Interest rates might cool the fevered debt market, but the IRS could freeze it.

In his debut teleconference with unit holders in KKR Private Equity Investors, Henry Kravis addressed a question he's been getting a lot lately – succinctly put, what happens if the credit markets dry up? How then will all the buyout money being raised get put to work?

Kravis noted the incredible amount of debt available for buyouts, saying: “I've never seen a market with this much liquidity.” While he acknowledged recent signs of tightening in the credit markets, Kravis expressed optimism that the deepening, global debt markets and the many new participants in it would add to long-term stability.

He also noted the participation of hedge funds in the current liquidity deluge. Far more often than they are competing with private equity firms for deals, hedge funds and other non-traditional financial firms are sopping up the debt for these buyout deals, allowing the ongoing boom to last longer than almost anyone expected.

There are several factors that could emerge to disrupt today's debt party. Two possible scenarios involve hedge funds and other operators of collateralised loan obligation (CLO) funds getting pushed out of the debt market. Scenario 1 would chill the debt market for private equity deals. Scenario 2, although far less likely, would turn current liquidity into a sudden and deep freeze.

Hedge funds are providing financing to private equity deals because, in a low-interest rate environment, the loan yields are fairly attractive. The institutional investors who back hedge funds are the ultimate determinant of how long these funds will stay in the debt game. As interest rates rise, investors will be less appreciative of the fixed-income work done by their hedge fund GPs, and an important pool of capital available for buyout deals may dry up.

But this scenario is code blue compared to what might happen if the Internal Revenue Service (IRS) changes its opinion on a key tax rule in the lending market.

The issue here has to do with what boosters of the alternative investment industry proudly call “convergence”. A blurry line has emerged between traditional lending and what hedge funds do, which is essentially lending but officially classed as something else, and for good reason. The IRS levies an effective 54 percent tax on the interest gains of foreign banks operating in the US. But foreign trading companies – firms that invest in equities and bonds, for example – pay no taxes. Almost all CLO operations are offshore and are classified for tax purposes as trading companies. But aren't they foreign banks? They sure act like they are.

“In a lot of the deals we've done, we've moved away from high yield and into what effectively looks like the bank market,” notes a GP from a major US buyout firm, in a recent interview. “These actually aren't banks that are lending the money. They're CLOs and other forms of first- and second-lien debt that are being provided on very attractive terms, often in a covenant-light structure.”

The broadening of the loan market is great news for private equity firms, and a development of interest for the IRS, which is currently pondering how best to deal with this convergence.

One technical destinction separating banks from non-banks involves the origination of loans. Banks originate loans. But CLOs typically wait 48 hours before buying syndicated tranches of a loan originated by a third party, thereby sidestepping the origination issue. Further blurring the line, however, is the fact that many hedge funds commit to buying the loans before the loan is even funded.

“In a lot of the deals we've done, we've moved away from high yield and into what effectively looks like the bank market.”

According to David Schnabel, a partner in the New York office of law firm Debevoise & Plimpton, recent comments from IRS officials have many tax experts wondering whether a revision to the definition of a bank might be on the horizon.

Furthermore, many hedge funds are seeking to create direct lending practices as niche accompaniments to broader investment programmes. This puts another strain on the definition of “bank” – if a firm originates a few loans per year, is it a bank? Hedge funds sure hope not.

Schnabel says it is far from certain whether the IRS will end up not clarifying the rules in this area, because it is so difficult to draw bright lines in this area and any new rules would merely create several new grey areas. He notes that other tax experts believe new regulations will eventually be issued, which may have the effect of driving hedge funds out of the loan markets, and with them, the enhanced liquidity in buyouts.