Carry On Investing in Debt

Exploring alternatives to default hedge fund structures

Originally published in the December 2012/January 2013 issue

Hedge funds have amassed a reported €40 billion to invest in European distressed debt (source: Bloomberg). Some firms have assumed existing structures – implemented for more traditional hedge fund strategies – are equally appropriate for distressed debt activities, but that assumption is not necessarily correct.

In key structuring areas – including the choice of fund vehicle and the delivery of performance rewards – the default hedge fund structure may not always be the most appropriate choice. The traditional UK-managed hedge fund structure has been driven by a number of commercial and tax considerations, among the most significant of which are:

1. The highly liquid/short-term nature of investments.

2. A fund vehicle that gives investors the ability to come in and out of the fund throughout its life (such investor redemptions facilitated by the fact that, per point 1 above, fund investments can often be readily monetised).

3. The fact that the fund’s activities may constitute trading (for UK tax purposes) and therefore require the benefit of the investment manager exemption (IME) to avoid direct exposure to UK tax on its profit.

4. In order to meet the terms of the IME, the UK manager needs to receive customary remuneration for its services. In practice, this has meant a management and performance fee paid to the manager (taxed as income at headline rates of up to 52% where that management vehicle is an LLP) based on movements in NAV.

When determining structure, a hedge fund investing in distressed debt should ask itself how many of these statements still apply and are commercially suitable to its investment strategy as well as investor expectations of this asset class. Key challenges to using the traditional hedge fund structure for investing in distressed debt are as follows:

1. A degree of illiquidity is inevitable in distressed debt given that liquidity issues drive the need for capital in this market. Of course, everybody would prefer liquidity, but funds may have to move to more illiquid assets to attract the desired returns because that is where there is less capital. This liquidity issue may be apparent enough to investors for them to appreciate the need for different commercial terms/structure.

2. If assets are illiquid (or at least more illiquid than historic investments) is unrestricted investor redemption appropriate?

3. Is investing in distressed debt really trading? This should certainly not be assumed (and in our experience in many instances the conclusion has been that a distressed debt fund is investing). As ever with the investing/trading question it will depend upon a firm’s particular strategy, its methods of selecting investments and its realisation profiles. A fund must come to a conclusion based on the specific facts and not typecast its activity either way.

It must also be appreciated that there is an enormous variety of activity within this asset class which will affect this analysis. Firms that have amassed money for distressed-debt funds have a broad universe that they can invest in, including high-yield debt, leveraged loans, mortgage-backed securities, real-estate assets and in some cases loan-to-own strategies.

Take a simplistic example of a debt investor buying the bonds of a distressed company at 25 cents on the dollar, hoping to double his investment or even get full face value if the company is restructured effectively. Clearly this investment strategy is quite different from that of an archetypal bond ‘investor’ such as a pension fund that holds bonds seeking steady income over time. Instead, the distressed debt investor is looking for a gain in a bond’s price or anticipated redemption amount. But this does not necessarily mean that he is trading.

This analysis leads to another centrally important question as regards tax structure: if the fund is not trading then the IME is irrelevant. Its purpose is to provide guidance on when a UK manager will and will not constitute a permanent establishment of an offshore trading fund. If the fund is not trading, the IME has no application.

4. If the IME is not required, then there are numerous structuring possibilities available in respect of the performance reward. If a fund is realising investment returns (say capital gains on debt), the performance incentive could be delivered as a capital return (maximum 28% rate currently) if it can be delivered as a share of that fund profit. There are, however,numerous tax issues that need to be addressed when considering such possibilities, principally the deep discounted bond, offshore fund and accrued income scheme rules – all of which can impose income tax over capital gains treatment.

Two of the most important structuring considerations thrown up by the issues outlined above are how the performance element is delivered and what fund vehicle/structure might be offered to investors.

How to structure the performance element
The important point to note here is that once a fund is liberated from the confines of the IME, there are numerous structuring possibilities available. For some of our clients, it has been suitable to use fund structures more aligned to those seen in private equity. In short, this involves delivering the performance incentive as a share of fund profits, payable on asset realisations. The aim here is to take advantage of the fact that the fund is realising capital profits to deliver a performance incentive taxed as capital. With some leading private equity firms already operating in this market, it was inevitable that a convergence in the assets of hedge and private equity funds would lead to a convergence in structuring. Absent compelling commercial reasons, why would a hedge fund manager investing in similar assets on a similar basis as a private equity competitor pay 52% income tax and NICs on his performance incentive when his private equity neighbour takes it home as capital?

But as many readers will know, private equity funds are typically structured with a limited partnership, tax-transparent fund vehicle whose performance incentive is delivered on asset realisations. This obviously differs from the typical hedge fund NAV-based fee arrangement. For some hedge funds, the more illiquid nature of distressed debt investments may give them justification for moving from this structure but such a change in terms may be unsuitable or undesirable in certain cases. Investors may still want a vehicle that they come in and out of at periodic intervals throughout its life. Managers may not want to wait until asset realisations to see their performance element. In these cases, Ernst & Young has been working with mangers to deliver an equity-based return, deliverable by reference to annual NAV increases within a typical corporate fund structure.

Hybrid fund structures
Recently, we have seen instances where a ‘hybrid’ private equity/hedge fund structure is attractive. This may be the case where funds pursue an illiquid distressed debt strategy alongside more traditional highly liquid hedge fund investments. The idea here is to create a “best of both worlds” solution -– a corporate structure for liquid investments that replicates the typical hedge fund features, i.e., a vehicle investors can come in and out of; yearly NAV-based fees; and the benefit of the IME. Alongside a partnership tax-transparent structure for illiquid investments is a realisation-based performance element that delivers capital gains treatment for recipients. These two, seemingly contrary investment strategies can be combined in a relatively simply master-feeder type structure as illustrated below.

The key structure points here are as follows:

• Investors hold interest in two feeders, one a partnership, the other a corporate vehicle.
• The fund vehicle is a partnership (Fund LP) comprising two classes of partnership interest: one linked to the liquid investments, the other to illiquid investments.
• The LP feeder delivers returns on illiquid investments and secures capital gains tax treatment for investors but offers no or limited liquidity.
• The corporate feeder delivers returns on liquid investments and offers regular redemption rights.

In conclusion, the typical hedge fund structure may be sub-optimal from both an investor and management perspective for distressed debt investments. In each case, hedge funds would be well advised to approach their structuring discussions on the basis of a rigorous review of their specific activities and investor requirements, rather than beginning this process with structural assumptions which are based on different investment strategies and asset classes.

Darrin Henderson leads Ernst & Young’s Financial Services Office Private Equity Funds Team and has led the delivery of tax advice on a number of global private equity, infrastructure and debt fund launches and transactions. Thomas Lloyd-Jones is a senior manager in Ernst & Young’s Financial Services Office Private Equity Funds Team. He is an associate of the Chartered Institute of Taxation and has over seven years’ experience of advising on the tax structuring of investment funds.