Ultra High Net Worth investors (“UHNW LPs”) and Family Office investors (“FO LPs”) now have an estimated 45% of their capital invested in alternatives, with 19% of their portfolios consisting of Private Equity[1]. Meanwhile in what is being termed the “democratization” of private markets, funds are increasingly targeting these LPs for fundraising given many large institutions are over-exposed to alternatives relative to their other holdings. The growth of UHNW LPs and FO LPs therefore looks set to continue, exemplified by the prevalence of large UHNW feeder vehicles in many recent subscription finance transactions. A recent rating report from Fitch shows that Alpinvest Secondaries VIII’s subscription line was rated AA despite the largest LP being a HNW Feeder.

As UHNW LPs continue to grow in prevalence in private markets, so does a relatively new product: LP Finance. Joel Buckett of FFA NextGen spoke with Sumaer Sandhu, Niall Spencer, and Mathan Navaratnam to understand why this product is rising in prominence and what the key considerations and pitfalls of these transactions are from both a credit risk and legal standpoint.

Before we get started, tell us a bit about your respective roles and backgrounds

Sumaer: I’ve been fortunate in my career to work in a few different geographies and divisions at Deutsche Bank. I started off working on Wall Street covering leveraged finance credit risk before moving to London on the Emerging Markets desk covering Eastern Europe and Africa. I moved to the UK Private Bank three years ago to help build out the structured lending product offering. We provide tailored solutions to our clients where their needs are not met with tradition Private Banking offerings, this includes financing against Private Shares, Art, Private Equity LP interests, Sports Financings and M&A.   

Niall: I’m a Vice President in the Legal team in Deutsche Bank’s UK Private Bank. I am based in London and cover the Swiss, Lux and London booking centres. During my time at DB, I have worked on fund distributions, including with respect to HNW Cayman and Lux feeder funds, various lending transactions, including subscription lines, NAV financings and LP financings and complex enforcements, including sales of aircraft, real estate and major corporations. 

Mathan: I am a Partner within Cadwalader’s London Fund Finance Practice. I have spent over 11 years advising financial institutions, sponsors and alternative lenders in respect of the entire range of Fund Finance products (including capital call lines, NAV facilities, hybrid facilities, family office/UHNWI facilities, GP and executive support facilities and secondary leverage products) provided via a number of different structures such as framework and umbrella facilities. Prior to joining Cadwalader I was legal counsel to the Investec Fund Finance team in London (whilst also providing legal support to Investec’s South African and New York fund finance teams) and before that I was an associate in Dentons’ London office, specialising in fund finance (including a secondment to the Fund Finance team of Lloyds Bank plc in London).

So Sumaer and Niall; what is LP Finance - who uses it and why?

Sumaer: Over the last decade as the Private Equity sector has significantly grown so have the investments High Net Worth Individuals (HNI’s) are making into funds, attracted by the significant returns, diversity from traditional real estate & listed equity and ability to return capital multiple times of investment within a 5-7 year horizon. Investors have been keen to gain financing against their investments (in the form of limited partnership interests) to release liquidity given the longer-term investment horizon as well as the constant need to meet capital calls made by the funds. In most circumstances LP financing is used to bridge these capital calls or to invest into additional funds. The challenge here for most lenders remains the illiquid nature of these investments vs listed equity, a strong secondaries market is helping mitigate this.

Niall: From a Legal perspective, the typical structure for an LP financing will be as follows:

1. a SPV (usually an LLP or a limited company) holds the LP interests and acts as borrower under the finance documents;
2. security is taken over the LLP interests or the shares in the SPV, as applicable, and the accounts in which LP interests are held and distributions and other proceeds are paid. However, if the SPV is a limited partnership itself, then we would also take security over its general partner in order to be able to direct the limited partnership; and
3. occasionally security may be taken directly over the LP interests the SPV owns in the funds, though owing to typical restrictions set out in fund documentation on taking direct interest over the LP interests this is not standard.

How are you seeing demand for the product at the minute and what are the key factors affecting demand?

