VC Vs PE: Comparing The Venture Capital And Private Equity Fund Financing Markets – Corporate and Company Law

Overview

Market trends in the fund finance space have been well
documented over the years. Following the collapse of Dubai-based
Abraaj in 2019 and the JES Global Capital fraud in 2021, lenders
have bolstered their diligence and compliance processes to ensure
that their collateral in the historically safe subscription
facility product – the rights to capital contributions from
investors – is well vetted and secure. More recently, (i)
pricing for capital call facilities has trended up in line with
interest rate hikes by the Federal Reserve, (ii) banks are
re-evaluating their portfolios in response to market conditions,
internal depository requirements and regulatory mandates, (iii) new
lenders continue to enter the market, (iv) alternative lenders are
edging into the market as well, particularly looking for the higher
returns associated with asset-backed leverage, including net asset
value (“NAV”) facilities backed by a fund’s
underlying investments, and (v) demand for debt facilities from
general partners (“GPs”) and their principals, to fund
GP commitments or for personal capital, continues to be on the
rise. As trends in the fund financing market continue to evolve, it
is also important to consider key differences in how private equity
funds and venture capital funds use the variety of available
financing products. This chapter explores some of those differences
and analyzes the benefits and challenges from both the fund and
lender perspectives.

Fund-level financings

At the fund level, capital call facilities or subscription
credit facilities are a standard product used by both private
equity and venture capital funds primarily as a bridge loan to
receipt of capital contributions. There is a huge competitive
advantage for a fund in having a capital call facility, because it
can boost its internal rate of return by borrowing and investing
prior to an investor having to part with any cash or make its
investment. The benefits for a private equity fund can be
significant, given that there is sometimes no requirement to repay
borrowings within a specified time frame in the underlying fund
documentation, or any such requirement can be fairly lengthy
(usually, up to 12 months, since that time frame helps mitigate
risks of generating unrelated business income tax for certain
taxexempt investors). This allows the private equity fund to
generate returns for an extended period of time before an investor
pays a dime of its investment. Venture capital funds, however,
frequently rely on an exemption to the U.S. Investment Advisers Act
of 1940 (the “Advisers Act”), which significantly
limits this benefit. The Advisers Act, which requires investment
advisers to register with the Securities and Exchange Commission,
provides for exemptions, including a venture capital exemption. The
analysis of the venture capital exemption can be complex, but one
prong of the analysis requires that a venture capital fund
does not borrow or incur leverage in excess of 15% of the
fund’s aggregate capital commitments and any such borrowing
is for a “non-renewable term of no longer than 120 calendar
days.” Thus, some of the instinctive benefits frequently
touted as relevant metrics for funds using subscription facilities
are less relevant for venture capital funds, and may not be a
significant part of the value proposition for the fund in using a
subscription facility. That being said, subscription facilities
remain attractive to venture capital funds for other reasons, such
as the administrative convenience of making multiple investments
and paying expenses without troubling investors with multiple
capital calls.

Relatedly, a useful feature of most fund-level credit facilities
is the ability of the fund to add holding company or portfolio
company entities as borrowers on the facility, backed by a secured
guarantee from the fund. This feature usually labels the holding
company or portfolio company borrower as a “qualified
borrower,” which is generally subject to limited covenants
given that the lender’s source of repayment is the underlying
commitments from the fund investors and not the assets of the
qualified borrower itself (although the scope of
covenants/representations applicable to qualified borrowers is
often a point of negotiation between the lender and fund). While
the qualified borrower feature has gained substantial traction in
the private equity market, where funds frequently add holding
companies or operating companies that have had difficulty getting
third-party financing on attractive terms, the feature is rarely
used in the venture capital market. Venture capital funds usually
only take minority positions (i.e., less than 50% ownership) in
emerging companies, and qualified borrowers are often required to
be wholly owned subsidiaries of the applicable fund for the lender
to provide financing to the entity on the subscription facility.
For this reason, the trend of adding qualified borrowers on capital
call credit facilities appears to be limited to private equity
financings.

