Private debt continues to develop as a distinct asset class in Europe with new funds launching across a range of strategies including direct lending and senior loan funds, secondary vehicles, mezzanine/subordinated debt funds alongside distressed debt and special situations funds. As the private debt fund market matures some distinct trends are emerging within the terms and structures of these funds. There is also greater understanding and alignment between fund managers and investors on the right liquidity profile and economics for debt funds depending on the investment strategy.
STRUCTURE AND LIQUIDITY
The structure of the fund depends on a number of factors including the strategy, the nature of the investments, the investment horizon and crucially, the familiarity and often specific requirements of investors. A key question is whether the fund will be investing – making longer term and generally illiquid investments – or trading, via more frequent, shorter term investments. This is important to consider at the outset as it will not only influence the structure and the liquidity profile of the fund but may also have significant tax implications for investors and the fund managers’ incentive arrangements.
Ultimately, whether a fund is regarded as investing or trading will turn on the specifics but in general, senior loan funds and mezzanine/subordinated loan funds are regarded as investing. On the other hand, if a fund is looking to acquire secondary NPL portfolios at a discount with a view to selling it on within a short period of time, it is typically regarded as trading.
Broadly, funds that are investing for the longer term adopt a private equity-style, closed-ended, self-liquidating structure. The terms for such funds are broadly similar to a private equity fund with some variations, particularly in relation to the fund life and the economics. At the other end of the spectrum, trading funds lean more towards a hedge fund style model with offshore corporate structures that offer some liquidity. There are also funds in the market that do not fall within either of these models and adopt a hybrid structure instead, with flexibility to make both long-term and short-term opportunistic investments.
Typically these funds also offer limited liquidity to investors.
IMPACT OF REGULATION
On the choice of jurisdiction, the key considerations were historically tax driven, but regulation is now just as significant a factor, as fund managers hoping to take advantage of the AIFMD marketing passport consider fully onshore structures with both the fund and manager entities being based in the European Economic Area. Luxembourg continues to be an attractive choice as a result of its extensive tax treaty network and the variety of fund structures available. Its unregulated limited partnership regime, which is modelled closely on the English and Channel Islands limited partnership structures, is also popular with those seeking an unregulated vehicle that investors are familiar with. Another onshore jurisdiction gaining visibility is Ireland, where a welcome change in lending rules in late 2014 gave permission for regulated loan origination vehicles.
Apart from marketing regulations, debt funds involved in loan origination need to consider whether they need a banking licence where they are based or in jurisdictions they intend to lend into.
Fund managers also need to take into account specific investor requirements when determining fund structure. For example, funds targeting European insurance companies will need to accommodate the implications of Solvency II, which will take effect in the EU at the beginning of 2016. In particular, European insurance investors will need reporting on the underlying credit instruments to benefit from lower risk weightings for debt investments. While some investors may prefer to acquire bonds, which may be listed and/or rated, instead of a traditional fund investment.
Managed accounts have also proven popular among investors especially for long-term debt investments such as infrastructure debt, as it allows them to benefit from enhanced information rights, lower management fees and carried interest and can give them greater control over investment and exit decisions. They can be an alternative or alongside a traditional fund structure, and range from full discretionary management at one end to execution-only or portfolio reporting service on the other. The most common is an arrangement between the two, where the manager is responsible for managing the investments with the investor retaining certain veto rights. The accounts can be structured to hold investments in the investor’s name or through an SPV established for their benefit.
ECONOMICS & OTHER KEY TERMS
Fee structures for debt funds vary significantly depending on the investment strategy and return profile of the fund. Funds that operate at the lower end of the risk spectrum, such as senior loan funds may have management fees of below 1 percent, often with no or reduced carry. On the other hand, funds with a loan-to-own strategy or those specialising in special situations typically charge management fees of between 1.75 and 2 percent, with carry of up to 20 percent, particularly if management requires a private equity or distressed skill set. In contrast, the fees for funds investing in secondary loan portfolios and mezzanine and subordinated debt tend to be somewhere between the two. It is also not uncommon to see management fees charged only on invested capital as it is recognised that deployment tends to be quicker with debt investments. Occasionally, a manager will charge fees on a portion of committed capital while charging full fees on invested capital. In some instances, fund managers are looking at alternative carry models such as yield-based carry arrangements whereby fund managers receive carry once an annual target yield is reached. Catch-up is also subject to negotiation between fund managers and investors in the debt fund space and a number of funds now operate a reduced catch-up.
Trading funds lean more towards a typical hedge fund model, with a 2:20 management fee and carry, the difference being that fees and carry are calculated on net asset value (NAV). They also adopt constraints on liquidity, typically building in three- to five-year lock-ups.
While funds investing in distressed, loan-to-own and mezzanine average 10-year terms, akin to the traditional private equity model, secondary portfolio funds generally have shorter fund terms of seven to eight years, while senior loan and direct lending funds range from five- to eight-year lifetimes.
Investment periods for debt funds tend to be shorter, with an average of two to three years in comparison to four to five years in the private equity (PE) space. Reinvestment is also generally more flexible in debt funds, with some able to fully recycle proceeds within the investment period.
While PE funds typically charge subsequent close investors an equalisation fee of two to four percent above Euribor, equalisation fees for debt funds will reflect the lower returns and some may be based on NAV. Managers considering multi-currency offerings will also need to have regard to additional terms regulating how the different currency pools will operate, including allocations, equalisation and hedging arrangements.
Overall, as private debt continues to gain traction as an alternative asset class with more investors setting aside exclusive debt allocations, there are significant opportunities for fund managers in the debt funds space. However, managers need to ensure that the structure and terms of the fund are properly aligned with the investment strategy and investors’ expectations to ensure a successful fund raise.