Over the last 18 months significant capital has been raised, outside of the retail market, for what can broadly be described as ‘debt funds’. This description, while a convenient shorthand, conceals a great variety of products. An investor seeking exposure to this asset class can choose from an array of sponsors to access direct lending, leveraged loans and high-yield bonds, mezzanine debt, distressed debt, as well as numerous real estate and infrastructure strategies. From a structuring perspective, the result of this diversity is that there is no single fund design that can be utilised across the range of debt products. A number of different models have emerged, each tailored to the particular requirements and investment strategy of the relevant fund. This, in our view, means that fund design has perhaps a greater role to play in developing a structure that is attractive to investors than in other asset classes where there is a dominant structure well known to, and accepted by, the market. The aim of this article is to highlight some of the key issues that asset managers will need to consider when determining fund design for a debt product and to look at how they have been addressed in recent fund launches.
Factors driving structure
In a number of respects, the structuring aims for a debt product are no different than for other securities funds. It will need to (amongst other requirements):
However, debt products do present some structuring challenges that seem to be bespoke to this asset class. Among the most important of these are:
1. The liquidity of the investment asset.
2. The nature of the investment return (yield versus capital appreciation or both).
3. The importance of offshore investment platform structuring.
4. The UK tax status of the fund’s activity.
These points are examined in further detail below.
Liquidity of investment assets
Like most alternative products, a debt fund will need to be aware of any liquidity mismatch in its offering (i.e., that the liquidity terms of the investment product differ substantially from the liquidity of the underlying assets).
However, it may be the case that there is less clarity amongst institutional investors as to the degree of liquidity of a particular debt investment, as compared to other asset classes with which they may have more experience and/or familiarity. Accordingly, asset managers may need to spend more time communicating to investors why a given fund strategy justifies limited or no redemption if the underlying assets are illiquid.
Where a fund is investing in illiquid assets that are held for the long or medium term, longer lock-up fund structures have tended to be more suitable. One commonly used structure is the closed-ended GP/LP model that has its origins in private equity (see Fig.1). This structure has been utilised in recent years by:
Senior debt and high-yield bond funds have taken a different approach to investor liquidity. Recently, funds have gone to market with a corporate vehicle offering liquidity primarily through means of a listing (see Fig.2). Some funds have supplemented this with a restricted internal liquidity facility that offers investors the right to redeem part of their holding if the fund trades beyond a prescribed discount to NAV. The intent, it seems, is to reassure investors about the valuation vagaries that can arise if liquidity is dependent on capital markets.
Another approach that has been adopted is to utilise ‘evergreen’ fund structures to try to meet investor liquidity demand. Certain infrastructure and real estate income products that do not wish to list their fund vehicle have offered investors a ‘best endeavours’ policy towards redemptions. Investors may request redemption at set times during a year with advance notice of at least, say, six months given to the sponsor. The fund will then undertake to finance redemptions out of its investment returns or other pre-identified sources, but will not be required to realise assets in order to do so. If insufficient returns are realised in the normal course of business, investors will have to stay put.
Some fund managers in more illiquid environments (such as private equity) have sought to solve the liquidity barrier by introducing secondary funds as investors at the outset. Their participation is on the basis that they will be obliged to redeem investors that wish to exit at a predetermined price. This reduces the due diligence costs and time-lag that would result on a normal secondary transaction and allows a fund to market an internal redemption facility. It remains to be seen whether debt funds investing in equally illiquid assets will consider such a strategy.
The nature of the investment return
Many debt funds’ returns will encompass both yield and potentially capital gains (for instance if secondary debt is acquired at a discount or mezzanine loans carry warrants or other equity kickers). However, one form of return will often predominate and be marketed to investors on that basis. The structure of the product will need to illustrate the chosen investment strategy and help position the product clearly in investors’ minds. Take, for instance, secure income products, currently popular with institutional investors seeking alternative forms of inflation-linked income. We have seen in practice that investors interested in this type of product often have a preference for participating via a debt instrument (i.e., a bond or loan note) rather than equity (say a preference share), even if it delivers an identical economic return. This may sometimes be an allocation issue, but often investors have a psychological preference for holding a debt instrument when what they are looking for is a stable yield. For them, a bond or loan note offering more readily signifies that this is a yield-delivering product. Of course, for some secure income funds, it may be too simplistic to reduce the investment to a straightforward bond holding. Funds may look to actively manage and turn over the yield-producing portfolio and want to build in a mechanism for delivering capital gains in the return profile. This can often be accommodated within both a debt and equity interest with appropriate drafting of the relevant instruments.
The nature of the investment strategy and return is also driving significant variety around manager terms, particularly the performance incentive. Whilst loan origination, mezzanine and some secondary loan funds have utilised carried interest-type structures (varying in range between 12-20%), recent senior debt and high-yield bond funds that wish to position their funds as offering a lower risk strategy have gone to market with a very low or zero performance incentive. Other funds have charged their performance incentive as a percentage of capital deployed (not profits realised), with payment being triggered only upon the safe return of investor monies. For an asset manager seeking to demonstrate the security and stability of his investment strategy, tying the incentive to the safeguarding of investor capital has clear marketing advantages.
Investment platform structuring
As a large component of the return for many debt funds will take the form of interest, mitigating the instance of local withholding taxes will be particularly important. The challenge here is to ensure the structure can cater for a potential high volume of investment assets, via differing legal forms (loans, bonds, warrants, etc.) across numerous jurisdictions. There is inevitably going to be the need for a holding structure that can invest tax efficiently on a pan-jurisdiction basis, but which is also administratively workable.
The issues that drive structure in this area are primarily tax-related. In short, they relate to the beneficial ownership status and corporate residence of offshore investment platforms that are used to acquire or make debt investments. The concern is to ensure (as far as possible) that such platforms are staffed, operated and funded in a manner that means tax authorities will respect their ability to utilise double taxation treaties. These issues are well known and have been the subject of much analysis by advisors, but additional thought may now be required in light of the OECD’s recent publications on the use of offshore entities to minimise global taxation exposure. Increasingly, where asset managers have multiple investment funds, they have found both operational synergies and a more robust tax position in implementing a ‘house-wide’ investment platform that has responsibility for financing and monitoring investments on a fund-wide basis.
The trading/investing distinction for debt strategies has, generally speaking, been the subject of less analysis than, say, private equity. Accordingly, investors tend to be less certain of their position in this context. In principle, a bona fide investment strategy that takes as its subject matter debt securities should not be in a substantially worse position on this point than an investment strategy that targets equities or real estate. Having said this, there are specific issues that need to be addressed in a debt context, particularly where loan origination (as occurs in direct lending or mezzanine strategies) is present. There has been a historic concern that loan origination may be regarded as trading on the grounds that it is essentially surrogate banking activity and should be taxed, as banks are, as trading profit.
The risk trading status brings is that if an offshore debt fund is managed from the UK, a proportion of its profits may be subject to UK corporation tax (on the grounds that the fund is trading in the UK via a permanent establishment). Although UK corporation tax will soon fall to 20%, this is a tax drag that efficiently structured funds cannot afford to suffer. Our recent experience suggests that H.M. Revenue & Customs may be moving away from a view that origination is trading, but nevertheless careful analysis of how to manage this risk is still required. It may still be the case that reliance on the UK’s Investment Manager Exemption is necessary or desirable if there is material uncertainty as to whether a given strategy will amount to trading for UK tax purposes.
The structuring considerations for many debt products are often more diverse and less homogenised than for other asset classes. The best structures will need to do more than merely accommodate investor requirements; they will hopefully assist a sponsor in distinguishing its product in what is an increasingly competitive environment.