Another development in subscription facilities is that lenders
are more frequently requesting investor letters for anchor
investors (usually, investors with capital commitments in the
25–35% range). Investor letters add another layer of comfort
for lenders with respect to their ability to obtain capital
contributions from investors upon a forced capital call. Such
investor letter requirements seem to affect both private equity and
venture capital funds in a similar vein. Whether investor letters
become a sticking point in negotiations depends primarily on the
investor make-up and/or any underlying concerns with the
partnership agreement/side letters not sufficiently protecting the
lender’s interests. Either type of fund may have a narrowly
concentrated investor base where the request for an investor letter
may come into play. However, funds should equip their partnership
agreements with (arguably) standardized lender protections (e.g.,
express authority of the fund to enter into subscription facilities
and the GP’s right to pledge capital commitments and the
right to call capital, waiver of investor defenses, lender
exclusion from the no-third-party beneficiary clause, etc.) to best
position themselves in a negotiation to limit or waive investor
letters. Funds may also benefit from having their draft partnership
agreement borrowing language reviewed by potential lenders prior to
execution to help streamline the financing process, and limit, to
the extent possible, the likelihood of requiring separate investor
letters.

GP-level financings

An investment fund’s GP may need to access liquidity for
purposes of supporting its own commitment to the related fund.
These facilities often take the form of a term loan credit facility
amortizing over time, to align with the fund’s investment
period. A GP facility will almost always also involve a pledge of
collateral from the GP, which can range from an “all
assets” pledge to the economic (not management) rights in the
related fund. Creative approaches to financing the GP position for
large sponsors can involve notes offering and securitization
structures. Large private equity sponsors often have easier access
to these types of structures, and GP financing generally, because
of their established track records and deep relationships with
lenders. Venture capital firms, in contrast, may be looking to fund
individual founder positions, and therefore generally confront more
challenges in finding lenders that are comfortable with the GP
collateral and/or are willing to accommodate a structure that does
not fit easily into their credit underwriting regime. Despite some
reluctance, however, lenders to venture capital funds may
accommodate GP financings despite credit concerns in order to
strengthen ties with established clients or as an investment in new
client relationships. Thus, in the venture capital space, a
GP-level financing may bear similarities to an LP-level financing
(discussed further below). GP financings can raise a number of key
issues relating to the collateral, including that a pledge of
collateral needs to be narrow so as not to conflict with any pledge
by the GP to a subscription line lender, and the scope of
collateral vis-à-vis the GP’s interest in a particular
fund needs to account for any conflicts in those fund-level limited
partnership agreements. Both GPs and lenders should take heed of
such collateral issues and address them in the loan documentation
early on to obviate unintended consequences and costs down the
line. Another common feature of GP-level financings is financial
covenants, either loan-to-value or liquidity requirements. Similar
to limited partner (“LP”) financings, GP financings can
sometimes require firm guarantees from the fund’s management
company, and/or personal guarantees from individual members of the
GP. Whether these features are included in GP financings in a
private equity or venture capital context can depend on the overall
strength of the firm and practical considerations in terms of
near-term future facilities with the particular proposed
lender.

Management line of credit

Management companies can also play an important role in a
fund’s overall financing structure, and lenders frequently
provide liquidity options to assist management companies, primarily
for working capital to help a management company manage payments
for expenses between the receipt of management fees from the funds.
Occasionally, management company lines are also used to warehouse
investments prior to an anticipated fundraise, but in the ordinary
course, these facilities are meant to assist a firm with
“keeping the lights on” in between fee payments. Strong
sponsor borrowers often have management facilities that are
unsecured, with just financial covenants relating to assets under
management or the amount of expected management fees received. For
newer or less established fund managers (and generally, in the
current economic environment), these management facilities will be
secured by all assets of the management company, including the
rights to management fees and any related bank accounts. Diligence
for management company facilities requires review of any management
company agreements, investment advisory agreements and the
partnership agreements of the relevant funds to ensure that a
pledge of the rights thereunder is permitted, and to determine
potential offsets that may reduce anticipated management
fees.¹ Complications may arise if the management company
and GP are the same entity, which occurs more frequently in the
Asia market. In this circumstance, an all-asset lien over the
management company/GP would conflict with subscription facilities
under which the manger/GP has pledged its right to call capital
from fund investors. Differences in the use of management company
facilities in the venture capital and private equity space are
minimal, as the primary driver of terms is ultimately the size of
the sponsor (venture capital or private equity), whether it
has an established track record and how comfortable the lender is
with the relevant fee streams. The less comfortable a lender is,
the more likely it will be to look for additional credit support,
including by way of guarantees from the founders of the particular
firm at issue.

