Summary and implications
Despite initial interest earlier in the year, and in the face of debt funds being successfully launched in other countries, debt funds have so far failed to take off in a big way here in the UK. Why?
- The banks have to date been reluctant to sell.
- It is difficult to raise equity in this economic climate.
- The pricing of available debt is not meeting the demand curve.
Nonetheless, debt funds remain attractive prospects for the future. But what are debt funds and why are they of interest?
- Debt funds buy distressed debt which offers an opportunity for investors to hold interests in debt in prime assets, something which may have been difficult for them to do in the past.
Debt Funds – failure to launch
Earlier this year the market was buzzing about the next new thing in the UK: debt funds. However, six months on and several debt funds have failed to launch in the UK. This has largely been driven by the banks failing to put to market their debt portfolios coupled with the ongoing state of the UK market where equity is still difficult to raise, and where the available debt is still priced higher than investors want to pay. In a nutshell, while we do expect to see a possible proliferation of debt funds in the UK at some time in the future, this will not be immediate.
This is contrary to the position in some other countries where many debt funds have been established – albeit in market conditions different to those of the UK. Despite a false start, most analysts agree that debt funds will open up investment opportunities that have historically been closed to all but a very few investors in the UK. Therefore, it's unsurprising that many investors are watching the market closely, waiting for the right environment to launch their debt fund and to take advantage of a rare opportunity.
Debt funds – what are they? A debt fund may be structured in the same way as a private equity fund. Once optimum market conditions exist, we expect this to be a growth area. So what are debt funds and what are the issues that need to be considered?
A debt fund may be established though a vehicle which acquires interests in existing debt from debt providers, paying for it using its own funds which may be:
- Equity invested by the partners in the debt fund.
- By separate borrowing by the debt fund itself.
- A mixture of both.
Each debt fund will have its own particular strategy. For example:
- A debt fund may favour debt purchased at par from banks and other lenders aiming to select debt instruments where there are higher returns.
- A debt fund may purchase senior debt trading at a discount to par in the secondary market.
- A debt fund may have a geographical or sector focus.
- The purpose of the debt fund may simply be to acquire the underlying secured assets.
A limited partnership structure would be a typical investment vehicle for a debt fund as if offers limited liability to investors and tax transparency. As with a real estate or private equity fund the object for the sponsor is to receive their return as capital not income and the object for the investors is to avoid tax at the vehicle level. This adds a further layer of complexity to the structuring, as the returns from the structure will be in the nature of interest paid on the debt, which would be taxable as income and not capital without any bespoke structuring. Our advice to clients is that precise structuring should be considered from the outset. A further structuring consideration is whether the interest payable is received gross or net of withholding tax. The structure will also need to cater for the position where the debt enters default.
If a debt for equity swap is agreed with the borrower then the fund will be holding the secured assets instead of, or as well as, holding the debt. This may require an alternative or parallel structure depending on the nature of the assets.
A debt fund's management structure will depend on the vehicle used. For example an English limited partnership will be controlled by a general partner and may also have an FSA authorised operator. This will vary depending on the relevant jurisdiction. However in all cases there will be an investment manager who will advise on selecting and managing the debt assets. In the UK it would not be required to be authorised as a lender under banking regulation where the fund is buying debt, but it will need the required FSA authorisation to provide investment management advice. This is not always the case in other jurisdictions though and the regulatory position may require differing authorisation depending on the location of the assets and/or the borrower and/or the fund.
Due diligence is also an important factor when considering investing in debt. Attention should be paid to the terms of the interest in the debt being purchased. For example: In all cases there will be an investment manager who will advise on selecting and managing the debt assets
- Will the fund also be taking an obligation to advance more monies to the borrower?
- If the debt fund acquires an interest in a syndicated loan facility, then what voting rights exist between the lenders?
Depending on the type of debt and other questions, these aspects may affect the method of acquisition. The debt fund will also want to closely look at the enforcement rights:
- Will the debt fund be able to enforce the security if the loan is in default?
- What standstill arrangements exist between creditors?
- Will it rely on being part of a majority of lenders to enforce or will it want to be part of a blocking minority if it wants to prevent enforcement?
- Close attention to intercreditor arrangements will be required in order to answer these questions.