Credit Crunch

A silver lining to the credit crunch

Originally published in the May 2008 issue

Whilst the credit crunch presents a bleak picture for many, there could be a silver lining for those who can harness long term funding and take advantage of the continuing decrease in the trading price of debt securities in the market.

Debt securities come in many different shapes and sizes and may be issued by a variety of different issuers for a multitude of purposes. In basic terms, however, most debt securities represent an obligation by the issuer of the security to make periodic interest payments during the term of the security and to pay the face value of the security on its maturity date. Much has been made of the losses on debt securities linked to the US sub-prime market, however, the number of issuers who have actually defaulted on their payment obligations across the debt market as a whole is surprisingly small.

Debt securities in the long term

Notwithstanding the relatively small default rate, an investment in debt securities is now a ‘no-go’ area for many investors. Banks who have historically been some of the biggest investors in this market are now much less able to access cheap finance to fund this type of investment and in any case will struggle to keep their own stakeholders happy where the perception is likely to be that further investment in this sector would be disastrous. Other investors including the open ended funds industry with large portfolios of debt securities have struggled with the lack of liquidity in the market and the knock on effect on NAV. This is all on top of the IFRS mark to market valuation headache for many whocurrently hold debt securities.

There may be some, however, particularly the managers of credit funds and those who can tap into long term funding who may take the opportunity to make the most of the falling prices of debt securities. For those who can make a relatively long term investment and hold to maturity (in this market one will need to contemplate holding for three to five years) the success of an investment in debt securities should not be blighted by their current market value or their perceived market value but will instead be dependant on the ability of the issuer of the relevant securities to pay back the debt represented by those securities. This is not to say that investments will be without risk, but in a buy-to-hold model, investors will be making an assessment of risk based upon the dynamics of individual issuers and their securities rather than on a blunt assessment of the credit market as a whole.

Credit fund managers who can capture long term investment capital are well placed to take advantage of the glut of cheap debt securities in the market. Credit funds have historically been established using both open-ended and closed-ended vehicles and have often depended upon leverage to magnify the tight margins available from trading in the credit sector. Funds which may be established to take advantage of the current market conditions are likely to be quite different and more simplistic in their approach. A plain vanilla closed ended single class corporate vehicle aimed at the professional and sophisticated end of the market should be sufficient for the purpose

“Much has been made of the losses on debt securities linked to the US sub-prime market”

There are a variety of different jurisdictions to choose from when establishing a credit fund, although, ease of establishment and expertise in the area are likely to be important elements in the decision making process. Offshore jurisdictions like Jersey and Cayman with strong existing connections with the debt capital markets and fund industries are likely to want to take the lead.

Jersey, which is already home to a number of existing credit funds, has recently added an unregulated fund option which will greatly enhance its ability to attract funds of this type. The new regime allows the setting up of funds in Jersey without advance approval from the Jersey regulator and without ongoing regulation provided that the new unregulated funds fall within a structure permitted under the new regime and that notification of the setting up of the funds is given to the Registrar of Companies in Jersey. The new regime introduces two new categories of unregulated funds – Unregulated Eligible Investor Funds and Unregulated Exchange Traded Funds.

New funds set up as Unregulated Eligible Investor Funds can be open or closed ended and are aimed at institutional and sophisticated investors including those who make a minimum initial investment of US$1 million or other currency equivalent. To some degree self policing takes the place of regulation and investors who fall within the eligibility criteria set out under the new regime must be given a prescribed investor warning before investing. Where an investment manager invests on behalf of an underlying non-eligible investor the manager must make a declaration that he is satisfied that the investment is suitable for the underlying investor and that the underlying investor is able to bear the economic consequences of the investment including the possibility of its entire loss.

New funds set up as Unregulated Exchange Traded Funds must be closed ended and their units may be listed only on one or more of 50 pre-approved stock exchanges including LSE, AIM, New York, the Channel Islands Stock Exchange, NASDAQ and Euronext. The prospectus of an Unregulated Exchange Traded Fund must contain a prominent warning that the fund is not regulated in Jersey and that the Jersey regulator has not evaluated or approved the fund arrangements, parties orprospectus. The only other administrative requirement is that once notice of the establishment of the fund is given to the Registrar of Companies in Jersey, the fund must be listed within 90 days of that date unless an extension is expressly agreed with the Jersey authorities. Unregulated funds have no limit on the number of investors and no investment or borrowing restrictions. Promoters can choose the type of fund vehicle from a Jersey company, a Jersey limited partnership of which at least one general partner is a Jersey company or a unit trust where at least one of the trustees or managers is a Jersey company.

Jersey is by no means the only jurisdiction which may offer credit funds a suitable home, although it is hoped that the benefits of the new unregulated funds framework and the reputational and time zone benefits of the Channel Islands will be an attractive option for European fund managers and promoters when establishing these funds.


John Ventress

John Ventress is a partner of leading legal and fiduciary services provider Bedell Group. He heads the team of lawyers providing specialist Jersey legal advice from the Bedell Cristin office in the heart of London. Ventress is also a director of Bedell Trust UK Limited, the UK resident corporate services provider. Ventress joined Bedell Group from leading City law firm SJ Berwin and specialises in capital markets, investment funds and structured finance work.