Sumaer: In the current rate and macro environment we are seeing individuals looking to raise financing from non-traditional sources such as art, private company holdings and limited partnership interests to ensure they have sufficient liquidity available for their needs. Additionally, with this being a relatively new product in the market, demand is increasing as the product becomes more common place and the secondaries market grows. Finally, the growth in the overall private equity space is fueling additional demand.

How do lenders look at these transactions from a commercial and a credit risk standpoint?

Sumaer: The structure as laid out by Niall above remains key for any lender to consider LP financing. Once the structure is in place lenders will focus on the quality and pedigree of the manager and fund as that will determine the ability and interest one may see in the secondary market. We look at assets under management, investment history and performance, current portfolio, strategy and geographic mandate, key additional investors amongst a range of other criteria. Diversification in the LP portfolio also plays a key role while evaluating the portfolio of funds. From a risk standpoint the enforcement and liquidity in the secondary market is always a point of focus along with the enforcement process as discussed by Niall in more detail. 

Niall: It is critical to ensure that we have clarity on the enforcement process from a Credit and Legal perspective on these transactions. The risks posed by indirect security naturally mean that we need to have certainty that a) our share/ interest security gives us the ability to control the SPV in a short timeframe and b) our account security does not allow for any unpermitted leakage. Taking each point in turn:

1. Security over the interests/ shares in the SPV is vital for enabling us to sell the LP interests in an enforcement scenario. This means that the SPV must be incorporated in a lender friendly jurisdiction (typically we would expect this to be offshore) and we are entitled to appoint receivers/ exercise rights under powers of attorney/ step in on the shares directly in a very short time-period and with limited frustration risk. A key reason that we need to be able to move fast is due to the potential length of any sales process which can be protracted by the fact that these assets are not highly liquid and there may be transfer restrictions in the fund documents.
2. Security over the accounts is key for us to be able to trap distributions. As funds flow into the LP interest account, they may then be swept into other accounts for the client group. This would typically only be permitted where the SPV is not in default under the finance documents, particularly with regard to financial covenants. It is therefore essential that our account security allows us to control this flow-through process/ restrict cash sweeps as appropriate. For that reason, we would typically expect to use accounts within DB.

Where we are less familiar with jurisdictions in which we would look to enforce, we work through the legal enforcement options and practical considerations with counsel to ensure that we are comfortable from a Credit perspective.

Mathan – you wrote an article on this very topic in Fund Finance Friday 2 years ago. How do you think the market has evolved since then and where do you see it heading?

Mathan:  

As Sumaer mentioned above, the current economic climate has resulted in an increased demand for this product as UHNW LPs and FO LPs look to borrow against existing exposure to private equity in order to fund future investments.

There has certainly been more attention to this form of financing from lenders and we are starting to see the product move away from a purely ‘relationship offering’ that financial institutions may have with existing clients as a number of lenders are now developing the product internally so that they are able to provide such liquidity solutions on a stand-alone basis.

However, this type of financing remains predominantly with lenders who have existing relationships with the relevant UHNW LP/FO LP as they are able to accommodate bespoke terms (such as evergreen facilities, uncommitted/on-demand facilities, inclusion of a Lombard facility tranche and creative pricing) tailored to the relevant LPs’ need as well as being able to monitor and lend against a variety of other assets that such LP holds with that financial institution (including liquid and non-liquid assets).

Looking forwards, I expect that both the demand and supply for this type of this facility to continue to grow with a number of new lender entrants and increased borrower demand against the backdrop of muted private equity-backed exits and distributions.  

Outside of the private equity exit climate, as we saw with the onset of the Ukraine war, a number of prospective deals in this space were abandoned given the identities of UHNW LPs and further major geopolitical events will continue to impact the availability of this product for a number of potential UHNW LP borrowers.

In the article you also spoke about restrictions on the ability to take security over LP stakes due to LPA provisions of the underlying funds around indirect security and UBOs. How would this be mitigated?

Mathan: Many of the considerations around secondary NAV financing entered into by secondary sponsors are applicable to these types of financings.

The limited partnership agreement (the “Underlying LPA”) relating to the UHNW LP’s or FO LP’s interest (“Underlying LP Interest”) in a private equity fund (the “Underlying Fund”) customarily include transfer restrictions restricting a change in identity of the UHNW LP or FO LP without the prior consent from the general partner (the “Underlying GP”).

