A number of managers have established so-called ‘hybrid’ funds/accounts, which invest in illiquid debt but adopt both closed-ended and open-ended fund structures. This is a response both to investors’ demand for vehicles into which they can deploy capital without having to make a new allocation decision every few years, and to managers seeking to avoid repeated fundraisings.
These vehicles tend to be tailored and are harder to set up given the predominance of pure funds and managed accounts. They might take the form of a hedge fund-style product or an evergreen investment period terminable on notice with a traditional run-off period. Alternatively, a hybrid might include defined vintages within one and the same fund, with each vintage having its own investment period, term and waterfall for the purposes of the performance allocation.
Occasionally there may be some form of limited redemption right if an investor specifically requires it for liquidity purposes. Hybrid vehicles often make greater use of working capital facilities, particularly to manage the timing or profile of investments.
In order to improve the return profile of private debt funds and against the backdrop of continuing low interest rates, some managers have established levered funds with security at the asset level and using concepts from structured financings.
Within private debt and other alternative asset classes, there is an increasing interest in structures that enable investment in private assets by ‘retail’ investors. These are typically ‘mass affluent’ or direct contribution pension schemes rather than true retail investors, though they nevertheless fall short of being classed as institutional investors.
These are usually regulated funds, such as European long-term investment funds, UK non-UCITS retail schemes and Luxembourg Part II funds. However, there is no perfect solution that enables such vehicles to be marketed to retail investors wherever they may be domiciled. Furthermore, the restrictions on permissible assets and other operational requirements can prove challenging for many managers.
Typically, European debt funds hold their investments through Luxembourg holding structures and manage tax payable in the structure by offsetting interest expense against interest income (while retaining a margin in Luxembourg). In the past year, Luxembourg has undergone one major change in law and is in the process of implementing a second. Both are having a significant impact on the structuring process for debt funds.
Pursuant to the European Anti-Tax Avoidance Directive (ATAD 1) Luxembourg has implemented an interest limitation rule. This restricts deductions for interest expenses where those expenses exceed interest income. Debt funds holding discounted debt or distressed debt, which can result in the fund holding minority equity positions, have been particularly affected because returns from such investments are not necessarily ‘interest income’.
This means traditional structures that repatriate realisations via debt instruments leave the Luxembourg holding company exposed to high taxable profits if some of the interest expense is not permitted as a deduction.
Luxembourg has been slow to issue guidance on these rules and there is not yet a consensus in the local market about the best way to respond. Many funds have therefore faced difficulty determining how to restructure their funding arrangements in order to minimise their tax requirements while satisfying the new rules.
ATAD 2 will be implemented in Luxembourg from 1 January and funds, as well as Luxembourg advisors, are grappling with what this will mean for fund structures. The ATAD 2 rules seek to limit interest expense deductibility in circumstances where hybrid entities or instruments are used to obtain tax advantages.
The remit of the rules is currently unclear. Most funds are not making structural changes at the moment, and are instead giving themselves flexibility in their LPAs to restructure if needed.