Invisible costs for international investors investing in US private debt could be eroding returns by as much as five percent, according to a report by investment consultancy bfinance.
Historically, high taxes have put off many Asian and European institutions from investing in US debt. However, recent developments in fund structures have attempted to make US funds more appealing internationally. Nevertheless, bfinance has warned that a number of visible and hidden costs cause leakage on returns.
The structures that have been used in recent years include treaty structures, tax-blockers, BDCs, “season and sell” and Irish collective asset management vehicles (ICAVs). Bfinance said that although these structures could all help to reduce tax leakage, they often led to increased leakage elsewhere, and some structures carried non-fee expenses as high as 160 basis points.
There can be other costs that are not so easy to identify. “Other costs are more subtle, especially where they do not come in the form of visible expenses,” the report stated. “The most long-established and historically popular model, ‘season and sell’, can often generate significantly lower net returns for offshore investors than their onshore counterparts.
“Some other models, which have been gaining traction during the last two years, involve greater parity between investors at home and abroad but bring other costs and challenges.”
Season and sell works by having onshore entities hold a loan for 30 to 90 days. They are then able to pass on a portion of that loan to an offshore vehicle without being subject to tax on effectively collected income. It has been one of the most popular structures for offshore investors in US private debt, but there are a number of ways that leakage can occur through it and erode investor returns.
Firstly, the delay incurred by the seasoning window means investors receive weaker returns on each deal as loans are transferred at fair market value. Offshore entities also typically receive origination fees for arranging the loans, often amounting to 1-2 percent of the value. Lastly, bfinance said there were miscellaneous fees that could be applied to these structures and which vary substantially between vehicles. These can include legal, audit and operational expenses, and can range from 5bps to 35bps.
BDCs have become an increasingly popular way for international investors to gain exposure to US private debt, bfinance said, because they function like normal equity stakes and pay interest-related dividends that are subject to special provisions under US tax law
However, BDCs are not completely tax-free, and fee-related income and dividends that are not based on loan interest are both subject to tax. The structures also have high administrative fees and other costs and lack a conventional LP/GP structure, which can put off many investors.
A third structure, the ICAV, is still relatively new, having been launched in 2015. However, bfinance said it had become increasingly popular in the latest private debt fund launches. The vehicle aims to address some of the problems of both season and sell and BDC structures.
The ICAV is treated as a corporation for US federal tax purposes, and loans originated in the US can be placed into the Irish-domiciled vehicle from day one without incurring taxes.
However, the ICAV’s tax exemption is based on at least half of the capital invested in the fund coming from US investors, and this could prove to be a vulnerability as secondary trading in private debt increases. Secondary sales some years down the line could change the composition and cause the structure to be subject to withholding taxes. The rules also mean the funds are limited in how much can be raised from non-US investors in order to maintain this ratio.
Bfinance concludes: “Investors should scrutinise all three dimensions of cost in order to assess potential value for money: visible fees, visible-but undetermined expenses and non-visible losses. The latter can be very significant for non-US investors in US direct lending: even where fees and expenses are identical, non-visible leakage can result in US investors earning nearly $5 million more on a $100 million investment than their non-US counterparts.”