Relevant nuances of a credit fund’s structure

When structuring any fund, the same questions need to be asked. For instance: What is the strategy? Who are the likely investors? Does the fund sponsor and/or the key investors have a preferred fund domicile? In what jurisdictions are the investors, assets and manager/adviser likely to be? What is the liquidity of the underlying portfolio (and to what extent should the liquidity terms offered to investors reflect it)? Is carried interest structuring required? 

For private credit funds, extra time and attention needs to be given to the questions relating to the liquidity of the underlying loans and the liquidity provided to investors (open-ended, closed-ended or somewhere in-between); upstream structuring (such as blocker vehicles above the fund); and downstream structuring (such as securitisation vehicles and/or SPVs beneath the fund vehicle).

1.     Open-ended, closed-ended or ‘hybrid’?

Open-ended funds allow new investors to come into the fund on a regular basis and investors can redeem/withdraw on request (subject to the fund’s terms). The classic hedge fund structure is open-ended.

Closed-ended funds permit new investors to come into the fund at the beginning of the fund’s life (via one or more closings) and investors generally have no redemption rights. These funds generally have a fixed life. The classic private equity fund structure is closed-ended.

Private credit funds are much more likely to be hybrids. They either start with the open-ended fund structure and add closed-ended fund features or liquidity management tools (e.g., side pockets and gates) or they start with the closed-ended fund structure and add open-ended features or liquidity options (e.g., tranches). Hybrid private credit funds that permit new investors to come into the fund on a regular basis are sometimes referred to as “evergreen” funds.

In our experience, investors are quite markedly split between those who prefer private credit funds to be closed-ended and those who prefer hybrid private credit funds.

2.    Upstream and downstream structuring

Both upstream and downstream structures are largely driven by tax issues. For example, upstream structuring can be used to mitigate the exposure of non-US investors to Effectively Connected Income (ECI) relating to US originated loans.

Downstream structuring can get complicated. One goal will be to reduce the rates of withholding tax on interest payments (e.g., by accessing treaty benefits) but downstream structuring can also be used to (i) shift tax filing responsibilities away from the fund vehicle and its investors, (ii) facilitate leverage and its related security, (iii) ring-fence liabilities, (iv)  facilitate re-investment, and (v) reinforce and support the liquidity offered to investors.

A key consideration for structuring a credit fund relates to the fact that lending (and often acquiring existing loans) could be regulated in the borrower’s jurisdiction, requiring strategic consideration to determine which entity in the structure is permitted to be the lending entity.

Credit funds as borrowers under subscription-secured facilities

As with any subscription-secured facility (a Subline), a lender’s recourse will be against investor uncalled commitments, rather than the fund’s assets. The lender will be looking up the fund structure rather than down for its collateral, the asset class of the fund is not relevant to the collateral package. However, the structure of the fund is dependent upon the asset class and the fund’s structure with respect to the type of fund vehicle used, its jurisdiction, and whether it is open or closed-ended is relevant to the structuring of a Subline. 

A Subline is structured around the mechanics of a fund structure so as not to disrupt the operation of the fund. Lender’s counsel will identify at due diligence stage whether the fund is closed-ended, open-ended or a hybrid. The limit on the amount that can be borrowed under a Subline is calculated by applying advance rates against different designations of investors dependent upon the creditworthiness of such investors. This ‘borrowing base’ will fluctuate to account for new investor closes, as well as any events that could negatively impact an investor’s creditworthiness or lead to the investor exiting the fund. If an event were to occur that negatively (and materially) impacts the investor’s creditworthiness, the investor defaults in its payment obligations to the fund, or the investor transfers, redeems or otherwise disposes of part or all of its ownership interest, the uncalled commitment of the investor relating to the interest affected will be excluded from the borrowing base calculation (Exclusion Events). 

An investor’s request to be redeemed in an open-ended or hybrid fund structure would be classified as an Exclusion Event. Due diligence will also reveal if there is a ‘queue’ system in place in relation to calling on investor commitments, i.e., the fund can start calling on investors that came in through a later close only once investors in prior closes have fully funded. If calling on newer investors is contingent on first close investors having fully funded, there can be an impediment to including the uncalled commitments of newer investors in the borrowing base unless specific wording disapplying this queue system in relation to calls made by creditors is included in the fund’s constitutional documents.

Redemptions impact the borrowing base, so representations should be provided by an open-ended or hybrid credit fund borrower under a Subline regarding redemption requests received to date, as well as undertakings to provide copies of redemption requests to the lender. If satisfying a redemption request would cause a borrowing base breach, a mandatory prepayment will be triggered. Where a fund borrower is structured to allow redemptions, an event of default will often be triggered in the Subline if a number of investors representing over a certain percentage of aggregate commitments request redemptions within a certain timeframe.

The above-mentioned protections are relevant to any borrower structured as an open-ended, or semi open-ended, fund which allows redemptions (which may include credit funds), rather than specific to credit funds as an asset class.

Credit funds as borrowers under net asset value (NAV) facilities

In contrast to subscription-secured facilities collateralised by uncalled commitments, in NAV lending, a lender instead looks to the assets of the fund and the cash flows, distributions and other amounts received in connection with the fund’s assets as the main collateral for the loan. 

NAV financing to credit funds (also called back-leverage or loan-on-loan financing) is typically utilised alongside other tools and products available to such funds as a long-term leverage approach to optimise its liquidity position and allow the fund to originate a higher number of generative assets.

Security structures are bespoke but typically consist of one, or a combination, of (a) security over shares or other ownership interests of a holding company between the fund and the underlying assets that will often be the borrower of the NAV facility, and (b) security over the accounts into which distributions from portfolio companies are paid, thereby capturing the value to the fund of both the portfolio as a whole, and the cashflows up from the portfolio.

NAV lenders must diligence the portfolio assets and fund documentation and carefully review the distribution flows (with a goal of taking account security as close as possible to the source of the distributions). Recourse on NAV facilities to credit funds is to the portfolio of loans owned by such funds. The value of portfolio assets that the lender deems valuable and stable enough to underwrite operates as a borrowing base to determine the size of the NAV loan available. Whether a lender includes such loans in its borrowing base will depend on whether such loans meet certain eligibility criteria, including: whether the loan is performing, the loan currency, how often interest is payable, that it’s a term loan rather than a revolver, that it does not contain any restrictive confidentiality wording etc. Where the portfolio is highly diversified, concentration limits may also apply in order to prevent the lender from being overly exposed to a particular type of asset. 

Lenders will usually require liquidity tests, portfolio interest coverage ratios and other financial tests depending on the portfolio/strategy of the fund. Diversity measures may govern the advance rate and a number of collateral quality metrics (e.g., the minimum weighted average spread of the portfolio). In some facilities, cash sweeps and loan-to-value tests are included with the intent of bringing stakeholders to the table when early warning signs appear, to avoid default. These early pre-default triggers could result in amortisation payments or initiation of a plan to cure specific breaches. 

As with any NAV facility, a NAV financing provided to a credit fund is a bespoke product with no ‘market standard’. Points to consider when providing a NAV facility to a credit fund include (i) which entity is the originator of the underlying loans? Is this the same entity as the borrower, and if so, does that entity hold the loan for the entirety of its term or sell down to another entity? and (ii) is there a separate ‘servicer’ entity that would be responsible for enforcing the provisions of the underlying loans? These are important points for a lender to consider at due diligence stage when determining which fund entities need to be party to the NAV financing. 
 

A Subline is structured around the mechanics of a fund structure so as not to disrupt the operation of the fund. Lender’s counsel will identify at due diligence stage whether the fund is closed-ended, open-ended or a hybrid.