During this podcast, Michael Doherty and Jason Kolman discuss some considerations for newer credit fund managers, including common differences between the various types of credit funds, as well as between private equity and credit funds generally. Managers considering entering the credit fund market will gain a better understanding of common differences between credit and private equity funds in regard to topics such as return profiles, recycling provisions, carried interest, management fees, conflicts, tax and leverage.
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Michael Doherty: Hello, and thank you for joining us today on this Ropes & Gray podcast. I’m Michael Doherty, a partner in the asset management group, and I'm joined by Jason Kolman, counsel in the asset management group. Today’s podcast is part of a series focusing on issues related to credit funds. It’s no secret that private equity fund managers are increasingly looking to establish a presence in the credit fund space. Today we’ll discuss some considerations that newer credit fund managers should keep in mind, including common differences between different types of credit funds, as well as between PE and credit funds generally. Jason, to set the stage, what types of credit funds are there, and why is it important to distinguish between them?
Jason Kolman: This is a good question because, while you’ll sometimes see articles on trends in “credit funds,” there are a wide variety of strategies included within this umbrella term. At one end of the spectrum are higher-risk strategies such as distressed debt funds, which invest in the debt of companies in or near bankruptcy. At the other end of the spectrum are “safer” products such as senior loan funds, which as the name implies invest in senior secured loans of typically healthy companies. And then you have a range of strategies – mezzanine loan funds, opportunistic credit funds, CLO funds – that typically slot somewhere in between from a risk-return profile.
It’s important to distinguish between types of credit funds because they have very different return profiles due to their different strategies, which in turn will influence terms. For instance, a distressed fund will have a much higher risk return profile than a senior loan fund, and will typically have higher fee and carry terms as a result. In the current environment, when there are so many credit funds being formed and so much competition among managers, it’s critical that managers are using the appropriate funds as benchmarks for what terms and structures are “market.” Mike, to get more specific, how do closed-end credit fund terms differ from traditional PE fund terms?
Michael Doherty: While there is a variation in the terms of different types of credit funds, which we’ll discuss shortly, there are a few important ways in which credit funds generally differ from PE funds. To start, credit funds typically have shorter investment periods and terms, which reflects that their investments tend to be more liquid and have shorter time horizons than a PE fund’s portfolio company investments. So you might see credit funds with four-year investment periods and eight-year terms – these periods are often five-plus and ten-plus years in the PE fund space.
Additionally, as mentioned earlier, credit funds often have broader recycling provisions than PE funds. This sometimes applies with respect to all proceeds, and sometimes only with respect to a return of principal. Since credit fund investments tend to be more liquid and shorter-duration as compared to PE fund investments, the idea is that managers should be able to keep putting proceeds received to work to generate returns. So you’ll often see credit funds where the ability to reinvest mirrors the ability to call capital. Recycling is typically more limited in the PE fund context, where you’re investing in long-term, illiquid portfolio companies and the general philosophy, albeit one subject to some exceptions, is that you only get “one bite at the apple.”
Another difference is that credit funds often make distributions of current income to investors. This is less common in most types of PE funds, which often don’t have steady current income streams equivalent to interest payments on a credit fund’s debt investments. This can be a nice selling point for investors who are concerned about the illiquid nature of closed-end funds, by providing them with at least some measure of interim liquidity. Jason, can you talk about some common differences in the economic terms of PE and credit funds?
Jason Kolman: Sure, For credit funds, return of all capital or European-style waterfall structures, where investors receive a return of all capital plus a preferred return before the GP takes carry, are more common than in the PE fund market, particularly for first-time credit funds and for credit funds that operate more like hedge funds in terms of their investment style during their investment period. By contrast, for PE funds it’s more common to see deal-by-deal or American-style waterfalls, which can provide a manager with carry more quickly if a particular deal is successful. Since PE funds tend to make fewer portfolio company investments, this lends itself to treating each investment as separate for carry purposes, though this often comes with interim clawback and similar mechanisms later in a fund’s life, to ensure the GP isn’t overdistributed on an aggregate basis. By contrast, credit funds generally make more investments than PE funds due in part to their more expansive recycling provisions, which makes a deal-by-deal waterfall a less natural fit and harder to implement from an operational perspective.
Regarding carry rates, you sometimes see lower rates such as 10% or 15% than in the PE fund context, particularly for senior loan and other strategies with lower return profiles. There’s generally more variability in carry terms as well as management fee terms for credit funds, due to the different risk-return profiles of different types of credit fund strategies.
