Created Date:
16 February 2024
Fund Finance

Assessing lender risk in fund finance markets 2024 (GLI chapter)

Partners Robin Smith, Alistair Russell, Jenna Willis, senior associates Holly Brown and Nick Ghazi have contributed to Global Legal Insights' Fund Finance Laws and Regulations 2024 (sixth edition) guide.

The chapter titled 'assessing lender risk in fund finance markets' includes commentary on risk analysis in an evolving market, complex fund structures market risk and conclusions.


Risk analysis in an evolving market

Despite being a relatively long-standing lending product, there have been limited public payment defaults by funds in the fund finance space.  Consequently, the market has legitimately considered this to be a safe product for lenders and encouraged more market actors to participate.  While the market has weathered, even prospered, in the face of certain challenges (from the 2008 global financial crisis to the US bank failures of March 2023), there are a new set of challenges (and opportunities) ahead.  The impact of anticipated changes to large bank capital requirements in the US is being felt, with demand exceeding supply, leading to an increased focus on innovative solutions and non-bank lenders entering and expanding their footprint in the fund finance market.  With these changes in mind, lenders of all shapes and sizes should remain alert to their possible (and changing) exposure.[i]

In 2022 and 2023, the market has seen a significant increase in the use of NAV facilities.  Market changes have also seen an increase in the use of other alternative lending structures, for example, hybrid facilities.  There has also been an increase in the number of GP facilities and loans made to single LP funds.

The market has seen global interest rates rise rapidly and although this has resulted in widening margins, which is clearly a plus for lenders, the higher cost of borrowing can depress utilisations.  In response, lenders often seek to increase commitment fees to make up for the unused portions and in a market that has less overall liquidity, ensuring that balance sheets are well used will remain important.

Given the overall market turbulence, there is an increased focus on mitigating risk and now is a good time for lenders to conduct their gap analysis and to protect against potential future risks in an evolving market.  We examine below some of the key and emerging risks that lenders should be aware of and discuss strategies to manage and mitigate these risks.

Our expertise is in advising lenders in relation to funds established in our key jurisdictions, principally the Cayman Islands, Guernsey and Jersey, although we also see activity in the British Virgin Islands and Bermuda.  The market in each of these jurisdictions is broad and we see all types of alternative asset classes.  The areas of risk that we focus on below relate to:

•      complex fund structures, primarily involving fund partnerships; and

•      market risk.

Complex fund structures

Typical structures in our jurisdictions

In Jersey and Guernsey, funds are commonly established as either corporate vehicles/corporate group structures (using companies limited by shares, protected cell companies or incorporated cell companies) or, more frequently, limited partnerships with a corporate general partner, often with an interposed GPLP between corporate general partner and the fund limited partnership (referred to as the “private equity model”, “layering”, or “stacking”).  To this basic framework is added any number of entities from a variety of jurisdictions: (i) fund asset-holding structures; (ii) carried interest and fee-sharing structures; (iii) feeder funds; and (iv) co-investment and other managed entity arrangements, each of which may guarantee and cross-collateralise lending.

In the Cayman Islands, the exempted limited partnership is the most common form of entity used to establish closed-ended funds, although funds may also be formed as exempted limited companies or limited liability companies.

In the British Virgin Islands, closed-ended funds are most commonly structured as limited partnerships.  Less common, but nevertheless possible, funds may be structured as British Virgin Islands business companies.

Feeder vehicles

Investors, for example, US investors, for ERISA purposes, will often invest in a feeder vehicle, which, in turn, invests in a master fund.

The feeder fund may present a greater degree of risk to a lender, as the lender will be a further step removed from the ultimate investors and source of funds for repayment of borrowings, and will need to rely on a chain of drawdowns (both at the master fund level and subsequently at the feeder fund level) in order for capital commitments to be paid down into the master fund borrower.  To mitigate this risk, lenders will typically seek to join the feeder vehicle as a party to the finance documents, and take security over the uncalled commitments in the feeder vehicle in addition to that of the master fund, although this is not always permitted under the relevant constitutional documents.

