The growth of the subscription credit facility market has resulted in many lenders holding significant exposure to the same investors across their entire portfolio. Many lenders are required to track their aggregate overall exposure to these investors in addition to tracking aggregate exposure to sponsors. To mitigate this concentration risk, many lenders are exploring adopting “cross-exclusion events” across their subscription credit facility portfolio. A cross-exclusion event is like a typical borrowing base exclusion event in a standard subscription credit facility, but the exclusion event is not “fund”- or “credit facility”-specific (much like a cross-default). Rather, this cross-exclusion approach resolves a concern that lenders are contractually liable to lend against an investor’s capital commitment in Facility A even though they know that this investor is subject to an exclusion event in Facility B.
Approaches We Have Seen Proposed
We have seen two approaches to cross-exclusion events proposed:
(1) A “sponsor-specific” exclusion event. Under this approach, an investor or its affiliate would be excluded from the borrowing base in Facility A if they were subject to or experienced certain disqualifying events for that same sponsor in Facility B (assuming the exclusion events in both facilities were substantially similar). For example, if the same manager has sponsored two funds (Fund I in Facility A and Fund II in Facility B), any repeat investor that failed to make a capital contribution to Fund I would be excluded from Fund II’s borrowing base. This seems logical—if an investor is failing to fund its capital commitment to a prior vintage of the same sponsor, lenders should be entitled to stop lending against that investor’s capital commitment in other facilities. Note that the exclusion event would occur under Fund II in Facility B even if the lender didn’t advance or participate in the subscription credit facility to Fund I and the sponsor would be obligated to disclose the exclusion event.
(2) A “portfolio-wide” exclusion event. Under this approach, an investor or its affiliate would be excluded from a borrowing base if they were subject to certain disqualifying events (largely mirroring the exclusion events negotiated in the subject credit facility) across the entirety of the lender’s portfolio (Facilities A and B). For example, let’s assume (i) an investor invested in two funds—one sponsored by Manager Y and the other, Manager Z—which had subscription credit facilities with the same lender (Facility A and Facility B) and (ii) the investor defaulted on its obligation to make capital contributions to the fund sponsored by Manager Y in Facility A. A “portfolio-wide” exclusion event would allow the lender to exclude the investor from the borrowing base of the fund sponsored by Manager Z in Facility B.
The Approach Likely to Be Broadly Adopted
From an underwriting perspective, the best-case scenario would be to adopt both sponsor-specific and portfolio-wide exclusion events. However, in our experience, sponsors are likely to resist portfolio-wide exclusion events by contending that the investor’s relationship with another sponsor should not impact its borrowing base with the lender. While this position is understandable from a fairness perspective, it undermines a key tenant of subscription credit facilities, namely, that the funding of capital commitments is not optional and must be funded by investors without set-off, counterclaim or defense. With that said, there could be situations where, without insider knowledge, the applicable fund would not be able to understand or know if the exclusion event was, in fact, appropriate (e.g., did the other fund wrongly classify the investor as a Defaulting Investor under the applicable limited partnership agreement). Portfolio-wide exclusion events also raise confidentiality concerns (e.g., do disclosure restrictions prevent the lender from applying its knowledge of a Defaulting Investor to other funds?) and, if desired, would need to be carved out of the standard confidentiality provisions currently in credit agreements. For these reasons, we think portfolio-wide exclusion events will not likely be broadly adopted. However, we anticipate that sponsor-specific exclusion events sufficiently address a current under-mitigated risk and that lenders may start implementing cross-exclusion events throughout their portfolio.