United States: HNW Feeder Funds: Considerations In Connection With A Subscription Credit Facility

EXECUTIVE SUMMARY

High net worth feeder funds ("HNW Feeder Funds") have emerged as a strategic resource for private equity funds seeking additional sources of capital. The HNW Feeder Fund structure often involves a partnership between private equity funds and financial institutions or private wealth managers (collectively, "PWMs"). This collaboration leverages the existing relationships PWMs have with high-net-worth individuals, creating a collective investment vehicle for fund participation. In this Legal Update, we delve into the dynamics of HNW Feeder Funds and considerations related to implementing a subscription credit facility for a fund structure utilizing such feeders.

BACKGROUND

Most private equity funds impose a minimum capital commitment (e.g., $5 million) for individual investors. High-net-worth individuals (including their estates or related family offices, collectively, "HNW Investors"), typically defined as individuals possessing over $1 million in available capital, may face challenges meeting this commitment for a single investment and/or prefer to diversify their portfolio by investing in several assets. Similar to traditional feeder funds where investors are pooled into an investment vehicle to facilitate an investment in a master fund that will ultimately hold the portfolio investments, HNW Feeder Funds pool capital commitments from HNW Investors, exceeding the minimum capital commitment required for fund investment. This facilitates collective investment opportunities with sponsors.

HNW INVESTORS IN SUBSCRIPTION CREDIT FACILITIES

Historically, HNW Investors' involvement in subscription credit facilities has been restricted due to several factors:

• Borrowing Base. Traditional borrowing bases favor institutional investors with readily available credit data, often leaving HNW Investors excluded due to a lack of comparable reference points.
• Know-Your-Customer ("KYC"). The KYC process, requiring detailed investor information, conflicts with HNW Investors' preference for anonymity, posing administrative challenges for lenders.
• Predictability. Lenders will structure a borrowing base in part based on the likelihood that each Investor will honor its capital contribution when called. Predicting the likelihood of HNW Investors meeting capital calls is inherently complex and often difficult given the nature of individuals managing their investments, making structuring borrowing bases challenging.

HNW FEEDER FUNDS IN SUBSCRIPTION CREDIT FACILITIES

When incorporating HNW Feeder Funds into subscription credit facilities, sponsors and lenders should consider specific characteristics:

• Borrowing Base. A reduced advance rate for HNW Feeder Funds, reflecting the less certain financial profile of HNW Investors, can be implemented. For example, while a rated institutional investor may receive a 90% advance rate, a HNW Feeder Fund may collectively receive a 50% advance rate.
• KYC. Leveraging well-established sponsors of HNW Feeder Funds can streamline the KYC process by enabling Lenders to rely on the KYC diligence performed by the HNW Feeder Fund, ensuring compliance with regulatory requirements while protecting investors' privacy. Instead of completing KYC on the underlying HNW Investors, the subline lender conducts detailed diligence on the sponsor's KYC procedures.
• Predictability. Diversification of HNW Feeder Fund investors mitigates the risk of individual HNW Investors failing to fund capital calls.
• Overcalls and Default Remedies. HNW Feeder Funds' overcall rights on individual HNW Investors within the HNW Feeder Fund, PWM intervention via capital contributions on behalf of HNW Investors, and provisions for defaulting HNW Investors in the fund documents help ensure compliance with capital calls.
• Exclusion Events for Defaulting Partners. Structuring HNW Feeder Funds and subscription credit facilities to exclude individual defaulting HNW Investors within the HNW Feeder Fund enhances risk management. Lenders usually also exclude the entire HNW Feeder Fund's commitment if a certain threshold of its HNW Investors default to guard against systemic risk with the HNW Feeder Fund's sponsor.

TAKEAWAYS FOR LENDERS AND SPONSORS

HNW Feeder Funds present valuable opportunities for private equity funds to access additional capital. Lenders and sponsors considering inclusion of HNW Feeder Funds in subscription credit facilities should collaborate with legal counsel to navigate structural and documentation nuances effectively. Understanding the intricacies of HNW Feeder Funds can unlock potential benefits for all parties involved.