The latest from the structuring frontline

As credit managers prepare to get back on the fundraising trail this autumn, there are at least half a dozen themes influencing fund structures. Managers in the UK and other countries outside the EU will also be navigating through a very different regulatory context when marketing to investors in the EU.

Six structuring themes

The following is a (by no means exhaustive) list of some of the influences on structure and terms:

Era of bespoke

Large investors demand bespoke arrangements with an underlying manager in the form of funds-of-one or other separately managed accounts, customised co-investment or direct investment programmes, and other arrangements.

Increasingly these may straddle multiple fund vintages or strategies. It is not uncommon for more than half of the capital raised in a particular strategy to be delivered via these ‘outside the fund’ arrangements.

New investor conduits

Alternative conduits to a strategy are increasingly being used. These include note programmes instead of fund investment – which can be very attractive to insurance company investors across the US, EU and Asia – as well as building interest in retail distribution channels.

Overage and syndication

Overage funds can be used to deal with excess capacity on deals too large to remain in the vehicle in full. Alternatively, such deals are syndicated across multiple investor vehicles or into the market. This raises questions around how fees, including origination fees or original issuer discounts, will be shared across syndicatee vehicles; and how any voting, such as on a restructuring or equity conversion, will work.

Strategy diversification

The trend of managers diversifying into new strategies continues. This is by no means limited to pandemic-related shifts towards opportunistic or special situations strategies. Put simply, sponsors are forming more funds across a wider range of strategies. Overlap in investment mandates is common, which creates the potential for internal competition for investor capital and for deals to be co-invested across multiple funds managed by a sponsor. Strategy diversification increases instances in which different funds are exposed to the same issuer at different points in the capital stack.

All this places a greater onus on the sponsor’s allocation and conflicts policies and disclosures. In addition, managers have been assessing and refining their ESG approach across all strategies, not least in anticipation of the next phase of the implementation of the EU Sustainable Finance Disclosure Regulation later this year.

Affiliated service provision

Managers are providing a wider range of services to their fund entities, borrowers and third parties, including loan administration and servicing. This can be a win for both managers and investors where such services can be performed more expertly and efficiently in-house. However, careful attention needs to be paid to disclosure, fees and structuring.

Maturing industry

As the industry matures, more funds are going through ‘end of life’ issues, including how to maintain their positions as preferred lenders to their borrowers through multiple fundraising cycles. This results in more cross-fund transactions, fund restructurings, continuation funds and other arrangements, with greater thought being given to these matters now at the outset of a fundraise. This ties in with the continued development of the private debt secondaries market.

Six fundraising developments

When managers do hit the fundraising trail in late 2021, it is not just the commercial environment that will be different from last year. Managers in the UK and other locations outside the EU will also need to carefully consider how they will engage with investors in the EU in a very different regulatory environment. Accordingly, there are six regulatory factors that will influence the way credit firms raise money from EU investors:

Passports no more

All UK managers and advisers have lost any ‘outbound’ Markets in Financial Instruments Directive passports that they had pre-Brexit. Without this protective shawl in place, UK firms need to reassess their role in fundraising and deal-related activity from the perspective of being so-called ‘third-country firms’. Although much fundraising activity should be outside the scope of MIFID, the various EU jurisdictions take different views on this and there are traps for the unwary (or the wilfully blind).

Pre-marketing codified

New legislation due to take effect in August will codify a concept of ‘pre-marketing’ across the EU 27. UK managers will not be licensed to conduct this activity on behalf of EU 27 alternative investment fund managers and, depending on local implementing legislation in each EU 27 country, they may also be restricted from doing so in their own right. This potentially changes the way UK and other third-country firms approach marketing to EU investors.

Time for action

Adopting a ‘wait-and-see’ approach to these issues was understandable earlier in the year. However, resolution of the Brexit hiatus as regards financial services seems unlikely in the near future. In the meantime, it should not be assumed that EU regulators will turn a blind eye. In fact, the predicament of UK firms is firmly in the spotlight among EU regulators. Accordingly, firms that have not focused on these issues should do so now.

Each firm is different

The impact of these changes will be different from firm to firm, as will the solution required. It will depend on a number of factors, including the size and scale of the firm’s EU 27 investor base, its planned fundraising, its operations in the EU, the roles and responsibilities of UK-based staff and its placement agent relationships. It is worth noting that UK-based placement agents are facing many of the same issues.

Small changes may have a great effect

It may well be that concerns can be dealt with through relatively small changes to responsibilities and processes, and backed up with appropriate guidance being given to UK-based executives.

Larger changes may be necessary

If and where necessary, more significant changes can be made. Some of these options have severe limitations and may not be a panacea, but may have a role to play. They include:

• Moving functions elsewhere in the group or ‘dual-hatting’ UK staff (e.g. to take advantage of an appropriately authorised EU 27 entity)
• ‘Chaperoning’ arrangements whereby appropriately authorised individuals in an EU 27 entity accompany UK staff
• Appointing UK individuals to fund or SPV boards
• Obtaining local authorisation for the UK firm
• Forming a new entity that becomes a ‘tied agent’ of an appropriately authorised third party firm or authorised in its own right
• Limiting EU investor interaction to genuine ‘reverse solicitation’ enquiries.

Gus Black is co-chair of Dechert’s global financial services group and a member of the policy committee. Mikhaelle Schiappacasse is partner, financial services and investment management.

This summer, the Alternative Credit Council and Dechert are launching a global market-wide review of trends in credit fund structures and terms. All private credit managers are invited to contribute to the survey stage of the project. Results will be presented in an aggregate format and the anonymity of individual respondents will be preserved.

To complete, please visit www.dechert.com/privatecreditsurvey