1. Introduction to rated note feeders
A rated note feeder (RNF) is a feeder vehicle that invests all or substantially all of its capital into an underlying master fund either directly or via one or more intermediate funds. In this sense it is similar to a traditional feeder fund vehicle, but with the key difference being that the investor in an RNF subscribes for debt interests as opposed to ordinary equity interests. The debt is typically constituted as notes issued under a note purchase agreement or indenture. An external rating agency rates the notes, thus allowing certain investors such as insurance companies to apply their desired regulatory capital treatment to their investment. In the Cayman Islands, the RNF is commonly formed as an exempted company, limited liability company (LLC) or an exempted limited partnership (ELP).
The RNF structure is becoming increasingly prevalent in the context of closed ended private fund transactions advised on by Mourant. The RNF concept has several key features it is important to be aware of:
- Utilisation: the RNF is designed largely for US insurers seeking better capital treatment of their investments in private investment funds.
- Structuring: borrows concepts from the securitisation and CLO industry, namely tranching, credit enhancement, external ratings and cash flow waterfall techniques, with equity in the feeder supporting the third party rating.
- Funding: investors commonly subject to a dual commitment, debt under the NPA and equity under the feeder’s constitutional documents, and the manager (or a secured lender holding capital call security) can call on either the debt or equity commitments as required.
- Documentation: an RNF structure will involve an LLC agreement, articles of association, or ELP partnership agreement (depending on the entity type), a note purchase agreement (NPA) constituting the rated notes, an offering memorandum and a subscription agreement.
2. Implications for subscription credit facilities generally
Sponsors increasingly expect RNFs to be accommodated in the facility structure and RNFs to receive facility borrowing base credit for the RNF investor's commitment. A subscription facility lender advances funding backed by the right to call capital from investors, and takes credit risk on the ultimate investor and must also address legal risk on each stage in the fund structure. Under Cayman Islands law, the noteholders (i.e. investors) are creditors of the RNF even if they are also equity holders, so the noteholders' position in the event of the RNF's insolvency differs from that of a limited partner or shareholder/member. Additionally, specific Cayman Islands law insolvency rules apply where the RNF is incorporated or formed in the Cayman Islands (a Cayman RNF) as detailed further below.
In order to address concerns under s365 of the US Bankruptcy Code relating to the potential lack of enforceability of "executory contracts" upon the insolvency of the RNF, many RNFs are formed with documentation mechanics in effect on day one allowing commitments to be called as both debt under the NPA or as equity interests in the case of an Event of Default or under certain other prescribed circumstances (Hybrid Debt/Equity Commitment). Cayman Islands law has no direct equivalent to s365 of the US Bankruptcy Code so the above "executory contracts" issue is not a Cayman-law specific issue. However, Cayman RNFs may still feature the Hybrid Debt/Equity Commitment concept to cater for a situation where a US Bankruptcy Court exercises jurisdiction on the basis of the governing law of the principal transaction documents, location of key assets, or other factors which confer jurisdiction on the US Bankruptcy Court.
3. Cayman Islands law considerations
3.1 Security over call rights
Aside from drafting nuances in the security documents, the Cayman Islands law analysis of creation and perfection of security over rights to call from a noteholder under an NPA is effectively the same as for security over capital call rights against a limited partner under a Cayman Islands law governed LPA. The right to call capital is classified as a chose in action and requires an equitable assignment by way of security of the contractual call rights, and delivery of customary investor notices to the RNF noteholders, as well as security over the contribution account (which in most US market fund financing transactions will typically be domiciled in a jurisdiction outside of the Cayman Islands).
Several important considerations are:
- The terms of the NPA, subscription agreement and RNF organisational documents must be carefully reviewed together and, in the round, to ensure that there is a binding contractual commitment for the investor to fund when note advances are required to be made. It is not sufficient for the investor to agree to subscribe for notes from time to time at its election.
- The specific entity type will inform which legal entity holds the right to call debt and equity capital respectively (ie, the general partner of an ELP, a managing member of an LLC, the exempted company itself or an investment manager delegated under an investment management agreement). This should be identified as an initial diligence matter and feed into the drafting of the security agreement.
