A recent emerging trend in European and UK net asset value (“NAV”) financings, particularly with respect to secondaries funds, “funds of hedge funds”, and open-ended funds, is that borrowers are increasingly requesting to receive borrowing base credit for listed equities.
Funds of this nature often hold such assets (in addition to the main portfolio investments) to maintain a certain degree of liquidity, to preserve value pending the acquisition of a major new investment (which may take longer in an environment of heightened investor scrutiny), or to diversify their portfolios. Hence, sponsors may wish for NAV facilities to be sized accordingly and reliance may be placed on such assets for the purposes of any liquidity covenants.
Structuring Considerations
If such arrangement is commercially acceptable, it gives rise to some key structuring questions for lenders. The first, and most important, question for a lender is whether the listed equities (1) will only constitute a small or “bonus” component of the security package; or (2) are one of the primary assets being underwritten and if the loan proceeds will be applied towards the acquisition of further listed equities.
Where the latter applies, this may result in the financing constituting margin lending, which may attract further financial regulatory considerations. For example, additional disclosure rules may apply under some jurisdictions of exchanges on which the relevant equities are listed or regulatory frameworks such as the US Margin Regulations may be engaged (which may result in, e.g., the need for additional filings for US-based lenders such as Form FR U-1s).
Another key structural consideration is how the listed equities will be held. From a lender’s perspective, the structure of choice is for the listed equities to be held via a custodian, which acts as the legal owner of the listed equities for the benefit of the fund, rather than the equities being held by the fund directly.
This structure provides lenders comfort that the equities are held with a reputable third-party institution. Crucially, it also enables lenders to take security, and exercise control, over such equities through the use of tripartite control agreements that allow lenders to toggle between different degrees of control over the custody accounts on which such equities are held control (including rights to instruct or block disposals of the equities) based on the presence of certain factors at the time (e.g., whether an event of default subsists), all whilst avoiding complex conflicts of laws issues.
Given the importance of a reputable third-party custodian to the lenders’ recourse to the equities, prudent lenders should also structure deals to protect themselves if something goes wrong at the custodian level. Typical “Custodian Events” include insolvency or insolvency proceedings of the custodian, repudiation, invalidity or unlawfulness of the custody agreement or tripartite control agreement, and loss of regulatory licences or approvals.
Lenders will want to ensure that equities held via custodians which are subject to such events lose their eligibility and drop from the borrowing base and, further, may consider requiring the delivery and implementation of cure plans pursuant to which the custodied equities are transferred to a replacement custodian in a phased manner.
A further structuring consideration with respect to taking security over listed equities is whether an enforcement over such equities (whether (1) by taking control of the securities account in which the equities are held; and/or (2) actually taking control over any equities and/or instructing a securities intermediary to dispose of them) may trigger mandatory takeover obligations, potentially obliging the secured parties to make a mandatory offer for the whole of an issuer’s share capital. Ultimately, this depends on local laws and regulations and on the proportion any secured equities comprise in the entire issued share capital of an issuer.
To avoid onerous legal analyses on the pertinence of such risk, a savvy lender may structure around this by including concepts within its security documents to the effect that any voting or economic rights attaching to any secured equities do not automatically pass to the security agent (or the secured parties) on an enforcement, but only upon the exercise of further steps by the security agent. Paired with complementary information undertakings and further assurances, this enables the lenders to fully understand the regulatory position (and to react accordingly) before it enforces (and potentially inadvertently triggers any such mandatory takeover obligations).
Eligibility of the Equities
In addition to being held via a reputable third-party custodian and subject to indirect security via a tripartite control agreement, borrowing base eligibility will also usually be informed by the following factors:
- Securities exchange – only equities held on reputable securities exchanges in sophisticated jurisdictions are eligible for borrowing base purposes as lenders rely heavily on accurate and up-to-date market prices being available and that such equities are readily tradeable during reliable trading sessions. Savvy lenders in the UK market will also seek to ensure that such exchanges qualify as “recognised securities exchanges” under the prudential framework with a view to potentially receiving preferential capital treatment for the NAV financing.
- The issuer – a lender may require that only equities issued by issuers incorporated or established in certain jurisdictions and with a certain credit rating are treated as eligible. There may be various legal and commercial reasons for this, but some include the presence of sophisticated shareholder protection laws and regulations, bankruptcy laws, financial reporting laws and regulations, and reduced risk of price volatility. For similar reasons, insolvency events at the issuer level also usually result in exclusions from the borrowing base.
- Trading disruptions – equities subject to recurring or prolonged trading disruptions will also usually drop from the borrowing base. Again, the lender relies on accurate and up-to-date market prices being readily available for listed equities in order to accurately assess the “V” of any LTV covenants applicable to the financing.
Repeated or prolonged market disruption events (e.g., early closures of an exchange or other events that impair the ability of market participants to transact or settle trades) or trading disruptions (e.g., suspensions of trading due to price movements exceeding daily limits) undermine this.
- M&A events – lenders may also not want advance borrowing base credit against equities which are the subject of tender or takeover offers or merger events (e.g., consolidations, amalgamations or binding share exchanges with or into another entity in which the issuer is the continuing entity). Such events, or the consequential enactment of, e.g., poison pill policies, may cause sharp price swings and reduce trading volume, resulting in less liquid and more volatile collateral.
A lender’s control over the listed equities under any tripartite custody account control agreement may also be limited by the mandatory application of takeover rules and so may also look to exclude such equities from the borrowing base where such takeover rules apply (or, for similar reasons, where such equities are subject to legal or contractual “lock-up” or similar restrictions).
Final Thoughts
In an increasingly competitive environment for lenders in the fund finance market, flexibility and the ability to structure around sponsors’ portfolio management strategies can be key differentiators for lenders to win competitive NAV financing mandates. In time, this may mean that more lenders need to be familiar with structuring around the unique risks that taking security over, and giving borrowing base credit to, listed equities may entail.