It is common for Underlying LPAs to go a stage further in that they impose restrictions on the UHNW LP or FO LP granting security over its Underlying LP Interest.

As Niall mentioned above, these restrictions on an Underlying LP granting direct security over an Underlying LP Interest can be problematic and time consuming as the borrower of these facilities will need to obtain consent from each Underlying GP in respect of each Underlying LP Interest which is subject to a restriction. The risk in attempting to take security in breach of the Underlying LPA is that such security is ineffective and there is a further concern that the UHNW LP/FO LP would be in breach of its terms under the Underlying LPA which could result in adverse consequences for such LP and its Underlying LP Interest which is in neither the lender’s or borrower’s interest.

For this reason, it is more common to hold the relevant Underlying LP Interest in an SPV and then take security over such SPV. This helps navigate the restrictions on granting direct security referred to above. However, careful due diligence is needed as:

• evidence of successful transfer of the Underling LP Interest to the SPV needs to be reviewed; and
• many Underlying LPAs contain restrictions on ‘indirect transfers’ which could be applicable to the taking of security over the SPV.

Assuming that legal counsel and lenders are comfortable with (a) above, the entity holding the Underlying LP Interest (which would now be the SPV) would need to obtain consent from each relevant Underlying GP in order to consent to the creation of security over the SPV.

Finally, whilst the above addresses some of the concerns found regarding taking security over direct Underlying LP Interests and over an SPV, many Underlying LPAs also contain restrictions around the change in identity (and the ultimate beneficial owner) of the entity holding the Underlying LP Interest. Therefore, whilst the creation of security restrictions has been addressed, this does not necessarily address the enforcement of the security package. In some instances, it is possible to obtain advance consent from the Underlying GP in respect of the enforcement of security (which would likely involve a change of identity or UBO of the entity holding the Underlying LP Interest), many lenders are comfortable with taking obtaining consent to the security package whilst looking to address consent to the enforcement of security at the time the need should arise.

Finally, do these facilities interact with subscription financing and will this become a more prevalent issue in the future – for instance, could large institutional LPs look to obtain similar leverage on their positions?

Mathan: We have advised on a number of LP secondary NAV facilities made available to large secondary managers and this is also an area where a number of lenders are looking to enter the market or expand their offering in this area. These types of borrowers are far more likely to establish SPVs to hold Underlying LP Interests (with the intention that some or each SPV is a borrower). Given that the Underlying LP Interests are not held by the funds themselves then it is very common to see that the fund has entered into a subscription financing at fund level. It is also common to see providers of subscription financing to a fund to also participate in the secondary NAV financing of the same fund.

Whilst family office / UHNWI financing has largely been provided by the Wealth divisions of banks on a relationship basis, managers of large secondary funds have been able to access liquidity for this type of product from the Investment Banking divisions of lenders which has resulted in less bespoke terms (compared to those offered by Wealth divisions) allowing for multiple lenders (including alternative lenders), syndication and larger facilities made available to such sponsors.

As regards large institutional LPs, Fund Finance has seen few pension funds (where their policy and laws to which they are subject permits) utilise NAV lines to leverage their commitments in private equity. Leverage for pension funds has, in the main (and up until central banks started hiking rates), been focused on enhancing returns on the fixed income portion of portfolios rather the equities. This is not to say that leverage has not been available to pension funds with PE commitments, in fact it is quite the opposite - this type of NAV loan follows a similar structure to the more established secondaries segment of the NAV market (as described above) and/or a privately held CFOs, where lenders allocate meaningful pots of capital. Benchmark rates having increased in the way that they have over the last 18 months and the subsequent effect on the all-in cost for such leverage, has limited the opportunity to materially arbitrage the cost and the additional return resulting from the NAV. In the current environment, what NAV against LP commitments does provide pensions funds, is the ability to access liquidity if the underlying funds do not have alternative options / solutions to create distributions either through primary or secondary sales, or indeed fund level (primary) NAV.

[1] UBS Global Family Office Report 2023