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...