Private debt funds have made impressive progress in alternative investments for years. With assets under management (AuM) of around $700b (as of October 2018), private debt is still far away from AuM we see in private equity ($3.1tn). However, the steady rise in fundraising suggests that private debt may one day catch up with private equity. Based on market analysis by data provider Preqin, the AuM of private debt fund is expected to double within five years, ie by 2023. Prominent market leaders (eg David Rubenstein, founder of the Carlyle Group) even expect the volume of private debt to outperform the private equity asset class in the medium to long-term. Institutional investors are increasingly seeking access to private debt funds, but often have to deal with regulatory and tax pitfalls.
Investments in private debt funds are attractive for many reasons. They offer stable returns that are higher than those of conventional bonds. They have a different risk profile from listed equities and bonds with a low correlation and are considered a relatively safe investment. The long existing low interest environment has only added to the attractiveness of private debt as investors look for higher yield.
Private debt funds are generally closed-end funds that pursue various investment strategies. A distinction is made between direct lending/senior debt, mezzanine and special situations strategies. All issue (‘originate’) non-listed (and thus private) debt instruments. While direct lending/senior debt funds grant senior secured loans to portfolio companies, mezzanine funds specialise in investments in subordinated mezzanine instruments (eg subordinated loans, warrants, equity kicker etc.). Special situations funds, on the other hand, focus on debt investments in portfolio companies that are in economic distress or in a critical turnaround situation.
As part of the due diligence process, investors must not only perform a customary review of the contractual terms and conditions of the private debt fund in question, but also look for legal and tax pitfalls associated with an investment in private debt funds.
Regulatory requirements for institutional investors
Many institutional investors have to comply with regulatory requirements when investing capital. Larger insurance companies have to adhere to Solvency II rules, which generally require detailed reporting and analysis of the underlying instruments (the ‘look through approach’). In Germany, small insurance companies and pension funds (among others) are subject to a different set of rules: the Insurance Supervision Act (Versicherungsaufsichtsgesetz, ‘VAG’) and the Insurance Ordinance (Anlageverordnung, ‘AnlV’). An updated Capital Investment Circular (Kapitalanlagerundschreiben) issued by German regulator BaFin at the end of 2017 brought new regulations, but not necessarily the wished-for clarity for investments in private debt funds.
According to the Insurance Ordinance, investments of so-called guarantee assets (Sicherungsvermögen) are only allowed within certain limits. A distinction is made between certain fund categories. Within the scope of the ‘participation quota’ (15 per cent of the guarantee assets), an investment in funds that invest in equity-like or ‘other instruments of corporate financing’ is permissible (§ 2 para. 1 no. 13b) AnlV). According to the official explanatory statements for the AnlV, private debt funds with an active debt strategy may also fall under this category. The prerequisite is that the activity is not limited to simple credit management, but that each granting of a loan is individually examined and monitored. These funds do not limit the investment risk by passive diversification, but rather by active portfolio management (in particular due diligence, monitoring, granting of contractual rights, covenants).
Uncertainties exist, however, due to the new BaFin Circular, which specifies the AnlV in greater detail. Its intention is to continue the previous practice of the supervisory authorities. With regard to the question of whether granting loans shall be considered a permissible activity under the requisites of the AnlV, however, the BaFin Circular focuses on the target companies of the fund and not on the fund itself. According to the BaFin Circular, a classification of a private debt fund under No. 13b) could be considered if the fund invests in companies whose activity is not limited to simple credit management, but which individually examine and monitor each granting of loans. However, there is no mention of (active) lending by the fund itself. This is systematically not in line with remaining article No. 13b), as such article refers solely to the fund level (rather than the portfolio company level).
In our view, it should therefore only matter whether the fund itself pursues an active entrepreneurial strategy in relation to corporate financing. This would apply to most private debt funds, including many with senior debt strategies. At the moment, the unfortunate wording in the BaFin Circular leads to a bit of uncertainty in practice. If an investment is not permissible under No. 13b), an investment may (only) be made as an ‘alternative investment’ pursuant to No. 17 AnlV. This, however, triggers additional burdens: Funds and fund managers must be domiciled in an European Economic Area (EEA) State and managed by a manager that is fully regulated under the EU Alternative Investment Fund Managers Directive. By contrast, No. 13b) also permits participation in United States funds and mere registered fund managers. It is therefore important that these ambiguities will be resolved in the near future as certain institutional investors may be hesitant to invest in private debt funds outside the EEA. Until then, a detailed regulatory case-by-case assessment will be required for investments in private debt funds.
US trade or business income (ECI) from participation in US private debt funds?
Beside regulatory pitfalls, tax consequences must also be considered, whether domestic or foreign – in particular if the target fund is a private debt fund located in the US. Given that many private debt funds have a US focus (68 of the largest 100 private debt fund managers are based in the US), this is of significant practical relevance. In particular, it must be examined whether the investment generates income effectively connected with a US trade or business (ECI) for non-US investors. Potentially, this could trigger tax (filing) obligations of the investor in the US and add considerable procedural and cost expenditure. This is in particular relevant for senior debt/direct lending funds that grant senior secured loans. Depending on the structure of the fund and nature of activities, this may also involve a bank-like commercial activity (loan origination) which may trigger ECI for non-US investors. In practice, various possible structuring solutions have been developed to minimise additional tax burdens due to ECI. In each case, it must be examined which structuring option is preferable (e.g. season-and-sell structures, use of Irish ICAVs etc.).
Private debt funds are an interesting asset class for institutional investors. Despite all the attractiveness, investors have to bear in mind the legal and tax peculiarities of this asset class. These challenges, however, can be mastered with internationally experienced advisors at your side.
This article first appeared on the website of the Investment Funds Committee of the Legal Practice Division of the International Bar Association, and is reproduced by kind permission of the International Bar Association, London, UK. © International Bar Association.