Where this type of security is not possible, either due to restrictions in the security regimes in certain jurisdictions or, if the constitutional documents of the feeder vehicle contain limitations as to borrowing or guaranteeing, preventing the feeder from providing direct security, then the lender may be able to take cascading security as an alternative.  Cascading security is where the feeder vehicle grants security over its uncalled commitments to the master fund and, in turn, the master fund grants security over its rights in the feeder vehicle security agreement to the lender (the terms of which would include an appropriate power of attorney and step-in rights).

Legal perspective

Capacity and authority

Complex cross-jurisdictional fund structures can present a number of capacity issues that need to be fully understood in each jurisdiction.  This is most evident where there are layered or stacked general partner or manager arrangements across jurisdictions, and it is crucial that the correct capacities are tracked through the relevant transaction documents.  In the fund documents, the power to issue drawdown notices to limited partners is almost invariably vested in the manager or general partner on behalf of the fund vehicle, but it should also be considered whether either entity holds any power or right in its own capacity.

Where the general partner delegates any of its powers relating to the calling of capital or the enforcement of the same to a manager, the security should fully reflect that chain of authority and capture both the rights of the general partner in the partnership agreement and also any such rights delegated to the manager pursuant to any management agreement.  Failure to do so may cause step-in rights to be ineffective on enforcement.

Similarly, it is surprising how often we come across bank account mandates that do not align with the structure as initially presented to the lending bank, or that do not reflect the correct chain of authority or rights in respect of the monies in the account.  In these instances, either the mandate or security agreement should be amended to ensure that the named account holder is the grantor of the account security, and that both reflect the chain of authority for each of the grantor’s capacities.

Cross-jurisdictional funds

Where a combination of jurisdictions are involved in a fund structure, there is an added level of complexity in determining the appropriate governing law for the security package, as the contractual arrangements may well be governed by a mixture of regimes.

We are often asked to advise on the most appropriate governing law for the security, particularly where the finance documents are governed by, for example, English law or New York law, and the fund vehicle is a Jersey, Guernsey or Cayman Islands entity.

In these circumstances, from a Jersey and Guernsey law perspective, we are likely to advise that specific local law security is taken over contractual arrangements that are, themselves, governed by such laws.  Usually, such structures also have a general partner or manager in Jersey or Guernsey.  An added complexity arises where there is a general partner resident in a different jurisdiction to the governing law of the limited partnership agreement.  In such case, generally, we would expect the governing law of the security over the capital call rights to follow the governing law of the limited partnership agreement, but careful analysis is required.

In contrast, in the Cayman Islands, it is not particularly common as a matter of market practice to take Cayman Islands security simply because the fund documents are governed by the laws of the Cayman Islands or if the general partner or manager is formed within the jurisdiction.

Similar issues may need to be considered in light of the situs of the collateral involved.  For example, some security regimes (such as Jersey and Guernsey) provide that security must be taken in the jurisdiction where the asset has its situs.  Therefore, where a Jersey bank account is to be secured, a Jersey security interest will need to be obtained over that account, irrespective of the existence of any foreign law security.

Again, in contrast, the Cayman Islands do not generally have any mandatory provisions of law that would require Cayman Islands security be taken over assets with their situs within the jurisdiction, and courts will generally respect and give effect to valid foreign law security.  However, it is worth noting that, notwithstanding the governing law of the security taken, there are a number of standard provisions that should invariably be included within Cayman Islands security documents that are helpful to lenders and are, in our experience, usually absent from foreign law security documents.  It is also of integral importance to ensure that, no matter what the governing law of the security itself may be, any security taken properly reflects the perfection requirements applicable to the Cayman situs property.

