In subscription line (capital call) facilities, lenders rely on the uncalled capital commitments of a fund’s investors as their primary collateral. As a result, the enforceability, scope and reliability of those commitments are central to the lender’s credit analysis. In certain circumstances, investor letters can play an important role in mitigating risk and strengthening enforceability.
Where used properly and effectively, investor letters can:
- help alleviate credit risks associated with lending against a single or small pool of investor(s)
- provide additional comfort and clarity with respect to an investor and its capital commitment in a fund, and
- enhance the enforceability of a lender’s rights to call capital in an enforcement scenario.
This briefing covers a number of legal, commercial, and practical points for lenders and sponsors when considering the provision of investor letters in capital call facilities.
For the purposes of this content, reference to a “fund” means an investment fund established as an exempted limited partnership under Cayman Islands law and reference to a “limited partner” or an “investor” means a reference to a limited partner in such fund.
The due diligence process
With the collateral used in subscription line financing being “upward” looking (that is, over the uncalled capital commitments in a fund), the due diligence process on the fund and its investors is a critical part of the transaction. This is especially true when the fund has a concentrated pool of investors or is a separately managed account (SMA), as this inherently exposes the lender to heightened concentration risks.
From a lawyer’s perspective, the documentation involved in the due diligence process can be broadly divided into three categories: constitutional documents, fund documents and investor documents.
Constitutional documents
When we refer to constitutional documents, we mean the statutory documents necessary for the fund to be validly formed and in existence. Under Cayman law, these are the:
- certificate of registration
- registration statement (and any amendments thereto)
- limited partnership agreement (LPA), and
- constitutional documents of the fund’s general partner (which will vary depending on the type of entity acting as general partner of the fund).
Of these items, the LPA will be the most closely analysed document, as it sets out the contract between the fund and its investors (as well as many of the operative provisions relating to the fund and the capital call process). The LPA will also typically include any restrictions or limitations on the fund’s ability to incur indebtedness under a subscription line facility (and any other forms of leverage and/or indebtedness).
Fund documents
In terms of fund documents, these would cover items such as the following:
- investment management agreement
- administration agreement, and
- offering documentation.
Investor documents
As for the investor documents, the main items here will be the subscription agreement and any side letters. In both cases, it is important to consider these documents alongside the LPA, as this will establish an investor’s obligations to pay capital calls and, in respect of any side letters, any specific terms which have been agreed directly between the fund and an investor which might deviate from the terms set out in the LPA.
For further information on the LPA and side letter review process, see our earlier briefing: Capital call facilities – LPA and side letter review
What are investor letters and why are they useful?
So where do investor letters fit into all of this? Generally speaking, an investor letter is a letter addressed to a lender (or a facility/security agent) which is issued by an investor. The fund in question is often a party to the letter to acknowledge the terms therein.
In terms of what might be included in an investor letter, this can range from a simple acknowledgement by the investor that a fund’s rights to call undrawn capital has been secured in favour of the lender, to a comprehensive letter agreement that supplements the provisions of the LPA and pursuant to which an investor gives a variety of representations and undertakings in favour of the lender.
In each case, the investor letter creates a direct contractual relationship between the lender and the investor that the lender may not otherwise have (where no such document is in place). It is recommended that the governing law of the investor letter should generally be the same as that of the LPA.
How can investor letters support lenders?
There are various drivers for a lender wanting to have an investor letter. In some cases, it is simply a requirement for credit approval in deals involving SMAs or funds with concentrated investor pools. Even where a fund has a diversified pool of investors, there may be reasons why a lender requires an investor letter, such as:
- supplementing provisions in the LPA: if there is any ambiguity in the LPA which might affect the subscription line financing, an investor letter can provide clarity as well as directly enforceable obligations against the investor(s)
- overriding provisions in side letters: if a side letter is in place and contains provisions which might adversely affect the lender’s ability to enforce its capital call rights, an investor letter could be used to override or waive such provisions
- where an investor is a sovereign entity: an investor letter can be used to mitigate any legal uncertainties in a scenario where the investor might be able to seek sovereign immunity
- enhancing enforceability of payment of capital calls: by creating a direct contractual relationship between the investor and the lender, an investor letter which includes undertakings and confirmations with respect to capital call rights can streamline a lender’s enforcement rights
- fraud mitigation and supplementing due diligence: similar to the above, creating a direct relationship between the investor and the lender can provide the lender with added comfort in terms of validating an investor’s status, existence, knowledge of the facility and quantum of undrawn capital commitments (where such representations or confirmations are included in an investor letter).
In the same way that the finance documents will include ongoing obligations and representations of the fund and monitoring of the same by the lender, where an investor letter has been put in place, there will need to be some ongoing monitoring of compliance with the obligations set out therein. Typically, it will form part of the fund’s undertakings to ensure that the fund does nothing contrary to the terms of the investor letter. We would also expect that non-compliance with the provisions of the investor letter would constitute an event of default (subject to the relevant provisions in the finance documents).
Key takeaways for lenders and sponsors
In the current climate of increased use of SMAs/concentrated funds, challenging fundraising conditions, and the generally accepted use of capital call facilities, many investors are likely to appreciate that investor letters are “part of the process” when investing in such funds.
Investor letters can also boost transparency between a fund and its investors since sponsors will need to be up-front with their investors when seeking to put subscription line financing in place. Provided that lenders are clear from the outset about their requirements for investor letters, a sponsor can typically approach their investor(s) in a constructive and collaborative manner.
As is commonly the case, the devil is in the details. A properly constructed investor letter should enhance the credit-worthiness of a deal, but it is not a substitute for proper diligence on the fund, the sponsor and the investor(s). Where a lender is working with a fund structure that inherently exposes it to greater concentration risks, it should not come as a surprise to the fund, the sponsor or the investor(s) that the lender will seek to mitigate these risks through the use of investor letters.
Ross Wilding is counsel at Ogier and advises on a wide range of banking and finance matters, providing Cayman Islands law advice.