The final distinction we’ll discuss is management fees. For PE funds, it’s common to have fees based on committed capital during the investment period, and then to switch to invested capital. By contrast, for credit funds it’s common to have fees that are based on invested capital from day one. This again reflects the notion that credit funds will typically invest at a quicker pace than PE funds, which may have an extended ramp-up period before they are fully invested. In other words, since credit funds will be invested more quickly, it may be less appropriate to use commitments as a proxy for a certain period. In addition, you tend to see a shift from commitment-based fees to invested capital-based fees as you move from higher returning funds to lower returning ones, and from more PE-style credit investing to more traditional credit investing. The fee rate for credit funds is also often lower, typically between 1-2%, although this depends on the fund’s return profile. Recently, we’ve been seeing that increased competition in the credit fund space has been putting downward pressure on fees, particularly from first-time managers that are willing to offer discounts in an effort to establish a market presence. It’s important to note that investments made via recycling are usually captured in the fee base, and investments made via leverage are sometimes captured although often subject to a cap. So it’s not a given that these differences will result in lower fees in the credit fund space – it’s really just a different construct. Mike, we discussed earlier why it’s important to distinguish between the various types of credit funds. How do their terms typically differ?
Michael Doherty: This is a very complex topic, but as a very general guide, credit funds’ core economic terms are driven primarily by their different return profiles. In particular, distressed debt funds tend to have a higher return profile (i.e. a high-teens IRR) similar to that of buyout funds, and as a result their terms often resemble those of buyout funds – so, for example, it’s not uncommon to see a distressed debt fund with some or all of a deal-by-deal waterfall, a 20% carry rate, and a 1.75% or higher management fee that’s partially based on committed capital. As the return profile decreases, fees and carry will generally decrease correspondingly, with senior loan funds on the opposite end of the spectrum. Any sponsor launching a credit fund should think carefully about where the strategy falls on this spectrum, as this will significantly influence terms and views on what’s “market”. Moving away from terms, there are some common challenges we’ve seen newer credit fund managers encounter as they expand into the space. Jason, can you speak to this?
Jason Kolman: Sure. To start, it can sometimes be challenging for newer credit fund sponsors to achieve a “meeting of the minds” with investors. On the one hand, some investors may be used to obtaining credit exposure through vehicles like mutual funds, which have a much lower return profile and fee structure than private funds. On the other hand, you have first-time credit fund sponsors who have been running buyout funds for years, and who may feel that any departure from a 20% carry, deal-by-deal waterfall is a major concession. So it can really require some recalibration of expectations by both sides.
Conflicts of interest are another significant challenge. As managers expand their product offerings, they’ll face allocation issues, questions relating to how investment team members will allocate their time, and scenarios where different funds could be invested at different levels of the same issuer’s capital structure, to give just a few examples. Managers also often want the flexibility to launch credit-focused separate accounts for investors who want more customization than a pooled investment vehicle, as well as multiple types of credit fund strategies which invest in different levels of the capital structure or which overlap, which can further intensify conflicts. There are other Ropes & Gray podcasts (including What Managers Need to Know and Practical Tips to Avoid Insider Trading Risks, How PE Funds Can Address and Minimize Conflict When Expanding Into Credit, A Framework for Addressing and Mitigating Conflicts of Interest, and How Managers Can Avoid and Mitigate ERISA Conflicts) that have addressed some of these conflict issues in more detail. This is an area of focus for investors and regulators, and will likely only intensify following the SEC’s recent proposed standard of conduct applicable to financial advisers and the accompanying reaffirmation of investment advisers’ fiduciary duties, which emphasize the need for full and fair conflicts disclosure.
Finally, from a tax perspective, credit funds raise complex considerations. In particular, loan origination activity and leverage give rise to ECI and UBTI issues, which sponsors will need to mitigate if they plan to market to non-U.S. and tax-exempt investors. While there are common structural solutions – including “season and sell” funds, leveraged blocker funds and treaty funds – each has its own distinct set of advantages and disadvantages. This is something managers should address early on in the fundraising process with their tax advisers, given the complexity and the importance of the issue to investors. For listeners that are interested, other Ropes & Gray podcasts will address these tax issues in more detail. The final topic we’ll discuss today is the use of leverage. Mike, what’s your experience on how this differs between PE and credit funds?
Michael Doherty: Although it’s common for both types of funds to use subscription facilities, it’s much more common for credit funds to have permanent fund-level leverage. Not all credit funds employ permanent fund-level leverage, but for those that do, it can raise unique challenges. For example, it may be difficult to get some types of common leverage on small or undiversified portfolios, meaning that the size of a fundraise and the pace of deployment, and understanding how this relates to the fund’s return profile, are all important factors. Additionally, certain types of assets may not be eligible for secured facilities, further impacting the ability to achieve leverage targets. Permanent fund-level leverage also raises various issues and concerns to address with investors. However, common types of fund-level leverage are often non-recourse to the fund itself, which can allay some of these concerns. In addition, PE fund investors are often sensitive to subscription facility usage, and may push for certain restrictions on these facilities. These restrictions may make less sense for a credit fund that intends to employ permanent fund-level leverage, and investors may therefore be more open to the use of subscription facilities, for example, until other types of leverage are available.