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Executive Summary
It has become increasingly common for private equity funds to
accept capital commitments in multiple currencies within the same
fund (or group of parallel funds), but having capital commitments
denominated in multiple currencies included in a subscription
credit facility (“Facility”) borrowing base creates
unique structural issues related to foreign exchange risk. In this
Legal Update, we provide an overview of how lenders can mitigate
these potential risks.
Background
When Facility obligations and the underlying borrowing
base/collateral are denominated in the same currency, there is no
risk that fluctuations in currency exchange rates could create a
shortfall between the uncalled capital commitments and the Facility
obligations. However, when loans are advanced in one currency (such
as US dollars), but the obligations are secured by uncalled capital
commitments denominated in another currency (such as euros),
Facility lenders face foreign currency exchange rate
(“FX”) risk. If the exchange rate has fluctuated
unfavorably when it comes time for repayment and a capital call is
made on the investors, the uncalled capital commitments securing
repayment of the Facility obligations may be insufficient even
though the uncalled capital commitments are fully called and
funded.
The fund finance market has generally addressed this concern by
requiring foreign currency borrowings to be measured against the
borrowing base on a US dollar-equivalent basis, including on
regular revaluation dates, and to maintain an FX reserve that
further reduces the borrowing base to protect against
intra-revaluation date movements.
Although the standard market approach addresses FX borrowings, some
lenders have struggled with how to address the FX risk when a
private equity fund’s capital commitments are denominated in
multiple currencies. In these situations, FX fluctuations may
benefit or harm the Facility lenders depending on the constantly
changing ratio of capital commitments and outstanding Facility
obligations in each relevant currency and on the exchange rates
between these currencies.
What Lenders Need to Know About How to Mitigate Foreign
Currency Exchange Rate Risks
This FX risk can be mitigated in a few different ways.
Excluding Investors
The most straightforward approach from a documentation
standpoint is to simply exclude investors with capital commitments
denominated in an alternative currency from the borrowing base, but
that approach may be too restrictive on the borrowing base in many
cases. Accordingly, this approach is usually used when the
alternative currency capital commitments would already be excluded
from the borrowing base or the additional borrowing base benefit
received is not needed or not worth the complexity of using a more
nuanced approach.
Applying a Haircut
An alternative approach used by many lenders is to simply apply
a haircut to the alternative currency capital commitments via an FX
haircut (much like the traditional FX reserve used for borrowings).
While this approach provides borrowing base credit and is
relatively straightforward from a documentation perspective, it can
also be overly limiting as the FX reserve and the FX haircut will
result in double counting. For example, in a US dollar-denominated
facility that has both US dollar and euro borrowings and capital
commitments, the borrowing base would be reduced for the FX reserve
associated with the euro borrowings (which is based off the premise
that the collateral is all denominated entirely in US dollars) and
would be further reduced by the FX haircut for the euro capital
commitments.
Cross-Netting
To address the double counting concerns associated with applying
an FX haircut, in certain circumstances facilities are structured
via a cross-netting approach. Under this approach, the borrowing
base reduction factors in that FX risk for borrowings is offset by
capital commitments in the same currency. There are a few
variations on how the cross-netting formula works. Most of these
variations address how the cross-netting takes into account
applicable advance rates and concentration limits, such as whether
the formula is currency specific and whether it is based on the
aggregate effective advance rate or determined on an
investor-by-investor basis applying the specific advance rate and
concentration limits with respect to each investor. While the
cross-netting approach can be useful, the calculations and
reporting requirements associated with it are more burdensome than
other approaches. For this reason, the cross-netting approach is
usually only used when there is an expectation that there will be
significant amounts of both alternative currency capital
commitments and borrowings in that currency.
Going Forward
As more private equity funds are open to accepting alternative
currency capital commitments, lenders should be well versed on ways
to address the FX risk without being overly punitive. The approach
chosen, however, should reflect the operational realities and needs
of the specific private equity fund(s) considering the complexity
of addressing the issue can result in the need for more operational
resources and increased compliance risk.
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This
Mayer Brown article provides information and comments on legal
issues and developments of interest. The foregoing is not a
comprehensive treatment of the subject matter covered and is not
intended to provide legal advice. Readers should seek specific
legal advice before taking any action with respect to the matters
discussed herein.
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