§ 12.05 Fund-of-Funds Credit Facilities

• Jurisdiction: United States
• Publication year: 2022

§ 12.05 Fund-of-Funds Credit Facilities

[1]—Overview

A fund of funds (a "FOF") is an investment fund that invests in equity interests of other investment funds, rather than in securities, loans or other instruments that have been issued directly by an operating company or holding company.⁷⁵ The assets of a FOF typically consist of only interests in other portfolio investment funds and any cash and cash equivalents on hand for operational purposes. The liquidity of a FOF is limited to the capital it may withdraw from its investments and any cash and cash equivalents on hand for operational purposes. The only significant collateral supporting a credit facility to a FOF will be the equity that the FOF holds in its "portfolio investment funds" and the deposit accounts into which its cash is deposited. The loan proceeds under a FOF facility can be used to acquire fund assets (i.e., interests in underlying hedge funds) or to cover redemption requests received from the investors in a FOF. Some FOFs maintain credit facilities that are rarely drawn down. Others draw on them more regularly to finance investments, redemptions and as an operating tool to limit the amount of cash needed to have "on-hand" at any given time.

When parallel U.S. and Cayman fund of funds exist, two separate facilities are often implemented at the same time. The documents may be almost identical, although some limited contractual and procedural differences may exist to accommodate foreign law considerations.

[2]—Advance Rates and Eligibility Determination

Lending formulas for FOF facilities vary. However, almost all of the lending formulas are tied to values of the underlying investments and, as such, function as a variant of a typical borrowing base. Advances are generally tied to the maximum commitment amount, with lesser amounts made available based on formulas intended to limit the aggregate amount of the loans to a percentage of the actual collateral values. In other words, lenders may commit to lend up to a specified amount, but such commitment amount will be subject to the existence of assets with an aggregate discounted value not exceeding the outstanding credit exposure.

For example, such maximum loan amount might be the lesser of: (1) the maximum commitment amount of the facility, and (2) the product of the aggregate collateral value (market value of all investments owned by the borrower that are subject to a perfected, first priority security interest in favor of the lender) and the maximum risk ratio (a formula set at the lesser of (x) a percentage (often 15-40%) and (y) one minus a complex haircut formula). These formulas may address aggregate redemption fee, asset class and manager concentration limitations and the types of assets held by the underlying portfolio funds (diversification). Haircut formulas are often lengthy and are customized to the fund's strategy. Borrowers test the haircut formulas in advance of closing by applying the proposed formulas to hypothetical portfolios of funds, to assess how the formulas will affect borrowing availability. While typically the borrower can borrow within the applicable formula up to the maximum principal amount allowed under the FOF facility, mandatory prepayment requirements will apply if the value of the assets of a FOF declines over time.

Maturity dates vary. Certain lenders have institutional preferences for shorter facilities with the intention that they be "re-upped" annually or every two years, while some prefer, for a variety of reasons, facilities with longer maturities.

[3]—Collateral, Perfection and Certain Operational Issues

A FOF usually secures its loans by granting a security interest in all assets, through the execution and delivery of a security agreement.⁷⁶ Perfection of a lender's security interest may be accomplished through the filing of a UCC financing statement.⁷⁷ Although the security interest covers all assets, the principal focus of the lender will be the portfolio investment funds of a FOF. These investments may be held directly by the borrower or through securities accounts. Inherent in this specialized form of lending is the risk involved in realizing upon the collateral. In a foreclosure, the lender will want to redeem the underlying fund interests. To do this, the lender will need to comply with the process applicable to any other investor that wishes to withdraw capital from a portfolio investment fund. This typically requires the lender to give a notice of withdrawal (in respect of the interest of the FOF) to the general partner of each portfolio investment fund at least some specified number of days prior to the end of a calendar quarter (assuming such fund allows withdrawal at the end of a calendar quarter) and using the proceeds to repay the outstanding...