The rush to regulate in the wake of the global financial crisis – indeed whilst that crisis was still in full swing – has led to a wholesale reshaping of the way alternative assets managers, and the wider banking community, operate.
For the emerging asset class of private debt, the regulatory landscape is now pockmarked with a series of regulatory instruments and national oversight bodies. Perhaps more so than private equity, private debt fund managers have a very broad suite of options when it comes to structuring their lending vehicles. From a traditional GP / LP fund structure, to something resembling a bank, and taking in US Business Development Companies (BDCs) in between, the plethora of options bring with them a host of different regulatory and compliance requirements.
Worse, the landscape is still fluid as governments react to the unintended consequences springing from hurried regulatory instruments. As they close one loophole, another emerges. Making sense of this landscape is therefore a full-time business.
Broadly speaking, there are three key elements for a would-be private debt fund manager: first, establishing the management vehicle; second, raising / marketing the fund itself; and third, transacting.
Establishing the manager
As any good lawyer will tell you, the first step for any would-be private debt fund manager is to seek expert legal advice. There are a host of considerations at this stage which will have far-reaching implications further down the line.
“A key consideration initially will be where do you set the manager and the fund up? Do you want an on-shore or off-shore vehicle?” asks Ian Warner, an investment funds partners at Pinsent Masons.
For European managers, the Channel Islands and Luxembourg continue to be popular ‘non-UK’ choices from a fund domicile perspective. For US managers, the Cayman Islands and Delaware are popular options.
There’s also a question as to which company or firm structure best suits your needs. In the UK, the choice largely comes down to a Limited Company or Limited Liability Partnership. The latter is popular with small teams who want to be seen as both owners and decision makers, and has a number of tax and national insurance-related advantages. Indeed, tax concerns are a key factor in structuring both the management company and ensuing investment vehicle.
Next, the management vehicle needs to be registered with the appropriate regulatory body – the Securities and Exchange Commission (SEC) in the US, or the Financial Conduct Authority (FCA – formerly the FSA) in the UK for example. This authorisation process can take months, so it needs to begin as early as possible.
Andrew Henderson, counsel at Ropes & Gray in London , explains: “As a prospective manager seeking to establish your business in the UK, you need to demonstrate to the FCA that you have the requisite skills, sufficient regulatory capital, and necessary compliance functions and other systems in place.
“There is of course a cost attached to satisfying those requirements which has to be factored in to any business plan. The key decision-makers within the management entity also need to be individually approved and satisfy fitness and properness requirements,” he adds.
Again, individual approvals can take months, and there may even be exams that have to be passed in some cases. One option, if this is to be an issue, is to pay for an umbrella organisation to satisfy requirements until the requisite qualifications and approval have been obtained, but this can be costly. Outsourcing many fund administration functions to third party providers can also help to lessen the load, advises Simon Crown, a partner at Clifford Chance.
Managers may need not wait for authorisation to come through before beginning to raise capital, although this varies from jurisdiction to jurisdiction. But the marketing and fundraising stage, perhaps more than any other, can be the most complicated given the diverse geographical range of investors many firms are likely to solicit commitments from.
In Europe, one regulatory instrument that has garnered more column inches than any other is the Alternative Investment Fund Managers Directive (AIFMD).
The directive, whilst designed with private equity funds in mind, also applies to private debt vehicles once they reach a certain size.
“Many debt funds will fall into AIFMD’s small funds exemption, which has a €500 million threshold,” Warner explains. “However, if leverage is used in the fund to supplement LP commitments or if investors can redeem their interests, that threshold falls to €100 million.”
Managers may choose to voluntarily submit to AIFMD however. “Managers who are thinking of not registering under AIFMD may still wish to consider it, however, in order to benefit from the marketing regime it implements,” Warner says. “At the moment, marketing to institutional investors involves making sense of the various private placement regimes in individual countries. Some can be problematic and are being reviewed, like Germany for example. But under AIFMD’s passporting regime, marketing is harmonised across the EU.”
“The main considerations when marketing a fund concern what you have to tell potential investors,” Henderson adds. “The law prescribes what you have to disclose. AIFMD sets out the sort of information that should be disclosed. Items include: a description of the fund’s strategy; the identity of the managers; details of valuation procedures, fees and charges and any special treatment for investors, such as side-letters.”
In addition to AIFMD, individual countries may have requirements above and beyond the EU-wide directive, so it’s important to seek advice on each jurisdiction you wish to market your fund in. ‘Reverse enquiry’, where an investor approaches a manager, can circumvent national placement regimes in some cases, advises Clifford Chance’s Crown.
It’s a simpler story in the US, Warner explains. “When it comes to the US, normally there’s no need [for a European manager] to register with the SEC as long as you are only marketing there to certain institutional investors. But if you invest there, FATCA becomes relevant. Indeed it’s still worth including FATCA-related provisions in your Europe-focused fund; they’re not too onerous and give you flexibility.”
There are also regulatory measures that may impact fundraising, albeit tangentially. Solvency II, for example, could limit insurers’ ability to commit capital to alternative investment funds, whilst Basel III and the Volcker Rule in the US do the same for banks. Fears concerning all three instruments have to date largely proved unfounded, according to market sources, with the proviso that both regulators and those being regulated are still feeling their way around the new instruments.
Let’s assume the fundraising has gone swimmingly (a big assumption in a taxing environment for raising capital), and as a manager you’re sitting on a large pool of dry powder. The hard work, from a regulatory and compliance perspective, seems to have been done.
Far from it, warns Henderson. “Once you’ve actually begun trading, it can really start to get complicated. It becomes particularly interesting in situations where in your capacity as a purchaser of private debt you become privy to knowledge of publically-traded debt instruments. That potentially places you at risk of accusations of insider trading. To avoid that eventuality, you can request that sensitive information not be shared with you in a data room situation, erect your own Chinese walls or otherwise screen information to avoid coming into possession of inside information.”
For loan-to-own players in Europe, in the event they’re left holding the keys to a company (i.e. with a majority stake), there will be disclosure requirements under AIFMD which normally apply to private equity funds.
More broadly, managers have to conduct themselves in a right and proper fashion. “As an FCA-authorised firm, you’re also subject to the principles of business which govern the manner in which you treat your clients, dealing with issues such as the management of conflicts of interest.”
In a post-Lehman, post-Madoff world, only one thing is really certain: the markets are only going to become more regulated, not less. The challenge for legislators and national regulators will be to construe new rules in a sensible, easily-understood manner. They’ll also need to ensure regulatory regimes are harmonised, which is difficult when countries are vying for business with one another – one need only look at the furore over Apple or Google’s tax arrangements to see the problems that can arise.
And the implementation of any new regulation is never smooth. In Europe, D-Day for the AIFMD comes in July this year, but tellingly, countries throughout Europe are at very different stages when it comes to implementing it. In the UK, for example, managers of existing funds at the time of implementation will have a year’s grace period to register.
There’s also an element of doubt concerning the sanctions that could be meted out in the event a firm steps out of line. Again, time will tell how stringent regulatory bodies will be, but the risk is that the first few culprits will be made examples of to prove a point.
For private debt funds then, the pitfalls are myriad. In time there will be greater clarity, and potentially greater harmonisation. For the time being though, the message is, tread carefully, and seek advice