- The scope of the collateral grant should be drafted broadly enough to capture the contractual rights under (i) the NPA itself and any related terms and conditions (ii) the RNF organisational documents and (iii) any subscription agreement between the investor and the Cayman RNF. This is particularly crucial where the Cayman RNF is an exempted company, as there is debate as to whether the rights under an exempted company's articles of association are capable of assignment to a third party.
- Where the Cayman RNF is incorporated as an exempted company, section 99 of the Companies Act (as amended, the Companies Act) may have implications as set out in more detail below.
3.2 Cayman Islands law insolvency implications
Relative priority positions of secured subscription lender vs RNF investor
Under Cayman Islands law, a legal person may exercise rights in a capacity as creditor separate from its rights as equity holder in the case of the insolvency of an ELP, exempted company or LLC. Depending on the facility structure, it may be important to ensure that the RNF's NPA obligations to its investors are contractually subordinated to all subscription facility obligations. Any such subordination language should be included in the NPA itself. Secured creditors generally take priority over unsecured creditors under common law principles, and under Cayman Islands law a secured creditor can enforce security outside the liquidation process without reference to the debtor's liquidator or the need to obtain Court sanction[1]. However, bear in mind that in many structures, the subscription lender will not be a direct secured creditor of the RNF, and will instead be an indirect beneficiary of security via a cascading pledge structure.
Insolvency set-off
Upon a winding up of a Cayman entity the liquidator takes control of the entity's assets and is charged with recovering and distributing such assets to the entity's creditors. Noteholders are creditors of the RNF in their capacity as such, so an RNF noteholder might seek to set off sums owed to it under the notes against its funding obligation. Set-off of claims is generally effective in a Cayman Islands liquidation process and accordingly an express waiver of set off, defence or counterclaim should be included in the NPA and RNF's organisational documents to prevent the investor from applying a set off or a related defence against that investor's funding commitment.
Bankruptcy remoteness and non-petition
As a corollary to the set off and defences waiver, some RNFs are formed as bankruptcy remote entities in order to reduce the risk that the RNF would be subject to insolvency proceedings in the first place. In these structures, the investor should agree not to petition to wind up the RNF without the subscription lender's consent. Cayman Islands courts have historically upheld non-petition provisions in a fund context so it is highly likely that such provisions would be respected, but note that a Cayman Islands Court may still reserve a degree of discretion over whether to assume jurisdiction in relation to a winding up action against a Cayman RNF.
Section 99 of the Companies Act
Section 99 of the Cayman Islands Companies Act provides that, once a winding up order has been made, any disposition of the company’s property, any transfer of shares and any alteration in the status of its members made after the commencement of the winding up is void unless the court orders otherwise. The winding up process is treated as starting on presentation of the petition, not on the date of the order, meaning that the effect of the provision is retrospective: it applies from the petition date but only if a winding up order is actually made by the Cayman Islands Court.
The theoretical issue this poses for Cayman RNFs formed as exempted companies with a Hybrid Debt/Equity Commitment is that section 99 effectively prevents new shares by the RNF being issued post-insolvency petition, which undermines the intent of the Hybrid Debt/Equity Commitment concept. While untested in Cayman law, the RNF investor might raise an argument that it is not obligated to fund in exchange for delivery of new shares, as such delivery of shares is prevented by operation of law. The solution is to ensure that the NPA, articles of association and or subscription agreement contain clear drafting committing the investor to fund equity calls notwithstanding any petition being filed. This may well be covered by customary defence and set off waiver language but this should be reviewed carefully in each case to ensure it is sufficiently robust.
3.3 Regulatory status
Under the Cayman Islands Private Funds Act (PF Act), an in-scope entity may not call capital from investors for the purposes of investments unless and until it has been registered with the Cayman Islands Monetary Authority (CIMA). Borrower's counsel should confirm whether a Cayman RNF is in-scope of the PF Act, as this will not always be the case for two reasons. First, the PF Act does not capture entities which issue only debt interests to investors, though the treatment of Debt/Equity Hybrid Commitments must be considered carefully. Secondly, RNFs are often formed to accommodate a single investor and such single investor entities are typically classified as out of scope, but the analysis remains fact dependent. If the Cayman RNF is in-scope and required to register, customary PF Act covenant language should be included in the underlying credit agreement and made applicable to the Cayman RNF, and evidence of registration should be sought as a condition precedent.
[1] Enshrined in section 142 of the Companies Act.