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In this episode of Fully Invested, Ropes & Gray asset management attorneys Laurel FitzPatrick and Jessica Marlin introduce listeners to private credit funds and the different types of debt in which such funds invest. They further discuss how a credit fund’s underlying assets affect fund terms and structure.


Jessica Marlin: Welcome to Fully Invested, a podcast series hosted by Ropes & Gray’s global asset management team. Drawing on the perspectives of over 350 attorneys from all areas of our practice, we provide insight into essential considerations associated with current and emerging asset management products. I’m Jessica Marlin, located in our New York office, and today, I’m joined by my Ropes & Gray colleague Laurel FitzPatrick, who heads our credit funds practice. On this episode, we'll be discussing the basics of private credit funds.

Before we discuss credit fund terms, it’s important to note the types of investments that credit funds make—generally, credit funds either directly originate private debt or they buy loans on the secondary market, or they can also buy public debt. When a fund directly originates a loan, the fund and the borrower negotiate the terms of the loan on a bespoke basis. It is largely the nature of the debt that drives the structure and terms of credit funds.

The private debt market has grown exponentially in the last 10 years—companies used to obtain loans from investment banks, but in the wake of the Dodd-Frank, investment banks became tougher lenders, and so, private funds stepped in to fill the gap. To demonstrate the magnitude, currently in the private debt fund space there is around $400 billion in dry powder, and $1.2 trillion in assets under management.

Laurel, do you want to start off by taking us through the basic strategies and features of private credit funds?

Laurel FitzPatrick: Thanks, Jess. First, private credit funds can be both closed-end funds, like a PE fund, or open-end, like a hedge fund. In closed-end credit funds, capital commitments are raised over a fixed period of time, such as a year or 18 months, and then those commitments are drawn down over time. Investors generally cannot redeem, and instead, the fund distributes out income from interests and principal payments on the loans and, in some cases, from realizations on the sale of loans. This occurs over a fixed term, similar to a private equity fund. For open-end private credit funds, investors typically subscribe on an ongoing basis and can redeem regularly, subject to a notice period, and sometimes to an investor-level gate or lock-up period, depending on the liquidity of the underlying loans. Today, we will be focusing on closed-end private credit funds, but it’s important to remember that, like all funds, the liquidity and structure of the fund need to match the underlying assets.

There are a wide range of private credit fund strategies. A fund may focus on senior debt, direct lending, unitranche loans, loans to distressed companies, real estate, high-yield, mezzanine, credit opportunities, CLO equity, specialty finance or many other strategies. Many credit funds directly originate their loans and hold them to maturity, while others buy and sell loans on the secondary market. On a basic level, a combination of the creditworthiness of the borrower and the debt’s place in the capital structure drives the interest rate on the loan, and the interest rate on the loan combined with the expected leverage of the fund drive the target returns of the fund. So, a senior loan to a creditworthy issuer will have a lower interest rate than a second lien loan to the same issuer, but a subordinate loan to a distressed issuer will bear a much higher interest rate. Credit funds generally have a specific flavor of risk and return that they focus on. Jess, do you want to discuss how credit funds target returns, management fees and carry compare to those of private equity funds?

Jessica Marlin: Sure, Laurel—thanks. As a general matter, credit funds have lower target returns than private equity funds (so, even as low as 7-8% target net returns for an unlevered senior loan fund). Debt yields lower returns because it is inherently less risky than equity, because in the event of a bankruptcy, creditors or lenders are paid back before equity holders. Therefore, funds that invest exclusively in credit investments should have less investment risk but also lower target returns, such as 10-12% or less on a net basis. However, credit funds that do mezzanine lending, which will include an equity component, or, in the case of high-yield or distressed debt, will have target returns above 15%, more closely approximate the net returns of a private equity fund, but also have more risk.

Note that a lower target return profile can impact fund terms, like waterfall, management fees, transaction fee offset and expense cap.

Management fees are frequently taken on commitments during the investment period and then on investments for the term of the fund. Some managers will push to include the full principal amount of the loan of any revolver or delayed draw loan in “invested capital” even though it’s not fully drawn at the outset for purposes of calculating the management fee base, even if a loan isn’t fully drawn at time of investment because those commitments are technically earmarked for the investment and must be available if the borrower draws on the loan. You’ll want to carefully draft the management fee provision to account for this to make sure the manager is getting paid on the full amount of the loan, rather than just the drawn portion, because those dollars are technically invested whether they are drawn or not. Some managers will face pushback if this wasn’t part of their initial formulation for the management fee in prior versions of the fund, which is often the case for managers who started with private equity fund documents, which wouldn’t take this into account.