Overall, we would also note that there is a relatively clear difference in practice between markets; the US market would tend to use US law security over capital call rights where local law permits, whereas the European market, and in particular in the UK, will largely see taking local law security as the preferred approach even where English law security is considered sufficient under local law.  The former US-style approach is not possible in respect of security over Guernsey or Jersey law-governed capital call rights unless the security agreement complies with all local law requirements and the relevant provisions are governed by local law.  It is usually much more efficient to start with a local law document.

Contractual matrix

As noted above, a careful review of the full contractual matrix is vital in ascertaining the extent of the parties’ capacities, rights and powers.  In time-limited situations or repeat transactions, there may be pressure from parties to undertake a limited review of documents in an attempt to shorten the transaction time and lower the legal spend.  This is likely to be a false economy, as the review may identify gaps and issues that, left unchecked, could have expensive consequences.

For example, investors will regularly seek to effect changes to the terms of the partnership/constitutive documents to meet their requirements, whether by way of direct amendment to the documents themselves, or by way of side letter.  If a complete and timely review is not conducted, relevant contractual provisions may be missed or discovered too late in the process.  Indeed, what may seem a minor amendment from the perspective of an investor or a fund (such as restrictions on the power of attorney or additional procedural hurdles for the delivery of drawdown notices) could, for a lender, result in costly consequences; for example, by defeating an integral aspect of the security package or rendering it difficult or impractical to enforce the underlying commitments.

Any introduction of conditionality to an investor’s obligation to fund a drawdown may put the ability to draw the capital at risk.  If lenders require the full pack of fund documents at an earlier stage, before they are executed, and allow due time for these to be reviewed, this situation can largely be avoided.  Further, if engaged early enough during the period when the fund is negotiating its constitutive documents and/or side letters with cornerstone investors, lender counsel can often add value by suggesting minor clarifications and amendments to the drafting, which could avoid the need for future complex drafting in the facility, or worse lending terms for the fund.  There has been a notable shift in the market as both borrowers and lenders appreciate the value in this type of due diligence, as well as the potential exposure where it is not undertaken.

Technological assistance

When used in conjunction with a traditional review, technology can be a useful aid to reduce document review times and ensure there are no gaps or new contractual limitations introduced.

As technology develops, contract mapping, legal automation and smart contracts will likely become more widely adopted in legal and banking practice.  There are numerous blockchain initiatives in the banking and finance space, which shows that contracting by smart contract is increasingly seen as a credible means of contracting, for example, blockchain solutions for standardised contracts such as ISDA[ii] and discussion around the digital future for syndicated loans.[iii]

In parallel fund arrangements, there are often either prohibitions or intra-fund limits in the parallel investment agreements or co-investment agreements, making guarantees subject to either a specific limit (being the lower of a percentage of the fund commitment or the aggregate of undrawn commitments) and/or requiring they be given in accordance with the partnership proportion (often linked to the capital commitments in each fund), effectively capping the ability of each parallel fund to guarantee the liabilities of the other.  Practically, this means: (i) there will need to be amendments to the standard facility agreement drafting; and (ii) it is hard, or even impossible, for a lender to adequately monitor whether such caps have been breached, particularly as committed levels in parallel funds may shift as a result of defaulting or excused investors or due to secondary movements where the transferee prefers to be an investor in the other parallel fund.  Not only does this highlight the importance of robust information covenants within facility agreements and/or third-party security documents, but also the importance of relationships with fund administrators who will be in possession of key information, in the event that step-in rights are exercised following a default.

Feedback from industry participants[iv] indicates that the use of artificial intelligence (AI) and machine learning has been most effective in the fund administration space and less effective in connection with due diligence and deal sourcing.  Consequently:

(i)   the extent to which AI will play a significant role in, for example, negotiation of side letters and side letter reviews conducted by lenders and their legal counsel is linked to whether that technology can be developed to produce reliable data based on interpretation of more complex contractual provisions; and

(ii)   there is hope that the success of AI in the fund administration space could give lenders “live” access on a blockchain platform to account information for all accounts (even those not held with them).

