrence of the second Facility, both the Fund and the unsecured lender should ensure that appropriate consents are given by the secured lender to the incurrence of indebtedness under the second Facility; a possible condition of such consent might be entry into a subordination deed between the first and second lenders.
While a first lien lender may assemble a borrowing base of certain Investor undrawn commitments, in an enforcement event (pursuant to the Security), it will expect its recourse to extend to all Investors (whether included in the borrowing base or not), not least as typically the partnership agreement of the Fund requires a capital call to be issued on a pro rata basis to all Investors in order to be valid. A second lien structure provides the additional lender with secured recourse to the same aggregate pool of Investor commitments but with its security interest subordinated to that of the first lien lender. In this scenario, the second lien lender is relying on the overcollateralization of the first lien lender; however, the second lien lender is specifically focused on an alternative borrowing base comprising the commitments of those Investors that the first lien lender has excluded from the borrowing base and/or by providing for additional headroom by applying a higher advance rate or concentration limits against the same Investors included by the first lien lender (for which the second lien lender is often compensated for by a pricing uplift).
Rather than relying solely on the overcollateralization of a first Facility, a second lender may assemble a borrowing base that does not overlap with that of the first lender on a "cross lien" basis, whereby one lender has first ranking recourse to a particular set of Investors, and the second lender, to the remainder. Each lender also typically has second ranking recourse to the other lender's "borrowing base" Investors. This approach is less typically adopted in our experience; however, from the Fund's perspective, this structure does offer an avenue to potentially reduced pricing of a second Facility, which can be attractive even after netting off a corresponding potential increase in pricing of the first Facility.
A particular consideration in respect of any such "cross lien" Facility, among others, is that a Fund's limited partnership agreement typically requires all Investors to be treated equally and, as noted above, for capital calls to be issued on a pro rata basis. Therefore, upon enforcement, the Security Agent(s) would be required to issue drawdown notices to all Investors and apply the proceeds of the capital call to the two lenders based on the agreed borrowing base and recourse allocation.
Unitranche structures could be adopted in the subscription financing market, whereby the characteristics of the financings outlined above are merged into a single Facility, offering a blended pricing rate to the Fund. This, of course, presents a more streamlined offering to the Fund (both in terms of the legal process and also operationally on a day-to-day basis), although it may not be as appealing from a pricing perspective should the Fund wish to use second lien financing as an "overflow" option to an existing first lien Facility. As in the leveraged markets, we would expect that these facilities would likely be subject to tranching into "first out"/"last out" structures, requiring intercreditor arrangements between the lenders.
The introduction of a second secured Facility to a Fund's financing package requires lenders to consider whether separate Security should be taken or a single Security package be shared. We have seen lenders in the European and Asian markets consider both options.
It may be that the two lenders wish to keep their interests distinctly documented, with the Fund and each lender entering into a separate suite of documentation (including facility agreement and security documents). Each Security package would be held by a Security Agent as a security trustee for the lender in respect of the relevant Facility. While the first lien Facility has not been discharged, the rights of the second lien Security Agent and lenders to enforce such security are limited by the terms of an intercreditor agreement.
Unlike with first/second ranking account security, which is a generally well-established practice, prospective lenders should take careful local law advice in respect of any second ranking capital call security. In particular, to the extent that any such capital call security requires a transfer of legal rights, a second lien Security Agent may not be able to concurrently benefit from the exact same Security (with the relevant rights having been legally vested in the first Security Agent (rather than retained by the relevant security "grantors," subject to the security interest of the Security Agent)).
In our experience, the commonly preferred approach for first/second lien financing structures is for each lender to be party to a separate facility agreement but with the Fund granting Security in favor of a common Security Agent as security trustee for both the first lien and second lien lenders. From the Fund's perspective, this is a neater solution, requiring it to enter into only one set of security documents. Also, with regard to investor relations, Investors will be notified only of the granting of a single security interest and will not be required, even in an enforcement situation, to interact with more than one secured party (i.e., the Security Agent).
It is not uncommon for the Security Agent to be the same entity as a lender in respect of the relevant Facility, even where a Facility is provided by more than one lender, given that the interests of all of the lenders in respect of a Facility are generally aligned. However, if the Security Agent is to act in respect of both a first lien and second lien Facility, careful consideration should be given to potential conflicts of interest (particularly if the Security Agent itself is a lender in respect of one Facility but not the other). A third party may be appointed as the common Security Agent to mitigate against any conflict of interest.
The introduction of a second secured Facility to a Fund's financing package necessitates that certain arrangements be documented between the respective lenders; these are set out in an intercreditor agreement.
