The Hidden Complexities of Private Credit
Private credit structures and their terms are complex. Legal documents need to align with operational execution and reflect an understanding of the intricacies of the private credit instruments.
Demand for private credit strategies continues to grow as investors seek alternative sources of yield and higher returns than what public credit currently offers. The pandemic-driven economic fallout has impacted many small to midsize businesses, forcing them to find alternatives to traditional commercial banks. In essence, 2020 has created a perfect match of investor demand and a need for alternative lending options, resulting in doubling the size of the asset class.
At Socium Fund Services, private credit strategies now represent approximately one-third of our client base, up from 20% at the end of 2019. This trend favors service providers who are structurally capable and experienced in servicing the asset class as they can help fund managers avoid the many pitfalls that can reside within private credit structures.
Closed-end versus evergreen private credit fund structures
There is market demand for private credit funds. However, they are challenging to administer correctly.
With both closed-end and evergreen fund structures, a fund administrator needs to possess three things:
- Industry knowledge to ensure the operating documents are understood thoroughly
- Technology (not Excel) that has flexible enough programming to handle both closed-end and evergreen fund structures
- The ability to predict future needs and issues
It is the last item that costs funds much more than they expect and where an experienced fund administrator can add tremendous value.
Closed-end fund structures operate similarly to traditional private equity fund structures. As with private equity, the private credit General Partner (“GP”) secures capital commitments from Limited Partners (“LPs”). The GP will raise a specified amount of capital for the initial close. After the initial close, LPs who demonstrate an interest in the fund will not be permitted to invest until the manager raises additional capital and the fund holds a subsequent closing.
Subsequent closes are the points at which the potential complexity of managing a private credit fund creeps in. The amount of disclosure required in the offering documents can be dramatic versus a traditional private equity fund as the documents need to address all of the possible circumstances over the fund’s life. GPs of closed-end funds must understand the downstream impact of accepting investor capital during subsequent closings, which should be clearly outlined in the fund’s offering documents. The life cycles of private credit funds, by the design of the type of investments, tend to be shorter than the life cycles of private equity funds. Therefore, the investment periods and harvesting periods, and the compensation related to both, need to be thoroughly understood before GPs accept subsequent investor capital.
As a result, the waterfall calculations, for all investors, also become more complicated. An alternative to distributing profits upon each realization (some of which may come quickly depending on the duration of the investments), a growing number of private credit managers are exploring evergreen fund structures. If they elect an evergreen fund option, they may choose to call 100% of the committed capital upfront to avoid the complexities of combining capital calls with the funding of investments with “recycled” capital and realized gains.
Evergreen private credit fund structures offer their own complexity. Fund documents often include significant language around redemptions and gating (limiting the amount of redemptions at a point in time) and the ability for investors to receive distributions of securities versus cash. Furthermore, liquidating trusts (or similar accounts) are often created as vehicles for LPs to receive funds as the trust assets are liquidated.
Although private credit evergreen fund structures appear to offer more flexibility on the surface, they introduce several intricacies with strict fund terms. GPs, LPs and the fund administrator need to understand how the subsequent events impact the liquidating trusts and the ongoing responsibilities of the redeeming investor.
Therefore, the closed-end model continues to dominate private credit funds.
Downstream operational impact of fund terms
The accounting considerations of private credit securities become more involved when fund vehicles are formed. Outlined below are key considerations to be mindful of before finalizing the fund entity structure and offering documents.
1 | Does the fund accept non-U.S. investors?
Non-U.S. investors can add additional complexity to private credit funds because direct lending is considered a U.S. trade or business. Therefore, the Effectively Connected Income (“ECI”) generated by the investments is associated with the United States and negatively affects non-U.S. investors from a tax perspective. If the GP plans to accept capital from non-U.S. investors, it is critical to set up a blocker vehicle when structuring the fund to prevent foreign investors from needing to file a U.S. tax return. For this reason, most private credit funds, both closed-end and evergreen structures, incorporate a corporate blocker to “trap” the ECI.
GPs have the flexibility to season and sell structures, so offshore investors may buy loans as a secondary purchase and are therefore not involved with direct lending. This treatment creates different performance returns for onshore investors versus offshore investors, as the offshore fund vehicle may not participate in the upfront fees earned in connection with the direct lending (e.g., origination fees). The “season and sell” complexities extend beyond the structure itself. Written policies and procedures are required to avoid potential conflicts in unfair treatment of the two investor sets.
2 | Does the fund’s valuation policy address the intricacies of private credit securities?
The valuation of private credit securities is complex. Loans with upfront fees and or backend fees or “kickers” can make valuation difficult. This is especially true with the effective interest method of amortization deployed on the upfront fees, which are categorized as an Original Issue Discount (“OID”). This interest needs to be accreted over the life of the loan, which is often not done in practice.
Additionally, the method and frequency of valuations need to be thoroughly evaluated to avoid complications as the fund ages. Similar to coupons, there could be arbitrage on the valuation if the GP is valuing the loans at anything other than cost. This mainly comes into play when subsequent investors enter the fund.
3 | Do any of the fund’s investors have Side Letter agreements?
Side letters can intensify complexity as well. More often than not, institutional investors are investing on their own terms. The traditional 2% management fee and 20% performance fee model has evolved into an environment of bespoke terms and more investor-friendly fee arrangements. Technology is vital to recording and maintaining these individualized terms. The ability to systematically record fee terms at the investor level, as opposed to the fund level, can alleviate the inherent issues in Excel-based carry models.
Experienced Fund Administrators Add Tremendous Value from Day One
An experienced fund administrator can be the backstop, the second set of discerning eyes, on a fund’s offering documents and fund operations, ensuring proper accounting and operational considerations are being executed. It is vitally important that the fund administrator is involved in the practical review of the fund offering documents to prevent costly mistakes. For example, how subsequent closes are handled after a fund has already started to make income distributions can add extreme complexity if not addressed correctly in the Limited Partnership Agreement.
Confirming the fund administrator has the experience to foresee the issues and the potential conflicts that could arise down the road are highly recommended. A seasoned fund accountant will deftly navigate the challenges of investor opt-outs, partner allocations, distribution details, carried interest waterfall calculations and all of the many other complexities that can arise with private credit funds. Flexibility and forethought into how the books and records of the funds are set up are critical.
It is essential to partner with a fund administrator who offers the operational infrastructure that is required for private credit. Institutional investors who are committed to private credit funds expect a robust infrastructure and often review the fund manager’s and fund administrator’s systems, processes and procedures during operational due diligence. They require transparency, which begets credibility in our industry. Fund administrators who properly service private credit funds have invested in the systems needed to effectively track unlimited loan-level data and report the information through visualizations in an LP/GP web portal.
In this case, as with most, the initial investment in time outweighs the cost of creating additional work later.
Outsourcing the operations of private credit fund structures to an experienced fund administrator can add tremendous value. When selecting a firm to partner with, ensure they have experience administering private credit fund structures and the technology to support the strategy. Ultimately, the fund administrator should provide you with confidence that the portfolio is being maintained accurately and that your investors receive the reporting and transparency they need. Equally important, the right fund administration partner will allow you to efficiently scale your fund operations, provide data protection and cybersecurity, and give you access to invaluable expertise.
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