THE CRED: Your New Private Credit Insights Hub

Originally published May 13, 2024 on dechert.com

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Private Credit and Traditional Banks Forge a New Path

By Thomas Friedmann and Ken Young

As direct lending becomes a more popular financing option for middle-market and large U.S. companies, banks are increasingly seeking new ways to leverage their existing customer networks to participate in the direct lending market. However, because traditional banks have been largely circumscribed by regulators in their ability to participate directly in the leveraged loan market, they have been seeking innovative ways to effectively access this market. One increasingly popular idea is for banks and private credit investors to partner to create a direct lending fund or a platform or other partnership, seeded by financing from both the bank and private credit investors. This approach provides benefits for both parties—banks are able to use their large relationship networks to source new customers for direct lenders, keep loans that do not pass leveraged lending guidelines off their balance sheet, and help customers access another source of funding, while direct lenders gain access to a new client pool for which to deploy their considerable capital.

Recently, Centerbridge Partners and Wells Fargo entered into a strategic relationship focused on direct lending to non-sponsor North American middle market companies, Société Générale and Brookfield Asset Management have partnered to create a private investment grade debt fund targeting a total of EUR 10 billion, and AGL Credit Management entered into an exclusive cooperation agreement with Barclays on the launch of a new private credit investment platform, AGL Private Credit. Through these partnerships and new platforms, banks are able to access the direct lending market through a variety of different structures, including business development companies (BDCs) and other fund vehicles, instead of on-balance sheet lending. 

As banks consider opportunities to play a bigger role in the growing private credit industry, determining the right structure, as well as thinking through regulatory and governance considerations, are vital. Interested parties should consider which structure best fits their goals, including whether a BDC or registered fund may offer regulatory and tax advantages over other vehicles and structures. Parties should determine their ideal capital structure and leverage, including the ideal amount of leverage for the platform and what type of financing will be offered, as well as considering important regulatory and tax issues, including bank regulatory issues, 1933 and 1934 Act issues, distribution issues, and seeding and stakes in connection with anchor investors. Ultimately, partnerships between banks and private credit firms canhelp both parties – as well as borrowers – by giving the private credit firms access to more companies and potential deals while allowing banks to offer their clients access to a new type of financing that wasn’t previously available.

Ultimately, partnerships between banks and private credit firms can help both parties – as well as borrowers – by giving the private credit firms access to more companies and potential deals while allowing banks to offer their clients access to a new type of financing that wasn’t previously available.

Structured Credit and Fund Finance: Rated Funds

In this first episode of the Credit Convos vlog series, global finance partner Lindsay Trapp and Gopal Narsimhamurthy of KBRA discuss the trends driving growth in the rated funds market as well as factors that fund managers should consider when determining their strategies for investing in new asset classes.

SEC Staff Issues New Marketing Rule FAQ on Private Fund Performance

By David Bartels , Michael McGrath and Lindsay Grossman

On February 6, 2024, the SEC staff posted a new Marketing Rule FAQ that will be important to many private equity and private credit managers.  The new FAQ addresses the presentation of net and gross IRR by managers of private funds that use subscription credit facilities. In short, the FAQ:

• States that the presentation of (i) gross IRR calculated from the time of a fund’s investments, together with (ii) net IRR calculated from the time of LP capital calls violates the Marketing Rule if the fund in question utilizes a subscription credit facility;
• Requires a manager that presents gross IRR calculated from the time of investment to also present net IRR calculated from the time of investment; and
• Requires a manager that presents net IRR from the time of LP capital calls to include either: (i) net IRR calculated from the time of investment; or (ii) disclosure describing the impact of the subscription credit facility on net performance. 

SEC staff issued this FAQ to address its concern that a prospective investor will consider the performance experienced by LPs without understanding the leveraging effect of the subscription credit facility.  As background, an IRR calculated across a shorter period of time is higher than an IRR calculated across a longer period of time.  Use of a subscription credit facility truncates the time that an LP has money at work in a fund compared to the time that the fund holds its investments, and consequently the IRR experienced by an LP is higher than the IRR experienced by the fund.  The staff appears to be concerned that the difference could be material in a recent-vintage fund with a short operating history despite the sophistication of private equity investors and notwithstanding that the performance experienced by LPs is likely more relevant to an investor’s understanding of its investment results.

The FAQ applies to every communication that is an “advertisement” as defined in the Marketing Rule, including presentation books, relevant portions of PPMs, and standardized RFP responses, among others.  To comply with the Marketing Rule as interpreted by the FAQ, a manager that presents gross IRR calculated from the time of investments must also present net IRR calculated from the time of investment “with at least equal prominence to, and in a format designed to facilitate comparison with” the gross performance.  Footnote or endnote disclosure generally will not satisfy this requirement.  By contrast, a manager that presents net IRR from the time of LP capital calls must include either net IRR from the time of investment or appropriate disclosures describing the impact of the subscription credit facility on the net performance.