Waiver of commitments

Though clearly a notably rare event, and indeed, one that many lenders would perhaps see as a diligence matter, recent cases have demonstrated that it is worth considering how to prevent or protect against the unilateral waiver or release of investor commitments by a fund, notwithstanding that it may be a breach of the finance documents to do so.

Some jurisdictions have enacted specific statutory provisions to mitigate the risk of waiver in certain circumstances by enabling lenders to enforce the original fund obligations directly against the investors.  While in the Cayman Islands this statutory protection has been introduced with respect to limited liability companies, it is not something that applies to exempted companies or exempted limited partnerships, which represent the majority of Cayman Islands funds.  Similarly, under Jersey and Guernsey law, in the absence of express statutory provisions regulating lending to fund vehicles, lenders would only have access to more practical solutions (such as notifying the investors about the granting of security to the lenders) and traditional remedies.

Market practice has developed to mitigate such risks through practical means by ensuring that borrowers give their investors notice of the security being granted as well as relevant covenants in the facility agreement, including the usual prohibitions on the general partner or manager cancelling or waiving investor commitments.  Jersey, Guernsey and Cayman Islands practice remains pragmatic and does not usually require a signed acknowledgment of the notice to be provided by each investor (although this would be preferred), but lenders are advised to request and obtain evidence of notice being given to investors.  Notice can be given: (a) in the traditional manner by hard copy; (b) by uploading the notice in investor portals; or (c) by emailing the investor.  We typically see combinations of (a), (b) and (c) being used depending on the general context, the particular lender and the make-up of the investor base.  If notice is given using method (b) alone, we advise lenders to request evidence that each investor has accessed and reviewed the notice if uploaded to an investor portal (wherever possible).

These steps are not required under statute but are practical steps to evidence that actual notice of the security has been given to investors, and may go some way to mitigate certain risks on enforcement.

Remedies: The principal remedy for balance-sheet-solvent structures is to call an event of default, accelerate the debt and enforce the transaction security.  However, for insolvent structures or where the default prompts insolvency, the remedies include:

(i)    redress under the relevant statutory framework relevant to fraud and solvency generally and, in respect of corporate entities, transactions at an undervalue and fraudulent trading;

(ii)   equitable remedies including claims against the management and dishonest assistance;

(iii)  tortious remedies including inducing a breach of contract and lawful or unlawful means of conspiracy; and

(iv)  customary law remedies in relation to fraud and, particularly, defrauding creditors.

These are explored in greater detail in respect of funds domiciled in the Cayman Islands in the article by Alistair Russell, Richard Munden and James Webb entitled:Fund finance and releases of investor commitments: How can lenders protect themselves?[v]

In Jersey, the relevant factual matrix will dictate the most appropriate course of action for the lender and clarify why the general partner or manager agreed to the waiver in the first place, but the starting point will usually be to consider what consideration (monetary or otherwise) the general partner or manager received in return for granting the waiver.

In our view, fund documents should ideally be drafted so as to provide lenders with a direct contractual right against investors preventing such a waiver, or release without lender consent.  While this may not be practicable in many cases, efforts to move the market in this direction for certain types of funds would no doubt be welcomed by lenders.  Notably, this is a right they are afforded statutorily in certain jurisdictions (for example, in the State of Delaware).

Where such a right is not granted (for instance, because the fund documents have already been executed), we would recommend that lenders ensure that the usual contractual restrictions on the fund’s ability to waive or release the commitments are clearly communicated to the investors.  This may help a lender seek a variety of remedies in the event of an unauthorised waiver, given that many such remedies will involve demonstrating a level of dishonesty or knowledge on the part of such investors.

There is also an added protection in the form of a statutory clawback in the Limited Partnerships (Jersey) Law 1994, which provides that, for a period of six months from the date of receipt, a limited partner is liable to repay (in whole or part) a payment it received representing a return of its contribution to the partnership with interest to the extent necessary to discharge a debt or obligation of the limited partnership incurred during the period that the contribution represented an asset of the limited partnership.