While we examine certain of the considerations relating to intercreditor arrangements below, it is important to note that these are by no means exhaustive, and the terms of the relationship between the two debt layers will require detailed consideration with experienced legal counsel on a transaction-by-transaction basis. Moreover, we note that these are generally on the basis of a "first lien"/"second lien" distinction between the lenders. In the case of Facilities provided on a "cross-lien" basis, that distinction may not neatly apply, and the negotiating positions of the parties should be considered accordingly.
Ranking and enforcement
Ranking of security (i.e., where separate security has been taken) is, of course, fundamental to the intercreditor arrangements between first and second lien lenders to ensure the second lien Security Agent is ranked second to that of the first (subject to any caps on first lien recoveries; see below).
A common focus of negotiations is an agreed enforcement trigger and, from the perspective of a second lien lender in particular, for that to be considered in conjunction with any "standstill period" following an enforcement trigger (during which the second lien lender is generally prohibited from directing a Security Agent to take enforcement action). Generally, certain exceptions are agreed in favor of second lien lenders in respect of such standstill periods, including the insolvency of the Fund, or enforcement action being taken by the first lien parties.
Consideration should also be given to whether, in an enforcement process, a single capital call can be issued to Investors in order to repay both Facilities; from the lenders' perspective, issuing a single capital call to Investors is often viewed as a more efficient process and also one with which Investors are more likely to comply. This is a particular concern in a two-Security Agent structure.
Application of proceeds
The rights of the first and second lien lenders to the proceeds of the Security will be a matter of intense scrutiny. The intercreditor agreement may require the full discharge of obligations owing to the first lien lender prior to any proceeds being paid to the second lien lender, but it may also be the case that the classes of lenders agree to build certain thresholds into the enforcement or payment waterfall (e.g., the first lien lender is paid up to an agreed cap, then the second lien lender up to its agreed cap, then the excess amount owing to the first lien lender, then any excess amount owing to the second lien lender).
Of course, if the Facilities have been structured on a "cross lien" basis, the waterfall will stipulate that the proceeds of an enforcement capital call will be applied by reference to the Investors from which the proceeds were received (with any excess from the proceeds first allocable to one class of lender then being applied to the other lenders).
Additionally, intercreditor agreements typically include turnover provisions whereby, should any second lien (or indeed cross-lien) creditor receive any proceeds of an enforcement to which they are not entitled, they are obliged to pay those to the first lien lender (including proceeds of enforcement received by a second lien lender following the expiry of a standstill period).
Other key provisions
When it comes to intercreditor negotiations, there are a number of other key points that parties may focus on. These include permitted payments or rights of a first lien lender to "turn off the tap" on payments by the Fund to second lien lenders and limitations on permitted borrowings (particularly in the context of the revolving nature of both first lien and second lien Facilities, where parties may consider whether, if the first lien Facility is not fully drawn, the Fund is entitled to utilize the second lien Facility (although, of course, the higher pricing of the second lien Facility often provides a clear incentive for the Fund to draw the first lien Facility as fully as possible prior to drawing the second lien Facility)).
In addition, given the relationship-driven nature of the subscription financing space, second lien lenders may be motivated to seek mechanisms to guard against any enforcement by the first lien lenders (which may be detrimental to the wider second lien lender's relationship with the sponsor or the second lien's perception by the wider fund and investor community). Typical protections that might be sought in this regard include the right of the second lien lenders to cure first lien Facility breaches by compelling the Fund to utilize available amounts under the second lien Facility and apply them accordingly or a right to purchase the first lien lenders' positions in the first lien Facility in certain circumstances.
Finally, first and second lien lenders may seek undertakings from one another to protect their respective positions. Such controls might include limiting or restricting increases in debt under either Facility, restrictions on set off, consent requirements should the Fund seek to purchase any interest in the second lien debt and restrictions on certain amendments to the suite of first lien and second lien Facility documentation without the other lender's consent. Such provisions are designed to avoid a scenario that may adversely affect the exposure of either the first lien or second lien lender.
Particularly with the growing demand for liquidity by Funds, which is exacerbated by current market conditions, we expect to see continued interest in European and Asian second lien financing as a supplement or alternative to NAV-based solutions. This not only follows a trend we have noted in the United States but also is a natural progression of the multi-layered approach to facilities seen in the wider European and Asian loan markets.
The application of these structures to the subscription financing market is not without its nuances and particular structuring considerations, and we would recommend that both Funds and lenders looking to expand into this area do so with experienced legal counsel to fully understand and address the legal issues involved.