The recent closing by Goldman Sachs of its highly innovative and market leading US$475 million “capital call” securitisation of subscription credit lines has generated a lot of interest in both fund finance and structured finance circles. It remains to be seen whether this deal remains a one off, or marks the start of a new and exciting era in the worlds of fund and structured finance, but it is certainly reflective of the steady evolution of fund finance transactions from a specialised “novelty” to a more mainstream financing and asset class.
What are capital call facilities?
When a closed-ended, private fund needs liquidity, whether to make new investments or to meet ongoing capital expenses, it would traditionally look to its investors to meet these costs. Under the terms of the fund documents (including investor subscription documents), the fund would generally have a right to “call” capital from its investors, and (subject to certain caveats) the investors would be required to meet that funding requirement up to a committed amount within a set period of time. For a long time these so-called capital calls were the primary source of funding for closed-ended funds, until the fund held a sufficient number of assets or investments that could then be used as collateral for more traditional forms of debt financing.
Over the past 15-20 years, a more sophisticated financing system has developed around private funds, particularly those in their early stages, with an increasing number of lenders now offering “capital call” or “subscription credit” facilities. These are facilities advanced by lenders to funds and secured against the rights of the funds to make future capital calls. They are therefore a useful tool for early-stage funds to obtain bridge financing for short-term projects or to leverage their anticipated future growth potential by assigning the unused capital call rights to one or more lenders. Should the fund default on its repayments under the loan, the lender(s) would have the right to step in and call the capital in place of the fund, which can then be used to repay the loan.
What is a securitisation?
By contrast, a securitisation is a structured product that is used to extract value from certain asset classes, generally in the form of illiquid or non-tradeable securities or other assets without a ready market. It involves the issuance of new interest-bearing notes or other securities (such as preference shares), the cash-flows for which are backed and funded by the future income streams of the underlying “collateral”.
There are a number of advantages to securitising assets. Securitisations allow a large number of similar collateral assets which individually would not have much value but when grouped together are capable of generating a significant income stream to be added to a single collateral “pool” which can form the basis of a new securitisation issue. Securitisations also allow the underlying collateral to be “repackaged” into a new form of debt, generally notes, with the character of the collateral being changed in the process. For example, the new note may be issued in a different currency from the underlying currency, or the new notes could be listed and/or rated to obtain better pricing or to make an investment in the notes more appealing to a new class of investors. Securitisations may also allow for removal of assets from the balance sheet of an organisation, thereby freeing up capital to be deployed on new projects or investments.
Once the underlying collateral pool has been identified by the originator or sponsor (which may be an investment bank, specialist investment firm or other financial institution or perhaps even a large corporate), a new special purpose vehicle (SPV) will be incorporated to act as the securitisation “issuer” vehicle. The formation of a new SPV allows the collateral assets to be transferred off the balance sheet of the originator and into an entirely separate corporate entity. In order to enable the SPV to fund the acquisition of the collateral assets, the SPV will issue interest-bearing securities (typically some form of debt note) to one or more institutional investors, typically through a US Regulation S or Rule 144 securities issuance, the proceeds of which will then be used to acquire the collateral pool. The income generated by the collateral pool will be used to pay the coupon on the new securities, and an appropriate security package will be taken over the underlying collateral by the investors (often represented by a trustee).
Securitisation SPVs are typically incorporated in an international financial centre such as the Cayman Islands or Bermuda. Given that the economics of securitisation structures operate on a pass-through basis, the use of a jurisdiction with no or very low taxation is attractive to prevent any unnecessary tax leakage during the life of the transaction. More often than not, however, offshore jurisdictions are chosen because they offer highly flexible and very cost effective corporate solutions for these types of transaction. When combined with a high level of political stability, internationally recognised and respected court systems (often based on English common law) and a large number of highly experienced professionals, this makes them very attractive options for establishing the SPV.
Why do capital call facilities make good collateral for a securitisation?
Repackaging and securitising pools of loans is hardly new – CLOs have been doing this for decades. However, the crossover of securitisation structures into the fund finance arena represents an exciting departure. CLOs themselves (especially since the birth of CLO 2.0s on the back of the global financial crisis around the start of the last decade) are generally regarded to have been structurally sound and comparatively safe investments. Yet they are, for the most part, securitisations of leveraged loans made to sub-investment grade corporates. One would imagine that, with some of the same features applied to capital call securitisations – diversification, credit enhancements and subordination of cash flows – these might prove to be equally resilient. This is particularly the case when many of the underlying LPs whose capital can be called up are likely to be well-capitalised institutional investors who are strongly motivated to meet calls owing to stringent default provisions which have now become quite standard across private fund LPAs.
The way ahead
Although there are some nuances around the securitisation of capital call facilities which are not present in other asset classes, capital call securitisations could provide an interesting option for some of the larger institutional lenders involved in the fund finance space to realise additional value from their portfolios, assist with capital requirements and free up space on balance sheets. In turn, this would allow them to further meet increasing demand from fund sponsors hungry for greater liquidity or to satisfy growing interest from institutional investors eager to take exposure to the underlying assets. It will be interesting to see how this area develops – for example, how the revolving nature of the collateral pool will be dealt with, how loan eligibility criteria may develop over time, the manner in which rating agencies will come to model the risks and how they construct their methodologies, how institutional investors will look at the product from a risk/reward perspective, the impact it may have on the underlying fund finance market itself, whether lenders’ approach to LP diligence will shift and, of course, the extent to which the product may encourage the continuing re-allocation and recycling of investor capital.
Anna-Lise Wisdom and Matthew Stocker contributed to this article.
Barnabas Finnegan is a partner at Conyers in London.
Nick Ward is a Senior Associate in the Cayman Islands Corporate practice,