Private credit managers will face challenges meeting this standard.  Unlike a buyout fund that makes a single investment funded by a subscription line and calls capital for that investment from LPs at a later date, private credit managers that utilize subscription lines typically draw on the line to fund multiple transactions without tying capital calls to specific transactions.  Consequently, there is no easy way for private credit managers to calculate net performance based on the time of investments.

The lack of clarity on this topic has not discouraged the SEC staff from citing this issue as a deficiency in examinations, and publication of the FAQ may increase the likelihood that the staff will seek to enforce this interpretation.  Managers that utilize subscription credit facilities should assess whether their practices are consistent with the FAQ and consider any necessary steps to adjust current practices.

Mandatory Prepayment Provisions and Secondaries - Is It a Change of Control?

By David Miles , Phil Butler and Jonathan Groves

In the current economic climate, the disposal of portfolio companies to continuation funds has become one strategy for private equity sponsors to create a liquidity event for some of their investors – this has resulted in the “change of control” provisions in their portfolio company loan agreements becoming an area of increased focus for those portfolio companies and indeed the lenders under those loan agreements.

Typically, a “change of control” is defined in leveraged loan documentation to occur when the Sponsor ceases to directly or indirectly have voting control or economic control of the parent entity of the banking group (or the parent entity of the banking group ceases to hold (directly) the entire issued equity of the borrower (which protects the “single point of enforcement”)).

The occurrence of a “change of control” normally results in all amounts outstanding under the finance documents (including principal and all accrued but unpaid interest under the loan agreement) to become immediately due and payable (or to be capable of being required to be prepaid). In addition, many private credit transactions in the European market include call protection such that if the “change of control” occurs within the call protection period, a prepayment premium would also crystallise and become due and payable at that time.

The inclusion of a flexible (or indeed to some a standard) definition of Sponsor for the purposes of the “change of control” might well result in what some would think should trigger the “change of control” prepayment obligation actually proving technically not to trigger any such “change of control.”

Take Your PIK: Trending Topics for Financing PIK Assets

By Jay Alicandri , Angelina Liang and Edward Newlands

As we see loans with PIK flexibility become more and more prevalent, managers are grappling with optimizing leverage on those assets. There are a plethora of questions and issues associated with financing PIK assets, including –

• Should “PIKable” assets be classified as PIK, or should loans be treated as PIK only if the obligor has actually elected to PIK?
• Should PIKable assets be treated differently based on whether the PIK feature was originally included in the underlying documents or added later by amendment?
•  Should there be different flexibility for full PIK vs. partial PIK?
• Should PIK assets receive more favorable treatment if they satisfy a minimum cash pay requirement?  If so, over what period should the minimum cash requirement be measured?  Should minimum cash be measured including the benchmark, or just the spread?
• Should the value of a PIK asset take into account interest actually paid in kind?
• Should there be a difference in the treatment for these assets under different types of leverage facilities? Compare, for example, some key features in the current treatment of PIK assets under two common types of asset-based financings for asset managers: fund-level corporate revolvers and SPV-level ABL facilities. At fund-level corporate facilities: (i) performing PIK high yield investments and PIK mezzanine investments typically receive a partial advance rate haircut that falls between performing cash pay and non-performing assets of the same type; (ii) PIK bank loans may immediately be treated as non-performing bank loans, which are subject to a steeper advance rate haircut; and (iii) PIK assets may also be subject to additional concentration limits (including, for example, junior, non-core and non-performing caps). At SPV-level ABL facilities: (i) in a facility with a VAE-based valuation construct, an obligor election to PIK or an amendment to the underlying documents to add a PIK feature is often a VAE; (ii) there is often a difference in treatment in the eligibility criteria and concentration limits for different categories of PIK assets, including PIKing vs. PIKable assets, full PIK vs. partial PIK, and assets with minimum cash pay requirements; and (iii) even in a facility with a box-based approval mechanic for certain assets, PIKable assets may still be subject asset-by-asset approval.

The answers to these questions are heavily fact-specific, and vary due to a number of factors, including lender, manager, and type of portfolio.  The Dechert Global Finance Team has extensive experience helping our clients navigate these issues. Please reach out to anyone on the team to help guide you on the latest trends!

Riding the Green Wave: Private Credit and Sustainable Infrastructure in Asia

By Dean Collins and Ong Shaw Shiuan

It is no secret that private fund managers are facing a brutal fundraising market in Asia. Yet, amidst the turmoil, some encouraging bright spots are emerging, one of which is private credit in the green infrastructure space.

