Summary and implications
Debt funds have so far failed to make a significant impact on the UK market. Why?
- The banks have been reluctant to sell.
- It has been difficult to raise equity in the economic climate.
- The pricing of available debt has not met the demand curve.
Nonetheless, debt funds remain an attractive but risky prospect.
An encouraging recent development has been the closing of two European debt funds. Debt funds buy debt which offers an opportunity for investors to hold interests, through debt, in prime assets, something which may have been difficult in the past. Other funds focus on investing in mezzanine debt, a market showing increasing signs of activity.
Notwithstanding the high risks involved, a variety of investors across various classes view investing in debt as part of their core investment strategy.
Debt Funds – failure to launch
In 2009, the market was buzzing about the next big thing in the UK: debt funds. However, a year on and we are only now starting to see European debt funds close, with M&G Investments and Duet Private Equity successfully raising equity of €140m and €100m respectively for their debt funds. There are two factors to help explain the scarcity of closings: the banks failing to put to market their debt portfolios; and 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 more debt funds in the UK at some time in the future, this will not be immediate. It is possible that traditional real estate funds will use broad investment strategies to invest in debt, popular due to its capacity to generate income but with a lower direct property risk. LaSalle Investment Management's UK Special Situations Fund which closed in Q1 2010 is planning to take positions between debt and equity.
The sporadic activity to date is contrary to the position in some other countries, such as the US, 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 is 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 established through a vehicle which acquires interests in existing debt from debt providers, at a discount to its face value and paying for it using its own funds which may be equity, debt or a mixture of both. It may seek to provide debt, including mezzanine finance, to investors across Europe, hoping to fill the void left by lenders exiting the real estate sector. The strategy sees scope for participation in the upside of recovery in the real estate market coupled with downside protection from interest payments. In the UK alone it is estimated that there are £160bn of commercial property loans which will reach maturity in the next five years. As loans are refinanced, debt funds will seek to take advantage of the market opportunity.
Each debt fund will have its own particular strategy. For example:
- A debt fund may favour a “trading strategy”, buying distressed debt to sell it, often quickly, at a higher price;
- “Buy and hold” strategy to gain negotiation leverage. By becoming a lender, a distressed debt investor may be able to gain access to restricted information about the company, meaning it is well placed to play an active role in managing its investment and take a key role in restructurings;
- A debt fund may favour debt purchased at par from banks and other lenders, aiming to select debt instruments with 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 be to take control of the underlying secured assets i.e. “loan to own”. By investing in a distressed company’s debt, usually taking security in the company’s assets, a fund will have an advantage in eventual liquidation proceedings.
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.
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:
- 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 strategy adopted, type of debt and other questions, these aspects may affect the method of acquisition. For instance, if the strategy of loan to own is important, the fund should look into change of control clauses present in contracts of the borrower which if triggered may lend to termination of such contracts.
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.
Attractions for pension funds
Pension funds have historically been slow to invest in mezzanine debt due in part to issues on how to value the asset. Recent investments in to debt funds by institutional investors such as the Church Commissioners are evidence of a change in the attitude of this investor class.
Another barrier to entry was lack of deals, but as markets have started to stabilise and banks actively seek to work out positions, there are more opportunities for debt funds to deploy capital.