Over the last ten years, there has been a steady trend transition from defined benefit plans to defined contribution plans. As further evidence of this trend, as recently as the end of the fourth quarter of 2013, defined contribution plan (“DC”) assets amounted to $5.9 trillion, compared to just $3.0 trillion in assets for private-sector defined benefit (“DB”) plans.1 At the same time, DC plan fiduciaries are seeking to achieve the historically higher returns of DB plans by venturing into alternative investments (real estate, private equity and hedge funds). In the face of the large amounts of capital now being funded to DC plans and the desire by DC plan fiduciaries to improve returns, fund sponsors have been actively courting such DC plans and establishing investment vehicles tailored to the needs of such DC plans (such investment vehicles are referred to herein generally as “DC Funds”).
Access to a line of credit offers a number of benefits to both DC plan fiduciaries and DC Fund sponsors. A credit facility can help DC plan fiduciaries and DC Funds manage the daily liquidity required by DC plan participants and fiduciaries, as well as provide bridge capital to fund DC Fund investments. While alternative investments (real estate, private equity and hedge funds) are typically illiquid, the higher rates of return offered by such investments may offset the risks to DC plans and fiduciaries caused by such illiquidity, particularly when a credit facility can mitigate much of the illiquidity concerns.
This Legal Update provides background on a number of issues for DC Fund sponsors and for lenders (each, a “Lender”) in connection with a credit facility to a DC Fund (such credit facilities referred to herein generally as “Facilities”). It also proposes structural solutions for certain of those issues.
Facility Size and Uses
Compared to credit facilities provided to typical private equity funds or private equity real estate funds, Facilities for DC Funds tend to be rather small in relation to the total size of the DC Fund. While Facilities may vary, they are often 10-20% of the total DC Fund size. While there is potential for Facilities to grow in size relative to DC Fund size as Lenders get more comfortable lending to DC Funds and DC Funds continue to find new ways to take advantage of the liquidity provided by a Facility, limitations on collateral (discussed below) and the DC Fund’s need for liquidity may prevent such Facilities from reaching the relative size of credit facilities traditionally sought by other types of private equity funds or real estate funds.