A waiver would probably hold if an investor would not reasonably be expected to know that it was given without lender consent or in breach of the fund’s obligations and such investor had provided consideration or altered its position in reliance on the waiver.  For these reasons, it is worthwhile that a lender seeks to protect its position in this regard.

Market risk

As lawyers, we generally leave technical market analysis to those better qualified; however, in the course of our work, certain trends do become apparent that are of note in the context of risk.  We look at four of those trends below, being:

•      competition in the market;

•      concentration risk;

•      liquidity in the market; and

•      the impact of environmental, social and governance (ESG) factors on credit risk.

Competition in the market

Prior to the US bank failures in 2023, recent years had seen an appreciable increase in the number of lenders and borrowers in the fund finance space, a fact echoed by many advisors and market participants.

In addition, subscription line facilities have historically benefitted from lower margins, which is no doubt popular with borrowers.  Although macroeconomic factors and new tighter capital adequacy rules are thought to have widened margins on subscription line facilities, the fund finance market has proved resilient in the face of these headwinds.  These same headwinds have, however, served to increase further the need to avoid unnecessary structural (or other) concerns; margins predicated on lenders rarely or never losing money require deals to be structured accordingly.  Prior to the advent of tighter capital adequacy rules and current macroeconomic impediments, there had already been a shift away from the increased pressure on lenders to accept greater levels of risk (for example, in the form of a more lenient covenant package, including hitherto “unfashionable” classes of investor within the borrowing base, or lending to funds whose managers have a shorter track record) and a move to increased scrutiny of the investor base and fund track records.  Lenders and borrowers alike should remain vigilant in ensuring that they and their counterparties are sufficiently familiar with the product and its pitfalls and are being properly advised.

The macroeconomic climate has, unsurprisingly, impacted lenders.  One notable change, as briefly mentioned below, is as a result of the “stress capital buffer” regime established by the Federal Reserve, which has required certain lenders to reduce their exposure to certain types of subscription-line financing.  This, in conjunction with the US bank failures in 2023 that resulted in the insolvency of certain lenders active in the subscription line market, has caused a comparative lack of supply in the market.

Innovation has nevertheless been prevalent, partly in response to market pressures.  NAV facilities, despite carrying higher margins than subscription line facilities, are increasingly popular, not least for their flexibility, with certain sponsors turning to NAV loans to fund portfolio asset acquisitions where leveraged finance facilities are unavailable or priced unattractively.  Separately, in 2023, Fitch Ratings finalised its rating criteria for subscription line facilities, a move that should boost supply in the market from, for example, regulated insurance companies that prefer to invest in rated debt instruments as they carry lower capital adequacy requirements.

Concentration risk

Central to any lender’s risk-management strategy will be how it approaches concentration risk and, more specifically, its exposure to specific investors, fund managers and fund sectors.  Macroeconomic factors and tighter regulatory capital requirements have resulted in greater focus on managing this risk.

In relation to investors, lenders will often encounter the same entities across multiple funds (in particular, large institutional investors such as pension funds and sovereign wealth funds).  Over-exposure to such an investor will increase the risk that its default on its commitments will translate into a lender ultimately being out of pocket.

European Banking Authority Guidelines[vi] address, among other things, the aggregation of bank exposures, and in particular, exposures to a group of connected clients.[vii]  The guidelines aim to help lenders identify all relevant connections among their clients, and specifically, two types of interconnection: (i) control relationships; and (ii) economic dependencies that lead to two or more customers being regarded as a single risk (subject to certain exceptions).

