§ 12.04 Traditional Credit Facilities

• Jurisdiction: United States
• Publication year: 2022

§ 12.04 Traditional Credit Facilities

[1]—Structure

The structure of a traditional credit facility for a hedge fund is as varied as the different strategies that funds pursue. Hedge funds vary remarkably, employing strategies ranging from global macro, directional, event-driven, relative value (arbitrage) to managed futures.⁷¹ These differences in strategy will affect the assets and liabilities on the balance sheet of a fund. A fund that is heavily invested in marginable equity securities will probably not have much need for a traditional credit facility, because its prime broker will provide the necessary financing. In contrast, a fund that invests in distressed debt may have assets that a bank or other lender can readily lend against. In short, the nature of a credit facility for a fund depends heavily on the fund's business and on the reason for the financing. Sometimes, a fund will use a credit facility to leverage its returns. Other funds will use a credit facility as a way to finance redemptions by investors. A credit facility to a fund's management company could be used to finance day-to-day operations or capital expenditures.

[2]—Amount Available

The amount of credit available under a credit facility typically depends on the assets comprising the "borrowing base." The borrowing base is the value assigned to a specified set of the fund's assets.⁷² The lender and the fund must agree on what assets will comprise "eligible assets" for purposes of the borrowing base and how such eligible assets will be valued. The lender then applies a "haircut" to the value of the eligible assets, to determine the maximum credit the lender will extend at any time. The applicable haircut will vary based upon the nature of the assets. Sometimes, the amount of credit may also be based on a percentage of assets under management or other collateral available to secure the loans.

[3]—Credit Agreement Provisions

A fund will have concerns about provisions in a credit agreement that might not receive the same attention in transactions with operating companies. A lender may view the fund as a special purpose entity, since the only source of repayment is the pool of assets owned by the fund. As a result, certain key issues often arise:

• Net Asset Valuation and Verification. How does the fund value its assets? What oversight exists with respect to the valuation of such assets?
• Concentration and Diversity Requirements. Lenders are concerned about a fund electing to place a big bet on a single asset. Often, a lender will set concentration limits for particular classes of assets, and the portion of an asset that exceeds the concentration limit will be excluded from the borrowing base.

• Right of Fund to Redeem Holders of Equity. One selling point of a hedge fund to its investors may be the ability of an investor to redeem capital. Funds typically impose restrictions on the right of redemption. These may include side pockets, gates, lock-ups and redemption suspensions.⁷³ It is standard operating procedure, however, for dividends and other similar distributions to be significantly restricted in a customary credit agreement. Lenders do not want equity holders to be able to exit before the debt; the equity is the subordinated capital that cushions the debt. Lenders will often be concerned that redemptions may cause a liquidation of the most liquid assets of the fund, leaving less desirable collateral, or otherwise adversely affect the stability of the fund. In contrast, the fund will want to provide its investors with the liquidity that they expect and will not want to impose greater restrictions on redemption than those

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