LP financings

In both private equity and venture capital funds, the LPs in the
fund frequently seek various forms of third-party financing to help
the LPs of the fund or GP to fund their capital commitments. The
most typical form of these is usually a partner loan program, where
the fund manager will arrange for a loan program for certain
affiliated LPs with a bank lender. The bank offers loans directly
to the LPs, and the management firm assists by providing regular
information to the bank, and, occasionally guaranteeing the
individual partner borrowings (allowing the partners to secure
advantageous pricing with minimal ongoing obligations). The
collateral for an individual borrower’s loan is usually its
individual LP interest in the particular fund, which the fund
acknowledges as part of the loan documentation and initial set-up.
The individual borrower’s loan may also be secured solely by
the management fees of the management company in the case of
partner programs that are linked to a management company facility.
A potential drawback to this type of facility when utilized by
partners of the GP, however, is the possible tax ramifications. A
partner’s capital interest in the GP that is funded with the
proceeds of a loan made or guaranteed, directly or indirectly, by
the underlying partnership, a partner or any related person may be
treated as carried interest, and would therefore be ineligible for
the capital interest exception set forth in Section 1061 of the
Internal Revenue Code. This means that any allocation to a partner
that is attributable to a contribution funded by such loan would be
subject to the longer, three-year holding period applicable to
carried interest rather than the one-year holding period that would
apply if the allocation were subject to the 1061 exception and
treated as capital interest. Care should be taken to ensure that
the financing of a partner’s capital commitment to the GP is
structured in a manner that considers any negative tax consequences
that may result if the facility is made or guaranteed by a
fund-related party (e.g., in some cases, if the partner of the GP
is “personally liable” for the loan, these adverse
rules may not apply). While these programs are popular, they can be
burdensome on a new manager, and if they are not otherwise
available, LPs will occasionally enter into bespoke negotiations
with a private bank to fund their positions. These loans can be
used either for general liquidity (in an attempt to monetize their
otherwise illiquid fund interests) or to allow for funding of
capital commitments. LP financings of this type often involve
negotiations between the LP and the fund or GP itself, in order to
address any transfer restrictions set forth in the related fund
limited partnership agreement. Because the collateral for these
financings is by its nature illiquid, advance rates against the LP
interest collateral can be quite low and lenders may require
additional financial covenants and minimum cash liquidity amounts
for their borrowers.

There are other debt financing options available to LPs based on
their fund positions. LPs sometimes obtain loans from the
applicable GP or management company for the related fund. These can
be easier to obtain since the affiliated entity is familiar with
the collateral (i.e., the LP’s interest in the fund) and has
a deep understanding of the valuation of the interest. That said,
in the venture capital space in particular, there are frequently
limitations in the fund documents about loans among affiliated
parties where conflicts of interest or other disclosure issues may
be in play. Some of these restrictions may pertain in the private
equity market as well, and it is important to check the underlying
fund documents and to consider any tax implications from any
related party loans when pursuing these transactions.

Another financing option for LPs that seems to be gaining more
traction lately with thirdparty financiers is restructuring an LP
investment to allow a preferred equity provider to provide
liquidity to the LP. The preferred equity would then receive
distributions from the fund until a negotiated hurdle rate is
achieved. This arrangement provides some of the benefits of both
debt and equity treatment.

LP borrowers in both the venture capital and private equity
spaces continue to look into creative ways to monetize the value of
their portfolios by relying on banks and non-bank lenders to
provide liquidity solutions. In doing so, fund LPs are acting
similarly to the investment funds themselves, looking to lever
their portfolio company assets in pursuing a NAV or other
asset-based facility.

Understanding the different objectives, limitations and credit
underwriting considerations of private equity and venture capital
funds and appreciating perspectives on both sides of the
negotiating table will help counsel negotiate meaningful terms that
are relevant for their clients, and thought should be given to
these considerations at every level of the fund structure.

Footnote

1. Notably, notwithstanding any anti-assignment
provisions in the applicable management agreement, terms that
restrict assignment of payment obligations (i.e., management fees)
are unenforceable under Section 9-406 of the Uniform Commercial
Code.

Originally published by GLI – Fund Finance 2023,
Seventh Edition

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