A control relationship is deemed or likely to exist where, for example, an entity appears in the consolidated financial statements of a structure or holds, with respect to another entity, a majority of the voting rights, the right to appoint or remove management, or the right to otherwise exercise a dominant influence.[viii]

An economic dependency is deemed to exist where the financial difficulties or failure of an entity would be likely to lead to funding or repayment difficulties for another.  For example: (i) where the source of funds to repay the loans of two or more borrowers is the same and there is no independent source of income to service the loans (for example, parallel funds with the same borrowing base); or (ii) where there are common investors or managers that do not meet the criteria of the control test (for example, there are common shareholders but no controlling shareholder, or they are managed on a unified basis).

Notwithstanding the foregoing, in the context of many fund structures, a lender may often be able to demonstrate an exception to the need for aggregation.  In particular, this may be the case where the lender can show that:

(i)    there is no economic interdependence;[ix]

(ii)   the entity is bankruptcy remote – this will normally be the case for funds that are limited partnerships, as there should be no commingling of partnership and general partner assets (even where the general partner is general partner of multiple partnerships), as the general partner will only have access to its own assets on a bankruptcy of the general partner and not partnership assets (save in relation to partner liabilities owed to the general partner such as for fees); and/or

(iii)  there is structural de-linkage of the obligations of an entity from its parent.

Nevertheless, lenders are advised to exercise caution in relying on an exception because, in practice, in the case of affiliated funds or funds under common management, they are more likely to be “connected” and will be affected by the success and reputation of the other funds and their managers, irrespective of ring-fencing of assets.

To that end, it is essential that lenders assess fund functionaries’ credentials whether they are managers, sponsors, or administrators.  For experienced lenders active in the fund finance market, existing relationships with fund functionaries will enable lenders to have visibility on a given manager’s track record and performance.  Funds promoted by high-quality and established sponsors with a track record would be expected to be lower risk.  However, for more recent entrants to the market, relevant information will be less readily available.  It is therefore important for lenders to understand both the expertise and experience of the functionaries’ key people in terms of portfolio management, investment criteria, business plan and financial model.

At the investor level, the most active lenders will generally hold significant information in relation to the investors and their participation in calls made by funds with which such lenders have an existing relationship.  The more informed the lender when assessing whether to include or exclude an investor from a fund’s borrowing base, the more reliable the borrowing base should arguably be.  Many institutional investors are themselves subject to various reporting standards, including in relation to the provision of financial and other key investor and stakeholder information.  Further, there is a wealth of publicly available information in relation to many pension funds and sovereign wealth funds including their financial accounts, their executive managers, their organisational structure and details as to their investment portfolio.  In addition, lenders that act as account bank to fund entities can also leverage their overview of account activity.

There is a range of sophistication in the financial modelling carried out by lenders and the monitoring thereof.  Newer entrants to the fund finance sector may not have the same resources available to them, and this can lead to different conclusions being drawn by such lenders in relation to the inclusion of investors in borrowing bases, which can be apparent on syndicated or club transactions.

Conducting a thorough review of all the investor side letters and expanding the covenant package in the facility agreement to include: (i) covenants relating to concentration risk; and/or (ii) concentration limits in the borrowing base provisions relating to the calculation of the borrowing base, will assist lenders in managing concentration exposures.

As above, with the increased use of automation, AI and data science in the financial services industry and more widely, lenders are becoming increasingly aware of the value of the data they hold in the course of, and for the purposes of, carrying out their business and understanding the dynamic between behavioural science and risk.  By deploying new technology such as blockchain or other distributed ledger technology, innovation, and data analytics, lenders can use the data that they hold to build a clearer picture of market activity and, in turn, to determine and anticipate risks.  The most obvious form of technology that could be used in this context is AI, which can be applied to conduct due diligence on funds, sponsors, and investors and keep up to date with sector trends and risks, valuations of fund assets, portfolio companies and net asset values (NAVs).

A lender’s success will be intrinsically linked to successfully identifying the parties to which it should extend financing.  Lessons can be learnt from the tech giants in modelling and manipulating data to establish trends and map the behaviour of key market players, noting the confines of ensuring that this is done for proper purposes in accordance with the prevailing data protection regimes.

