Levered feeder structures are a relatively new development in the private credit space in Europe. They produce an alignment of interests between private credit funds seeking to introduce leverage to structures and insurance companies seeking to invest in alternatives while avoiding additional capital adequacy burdens.
They share many of the same characteristics as rated-debt feeders, already a well established method for insurance companies to invest in credit funds. In particular, the investment by the insurance company is directly to the feeder vehicle and thus sits in the same place in the capital structure as the equity investments made by other investors.
However, unlike rated-debt feeders (where the terms of the debt advanced by the insurance company are intended to replicate the terms of the equity investment by the other investors), an insurance company’s investment in a levered feeder takes the form of traditional debt.
As such, an insurance company lending to a levered feeder structure will receive a coupon or interest at a rate similar to that charged by a traditional lender.
There are a number of reasons why these structures can be advantageous. For credit fund managers, insurance companies are an important source of capital. Introducing such capital in the form of debt can provide a mechanism for injecting leverage into a fund structure. This in turn may increase a credit fund’s internal rate of return. Such debt will typically have a long-dated maturity and, where the debt achieves an investment grade rating, competitive pricing.
Further, as the debt is not incurred by the main fund, it will not be subject to any borrowing or leverage restrictions in the limited partnership agreement. For insurance companies, the provision of rated debt to a levered feeder offers attractive risk-adjusted returns with favourable capital treatment and may complement the company’s investment in the fund as an equity investor.
The documentation package needs to be considered on a holistic basis, with proper consideration of the interplay between the debt and equity investments made directly or indirectly to the levered feeder. As would be typical for any debt investment (and unlike with equity), there will inevitably be conditions that must be satisfied by the credit fund in order to utilise the debt provided by the insurance company lender.
However, from a credit fund manager’s perspective, one of the key objectives will be to minimise the circumstances in which the insurance company lender can refuse to make advances. This is to ensure that the debt is available to be utilised, subject to adhering to the facility limit, whenever a capital call is requested by the master fund.
As such, we would typically expect to see only a short list of ongoing conditions to drawing and a relatively light covenant package. Ideally, there will be no draw-stop events linked to financial covenants or failure to maintain ratings (although, these may still be relevant in the cashflow waterfall). Further, a credit fund manager may seek to enhance flexibility by structuring the facilities with both term and revolving tranches.
Instruments of this kind tend to have long-dated maturities to match the fund life, with flexible repayment mechanics. It would be typical to utilise a pledged account structure, with all distributions from the master fund payable into the pledged account and subject to application of a cashflow waterfall on regular payment dates. This may require repayments of debt and equity in a fixed split, or there may be no requirement for repayment of the debt in the ordinary course until maturity.
Regardless of the ordinary repayment terms, the insurance company lender will typically require mandatory prepayment of the debt via the cashflow waterfall in order to cure breaches of financial covenants or during the continuance of trigger events. The partnership documents will need to be drafted to allow proceeds received by the levered feeder to be applied to satisfy any outstanding debt obligations in priority to distributions to equity investors.
While the insurance company debt provison can benefit from a high level of flexibility in terms of the covenant package and repayment mechanics, this must be balanced against the need to ensure the investment maintains its characterisation as debt and obtains the required NRSRO rating. Both credit fund managers and insurance companies should take specialist tax and regulatory advice in relation to these structures.
Credit fund managers and insurance companies can benefit from levered feeder structures. However, given the bespoke nature of these transactions and their complexity, they should only be approached with a proper understanding of the issues that will likely arise.
The main features of a levered feeder structure
- A feeder fund is established as an investor in the credit fund’s master fund vehicle.
- The insurance company lender provides debt to the feeder fund, although there are different ways this can be affected. The debt may be structured as a vanilla loan or as a note issued by the feeder fund.
- The debt instrument (whether a note purchase agreement or a loan agreement) will contain the mechanics for obtaining advances from, and making repayments to, the insurance company lender. It will also include a tailored set of representations and warranties, undertakings and events of default. The debt terms are explored in more detail below.
- The debt may be provided to a separate borrowing vehicle (which is itself an investor in the feeder fund), rather than directly to the feeder fund.
- To ensure that the insurance company benefits from the most favourable capital treatment in relation to the debt, the credit fund manager will need to obtain a rating for the debt from a Nationally Recognized Statistical Rating Organization, a credit rating agency approved by the US Securities and Exchange Commission.
- The feeder fund’s limited partnership agreement will need to cater for the debt structure, including the interaction between the rights of the insurance company lender and the regular equity investors in the feeder fund. In particular, this will need to regulate how capital is called from both the debt and equity elements of the structure and the order of distribution of cashflows received by the feeder fund.
- It is also possible for the insurance company to make a separate equity investment in the feeder fund, although such investment will not benefit from the reduced capital adequacy requirements of its rated-debt investment.
- A credit fund manager may operate both levered and unlevered sleeves of the same fund (through a parallel master fund structure), offering other investors an opportunity to select an option that best matches their risk and return requirements.