March 2021

Only a few decades old, subscription finance has evolved into a mature market benefiting banks, limited partners and fund sponsors alike.  The biggest factor behind subscription finance’s maturation, and the benefits to everyone in the industry, has been the safety and soundness of the credit and collateral.  That factor is no longer indomitable, as the subscription finance market comes to grips with the first widely reported loss incurred by a subscription credit facility provider to a general partner (“GP”) located in the United States, which is alleged to have forged investor subscription agreements.  Even though subscription finance no longer benefits from its gilded status as a credit product with no loss history, Fund Finance Partners is defending the product’s integrity and universal application by developing due diligence enhancements and loss mitigation solutions in response to this recent, negative outcome.

Subscription credit facilities have become the rule, rather than the exception, for fund sponsors seeking portfolio and capital optimization of their funds.  Limited partners (“LPs”) and SMA holders nearly universally accept (and expect) their commitments to benefit from these facilities and their impact on returns, capital allocation budgeting and portfolio diversification.  There are now dozens of banks leading bilateral and syndicated subscription and capital call lines of credit for all types of funds.    Banks extend subscription and capital call lines of credit following rigorous due diligence into the creditworthiness of a borrower-fund’s underlying investors, legal due diligence in respect of the LPs’ obligation to fund their respective capital calls, as well as the right of the GP to pledge that indefeasible right to the lender.  Reputable fund sponsors must be able to procure efficient, low-cost subscription financing.  Any impediment to doing so is detrimental to financial institutions, institutional and individual investors and fund sponsors.  Rather than publishing a post-mortem explaining what went wrong, Fund Finance Partners supports a forum in which all interested subscription finance constituents can discuss changes preventing similar outcomes in the future.

Much of the market’s discussion regarding this loss has centered on the relative impacts to banks and fund sponsors, respectively.  Meanwhile, LPs await their consideration in respect of this important issue.  Increased borrowing costs, notwithstanding the potential to make subscription facilities impossible to procure for some funds, are two highly undesirable outcomes for LPs.  Perhaps more importantly, most Limited Partnership Agreements require LPs to fund their capital commitments without setoff, counterclaim, setoff or deduction – an obligation that the GP may pledge to the bank to enforce.  Since a legitimate LP’s capital commitment can be called and applied to mitigate the impact of a subscription line secured by a fraudulent commitment, LPs stand to gain the most by reducing this type of fraud risk moving forward.

Since the disclosure of this loss, FFP has been in contact with numerous banks active in the subscription finance market and the unsurprising consensus is that additional diligence is needed.  Fraud is one of the most difficult risks to mitigate; however, a few obvious actions can do just that.  Subscription facility lenders can and should be more scrutinizing of fund sponsors with which they don’t have a pre-existing relationship, but that won’t remedy the underlying concern.  It’s time we acknowledge the proverbial elephant in the room: actual diligence into the validity of the underlying investor subscription agreements is essential to maintaining the product’s viability.

For most sponsors, fundraising is already challenging enough.  The regulatory basis for most fund sponsors’ compliance programs’ requirements in connection with accepting capital commitments (e.g., OFAC, AML, KYC, etc.) can be burdensome and tedious.  Further, when accepting commitments from certain legacy investors, the dispensation of the fund sponsor’s investor due diligence is sometimes under-emphasized (or neglected entirely).  Whether validating known anchor investors or peeling back entity-owners to determine ultimate beneficial ownership, there needs to be a balance that recognizes the primacy of the LP/GP relationship while also addressing subscription lenders’ legitimate concerns.

It’s one thing for a subscription lender to simply rely on the fund sponsor’s representations that subscription agreements are in fact valid.  It’s another, entirely, for a subscription lender to inquire as to the validity of such commitments directly to the investor.  Neither path is an ideal resolution to the need for enhanced transparency into the accuracy and legitimacy of the LP subscriptions.  Similarly, legal opinions aren’t a panacea, as they don’t address investor commitment verification.  Many of FFP’s fund sponsor clients would reject banks directly contacting their investors to ask whether their capital commitments were in fact made by them. Absent specialized fund-of-one situations, lenders have been reluctant to ask GPs for direct contact with LPs out of fears of disrupting the fundraising process (now or in the future) and opening themselves up to lender liability claims stemming from such disruptions.

Verification by a third party with asset management credibility of the existence and validity of investor commitments is the best way to address this key diligence need.  Based upon discussions with a variety of banks, relevant law firms and GPs with whom we’re in contact, we believe that subscription finance providers will begin to seek such expert verification, especially in connection with new lending relationships.  This begs the question:  if not the bank, then who?  To protect the breadth and availability of subscription finance to all worthy fund-borrowers, and the benefits of optimal subscription financing for LPs, FFP is working on solutions to reassure lenders, while minimizing the potential intrusion into the GP/LP relationship.

After two decades of unprecedented growth, words like “routine” and “commoditized” were creeping into the fund finance lexicon.  For all but the most established and preeminent fund sponsors, it will be years – if ever – before that market will warrant either of those adjectives.  We look forward to continued dialogue with all constituents, including our fund sponsor clients, placement agents, insurance providers, LPs, banks and attorneys, to achieve a thoughtful compromise that protects the market we’ve all worked so hard to create.  We all have a role in finding a solution, and FFP is committed to doing its part.