The shape of things to come

Debt funds are not a new phenomenon, but the shape of the private debt fund market is in the process of a dramatic transformation, and so too are the structures and terms such funds employ, writes Weil Gotshal’s James Gee.

In the wake of the financial crisis capital constraints and regulatory pressures are causing banks to reduce their lending.  At the same time CLOs have (in Europe) been made unattractive by the retention provisions in the Capital Requirements Directive.  This has created a funding gap across a variety of different asset classes and managers are stepping into these gaps.

Some of these are new managers. Some are platforms being built within wider alternative investment houses keen to exploit their existing skills and to create a new offering.  At the same time as this new market for senior debt funds has emerged, many managers of mezzanine and distressed debt, are having, in relative terms at least, a ‘good’ crisis. Mezzanine returns have held up relatively well and the opportunities for distressed debt specialist are clearly expanding. In many cases it is these managers that are looking to expand their offering ‘upwards’ into the senior debt space.

The result is a wider and more complex class of private funds that demands specialist attention.  It crosses the whole range of alternative assets. It extends up and down the capital spectrum. In such circumstances it is legitimate to ask, what, if any, are the common features that hold these funds together?

Most obviously – they are not (generally) investing in equity: debt has certain defining characteristics that means even quite different products face similar issues.  To start with, private debt managers need to ask who will invest in these funds and what allocations will they use?

Furthermore, the debt instruments themselves may well face similar tax and regulatory issues regardless of what the underlying assets are. It is possible that some debt investments will ultimately benefit from a more favourable capital treatment under the newly emerging regulatory regimes (such as Solvency II for EU-based insurers).  But this can require complex and careful structuring.  At the same time, debt funds clearly operate in the shadow-banking world.  Some debt funds, particularly at the senior end, are effectively originating debt.  They need to study the regulatory line between banking and fund management carefully across a range of jurisdictions. 

From a tax perspective, certain similar themes also emerge.  The principal investor-facing vehicles may appear very similar to fund structures used for equity investments: partnership vehicles continue to be common.  But upstream and downstream structures may need different solutions. Some debt managers have a much higher turnover of investments in their portfolios; if they are potentially treated as trading then the tax consequences can be dramatically different. This can often mean that structuring considerations arise within this class of funds, which would be less of a concern in other areas of alternatives investing.

As with all fund managers, debt fund managers are beginning to wrestle with the waves of new regulation and tax initiatives falling upon the wider industry, particularly AIFMD in the EU, FATCA and the Advisers Act in the US. All these have quirks that will have particular resonance for debt fund managers.

Finally it is worth noting that debt funds are less likely to be involved in the activities of the companies or other assets in which they invest.  The skills offered by managers are origination, selection and analytical rather than operational. Also it is likely that the debt instruments, whilst generally not granting their holders control of an underlying investment, are at least more liquid than equity. This can result in different fund terms.

It is worth touching briefly upon fund terms.  They encapsulate the manner in which the debt fund industry has evolved out of other alternative asset classes.  In some cases the similarities are notable but a number of differences are apparent, particularly as regards fee levels.