In a syndicated loan context, the more efficiently data is shared among the syndicate, the quicker the syndicate will be able to react to situations such as requests to increase facilities and amend terms.  The developments in the syndicated market space, and Loan Market Association (LMA) initiatives to explore technology and automation, should mean that in the future, a common syntax is applied to syndicated lending, and a common standard can be applied that will improve the customer experience.

Liquidity risk

Liquidity is a perennial risk attached to lending and lenders will be familiar with the challenges this presents post-financial crisis, in the wake of the Basel III Framework and the introduction of liquidity ratios.

The revised regulatory landscape post-financial crisis required banking institutions to increase their capital and liquidity buffers, to help alleviate certain liquidity pressures and equip lenders to tolerate greater stress in financial markets, such as the continuing economic fallout of COVID-19, Brexit, the war in Ukraine and rising inflation and interest rates.

However, recent equity market volatility, liquidity tightening, widening funding spreads, operational fails, and other challenges have put significant pressure on the financial markets.  We are aware that certain bank lenders have taken steps to strengthen their liquidity and reporting capabilities and, in some cases, to monitor them more frequently.  There is also the introduction of new capital rules by the Federal Reserve that will force certain US lenders to hold more capital relative to their “risk-weighted assets”.[x]

Generally, lenders may take a number of steps to manage exposure, including: (i) stress-testing the loan book; (ii) monitoring for concentrations of investors, functionaries and sectors as outlined above; (iii) considering the profile of investors with higher potential for exposure (including in terms of jurisdiction of domicile, ticket size, track record of making payments following drawdown requests, likelihood of themselves being a levered fund) and other reputational matters, noting that if a borrower is at the later stages of the fund cycle or the fund is fully committed, the lender may be less sensitive to the inclusion of such investors and borrowing base requirements may be relaxed accordingly; and (iv) considering whether there are any mismatches between the level and frequency of fund distributions made to investors and the level and frequency of capital calls made by the fund.

In terms of NAV and hybrid facilities, there is an additional liquidity risk to lenders, where assets provided as collateral for the facilities are overvalued or lose value and become insufficient to meet the borrower’s obligations under the facility.  Inability of lenders to challenge valuations could also play a role here.

Facility information covenants, requiring borrowers to obtain robust and frequent asset valuations or requiring notification of any significant change in NAV, would assist the lender to monitor downstream valuations, in addition to the typical loan-to-value covenants and other financial covenants within facility documents.

ESG risks

ESG risks have been recognised as credit risks in their own right as early as late 2019 (if not earlier).[xi]  Most lenders have adopted explicit ESG policies, and an increasing number of institutions have an ESG-dedicated resource in their credit risk teams.  Lenders are therefore both increasingly aware of the risks and actively managing these risks as part of their usual assessments of credit risks.  This should serve them well as the legal and regulatory framework increasingly moves to requiring more rigorous reporting standards in line with various taxonomies and local law requirements.  As reporting standards and regulations continue to develop, we are likely to see ESG provisions given more prominence in the substantive fund constitutive documents, rather than left as an optional extra for investors to request in their side letters.  As a result, more fund managers and lenders alike will need to ensure that a fund’s performance is monitored against the ESG key performance indicators (KPIs).

A backdrop of high interest rates has seen a more cautious approach from some lenders concerned about regulatory risk, in particular after the US Securities and Exchange Commission fined BNY Mellon’s investment adviser division for “greenwashing”.[xii]  This caution has also led potential borrowers of ESG-linked loans to switch away to conventional loans.[xiii]  The publication of the Financial Conduct Authority’s (FCA) policy statement on “Sustainability Disclosure Requirements (SDR) and investment labels” on 28 November 2023 demonstrates the direction of travel.  It introduces a new “anti-greenwashing” rule that will apply to all FCA-authorised firms from 21 May 2024 and requires all claims made about the sustainability characteristics of a product or service to be clear, fair and not misleading.  The policy statement also introduces four investment labels to help investors navigate the market (and the criteria that must be met in order to use an investment label), and new rules and guidance for firms marketing investment funds on the basis of their sustainability characteristics.  While the majority of the rules apply to products offered to retail investors, the pre-contractual, ongoing product-level and entity-level disclosure requirements in Chapter 8 apply to products offered to retail and institutional investors.  The direction of travel is therefore towards greater integrity in the ESG market, based on a regulatory framework that requires transparent sustainability standards that allow investors to assess whether investment opportunities are genuinely orientated towards sustainability.