Additionally, because borrowers typically make regular interest and principal payments on the loans over the term of the loan, credit funds generate regular income rather than just at the time of realization of a portfolio company, like a PE fund. Credit funds typically undertake to distribute those amounts, in particular, the interest to investors on a quarterly basis. These amounts can begin to be distributed before the fundraising period is even over, which can complicate the accounting around late-coming LPs. Also, such current income amounts usually go through the waterfall. In certain cases, credit funds will have a bifurcated waterfall with current income going through one waterfall and repayment of principal going through another. This can help the general partner and adviser get paid carry more quickly.

Laurel, what other features of credit funds and their underlying investments are important to consider?

Laurel FitzPatrick: There are a few other features, such as the term of the fund, fee offsets and conflicts that we should touch upon in the brief time that we have. Credit funds frequently have shorter terms than private equity funds because, unlike an equity investment that could theoretically be held indefinitely, the underlying loans often have finite maturity dates. This is an important reason to carefully consider a fund’s recycling provisions. If a loan is paid off early, for example, and the fund doesn’t permit recycling at the time it’s paid off, both the manager and investor could be disappointed to learn that the capital would not be invested for the term originally contemplated. In addition, the manager may miss out on the opportunity to earn management fees and carry.

Another issue where credit funds differ from other kinds of funds is the fee offset provisions. Managers of credit funds can earn different types of transaction fees than private equity funds—instead of earning a fee for serving on a board or providing consulting services to a portfolio company, a credit fund manager might earn a fee in connection with arranging or syndicating a loan. That fee may or may not be figured into the cost of the loan. In certain cases, credit fund managers will negotiate to retain some of these fees, and then they are not offset against management fees or expenses. As a result, you’ll want to make sure these fees are described accurately in the fund documents and that you aren’t piggybacking off a private equity transaction fee description that you may have had in one of your existing funds. In addition, you’ll want to make sure that you’re discussing these concepts and issues with the deal teams to make sure they understand the expectations around disclosing to investors all of the fees the manager might retain. This is an area where managers’ practices are evolving rapidly and where many managers have added additional disclosure and additional fee carveouts to the offset provisions in their more recent funds. It also remains an area of close scrutiny for the SEC, so you will want to make sure that you focus on it at the time you draft your documents.

The last issue to mention is the perennial favorite: conflicts. Conflicts are especially relevant when running private equity funds alongside private debt funds. When a manager’s funds are invested in different parts of the capital structure of the same portfolio company, managers will face difficult decisions in times of distress. The interests of the credit fund holding the debt will often conflict with the interests of the private equity fund holding the equity investment in the same portfolio company. In the event of a bankruptcy, equity holders are unlikely to see a return of their investment while debt holders may fair better. The same holds true for two credit funds holding debt in different layers of the capital structure because one may get paid off before the other or on different terms in the event of a bankruptcy or restructuring. In this era of creditor-upon-creditor violence, even in the run-up to bankruptcy, different decisions by a portfolio company (and the funds controlling it), such as delaying a payment to a creditor, deferring a dividend or offering a new tranche of debt, could adversely impact one fund over another. These conflicts need to be carefully disclosed to investors, and managed by the fund manager. For example, to the extent the credit fund’s strategy is to intentionally lend to the manager’s portfolio companies, the credit fund may agree to limit its ownership of each tranche of the debt to less than a given percentage and/or to refrain from voting on creditors committees. This obvious preference to the private equity fund over the credit fund should be disclosed to investors.

Jess, do you want to discuss some of the basic structuring considerations for credit funds?

Jessica Marlin: Sure—thanks, Laurel. U.S. taxpayers don’t have particular structuring considerations for investing in credit funds beyond wanting to invest in a partnership for U.S. tax purposes. However, U.S. tax exempt and non-U.S. taxpayers have unique issues because originating loans in the U.S. can generate certain types of U.S. tax that are undesirable for U.S. tax exempt and non-U.S. investors—for tax exempts, this is called “UBTI,” and for non-U.S. investors, this is called “ECI” or income effectively connected with a U.S. trade or business. Blockers can, in certain cases, create considerable tax drag, and it is important to work closely with the tax lawyers and accountants to make sure that you are creating a structure that works for your investor base. Even the same types of investors will have different preferences and tolerances for these taxes (for example, some UBTI-sensitive investors are fine with some UBTI, while others won’t tolerate any), so, frequently managers will delay setting up a final structure until they are further along in the fundraising process to make sure that they have critical mass to support a particular addition to their structure. Furthermore, some credit strategies, such as mezzanine and real estate, can take advantage of even further structuring options, and funds that only buy credit on the secondary market aren’t typically engaged in origination, and therefore, won’t necessarily have the same considerations.

There is much more we could discuss about private credit funds—including fund terms, strategies, leverage and structures—but our intention is to keep this high-level. We have a more detailed Ropes & Gray podcast series on credit funds available on our website.