The ability of lenders to access, analyse and rely on the integrity of information will be central to their ability to navigate what is a complex and changing landscape.  Of the risks noted above, many of these may be managed and mitigated by real-time access to information (e.g. by way of blockchain or otherwise), as it adds colour to the facts, which are borne out through the financials, and facilitates better-quality decision-making by the lender.  Further, regulatory rules that require borrowers to report sustainability information such as the EU’s Corporate Sustainability Reporting Directive should enable lenders to calculate more effectively their own sustainability metrics.

There are also other steps that lenders can introduce now to maximise the information they receive, such as placing the burden on fund functionaries to store, maintain and share management information, financial information and investor lists on systems that can be readily accessed such as private web portals or a private blockchain, for the lender to freely access.  This would increase transparency, as such information could be made available in real time to lenders and assist in easing the burden of monitoring the performance of the loan.


This chapter has shown that, despite having a reputation as a low-risk product, the fund finance sphere is not without risk, but rather is a low-risk product due to the effective management of the risks present.  In managing the current and evolving risks, we highlight the importance of engaging lender counsel at an early stage, both to conduct full diligence on the structure and to manage the documentation risk.

As the fund finance market continues to evolve, lenders will need to remain alert to the risks associated with lending in the market, notwithstanding the continued low default rate.  In particular, the rapidly evolving macroeconomic picture may require the re-balancing of lending books or new approaches to risk migration.


* * *


The authors would like to thank Holly Brown for her valuable contribution to this chapter.

Holly is a senior associate in Carey Olsen’s Jersey corporate team.  She assists with a range of corporate, banking and finance matters.

Holly is an advocate of the Royal Court of Jersey.  She was educated at King’s College London.  Holly joined Carey Olsen in 2013.

Tel: +44 1534 822 231 / Email: [email protected]


[i] This is in addition to the complexity and cross-jurisdictional dimensions of many fund structures, the size of the financial transactions and, in some cases, relatively slim margins.

[ii] ISDA has issued a number of whitepapers and academic papers in relation to the broader legal and regulatory aspects of distributed ledger and smart contracts technology.  See: [accessed on 5 November 2023].

[iii] Clifford Chance (2021) “The digital future of syndicated loans 2021” available at: [accessed on 5 November 2023].

[iv] Insights Survey 2024: Seven key findings, available at:

[v] Russell, A, Munden, R and Webb, J (2019) “Fund finance and releases of investor commitments: How can lenders protect themselves?” [online] available at: [accessed on 5 November 2023].

[vi] Committee of European Banking Supervisors (CEBS) (2018) “Final Report, Guidelines on institutions’ stress testing” CEBS [online] available at: [accessed on 5 November 2023].

[vii] As defined in Article 4(39) of Regulation (EU) No 575/2013.

[viii] Although these criteria are non-exhaustive, and other aspects may be relevant.

[ix] For completeness, there should also not be a material positive correlation between the credit quality of the parent and subsidiary entities in a control relationship; however, this should not apply to fund structures either.

[x] See: [accessed on 5 November 2023].

[xi] See: [accessed on 5 November 2023].

[xii] See: [accessed on 5 November 2023].

[xiii] See: [accessed on 5 November 2023].

Please note that this briefing is intended to provide a very general overview of the matters to which it relates. It is not intended as legal advice and should not be relied on as such. © Carey Olsen 2023