Filling a Funding Gap

The need for private credit to support the development of sustainable infrastructure in Asia is driven by a confluence of factors, biggest of which is the presence of supportive institutional policy. Governments in Asia, multilateral development banks (MDBs) and development finance institutions have made significant efforts to bolster investments into sustainable infrastructure. Recognising that public financing alone will be insufficient to meet green infrastructure demands in the region, initiatives have been put in place to crowd-in private capital under the banner of blended finance. In Singapore for instance, the Monetary Authority of Singapore has established the Financing Asia’s Transition Partnership (FAST-P), a blended finance initiative in collaboration with public, private and philanthropic sector partners which aims to mobilise US$5 billion to de-risk and finance marginally bankable green infrastructure projects in Asia.

Against this backdrop, private credit is especially well-suited to address the funding gap. Infrastructure projects are predominantly financed by debt, a significant portion of which had traditionally been provided by MDBs and the commercial banking sector. However, with such banks facing stricter credit environments, it may be that obtaining loans for marginally bankable green infrastructure projects will become increasingly challenging. This shift presents an opportunity for enterprising private credit managers to offer innovative and tailored sources of debt capital to finance green infrastructure projects in Asia.

Key Considerations

Managers who are looking to enter this space should consider the following:

• Fundraising and Capital Structure. A sizable proportion of green infrastructure projects in developing Asia are marginally bankable. As such projects are typically unable to attract private capital on their own merits, raising funds for such projects is inherently challenging. One solution to crowd-in capital is to utilize philanthropy-backed blended finance, which involves interlaying philanthropic funds with private and public capital. As philanthropic funds tend to be concessional and can bear below-market returns, this solution allows managers to leverage philanthropic contributions to mitigate risk and attract private and public capital by offering a cushion that can enhance the project’s financial viability. This blending can be done at the project level, but for greater impact, it is possible to interlay these different forms of funding within the “waterfall” of an investment fund. However, this is easier said than done. From a structural perspective, not only will managers need to figure out the right mix of concessional and commercial capital, they must also consider how to structure the fund’s capital stack to accommodate both philanthropic and commercial investors, each with distinct risk and return profiles.

• Duration. Infrastructure-focused funds tend to have a longer fund life (often upwards of 15 years) compared to traditional private credit funds (around 5 to 8 years). Accordingly, managers need to consider how this timescale affects the fund’s economics structure. For instance, the fund economics may need to be tailored to allow commercial investors, who typically have a shorter return horizon, to extract value earlier from their investments. Internally, managers will also need to consider how their carry incentive scheme should be structured to motivate their team members for the long haul.

• ESG Reporting Requirements. Investors may impose ESG reporting requirements and, to the extent the fund is classified as an Article 8 or Article 9 Fund under the EU Sustainable Finance Disclosure Regulation (SFDR), there will be additional ESG reporting requirements. As lenders have limited ability to influence borrowers, managers need to consider early if operationally they will be able to meet such ESG reporting obligations.

Private credit in the green infrastructure space is an emerging bright spot in Asia as it is key to meeting a large addressable market in the region.

Is the New Irish ELTIF a Good Vehicle for Private Credit?

By Dan Morrissey

The introduction of ELTIF 2.0, and the broad range of investment strategies and eligible investments which ELTIFs can now pursue, is expected to be a game-changer for the private credit industry in Ireland.

The ELTIF (or European long-term investment fund) framework was originally adopted in 2015 with the goal of providing long term finance to the real economy (including in unlisted companies, listed SMEs and infrastructure projects), however its initial iteration had limited success due to a number of different factors, including, but not limited to, restrictive rules on eligible investments.

Now, ELTIFs, particularly those targeted at professional investors, are subject to very few investment restrictions with professional investor ELTIFs (“P-ELTIFs”) only needing to invest 55% of their capital in “eligible investment assets”, and being subject to a borrowing limit of 100% of the net asset value of the ELTIF.

In further good news for private credit managers, Irish ELTIFs are also not subject to any of the local rules or restrictions that apply to other Irish funds that wish to originate loans. This is expected to increase the rate of growth of the private credit industry in Ireland which, pre-ELTIF 2.0, has been slower than that of other jurisdictions due to the additional structuring considerations arising from such local rules.

The universe of ELTIF eligible investment assets is a good fit for a traditional private credit strategy as “eligible investment assets” includes debt instruments issued by a qualifying portfolio undertaking (“QPU”) and loans granted by the ELTIF to a QPU, as well as other categories of assets such as equity / quasi-equity issued by a QPU, other European investment funds, real assets, certain simple, transparent and standard (“STS”) securitizations and European green bonds. ELTIFs may also invest in UCITS eligible investments. The type of entity that can constitute a QPU is similarly broad and suitable for traditional private credit strategies. It encompasses entities established in any jurisdiction (excluding AML high risk and non-cooperative tax jurisdictions), provided that they (a) are not admitted to trading, (b) are admitted to trading but have a maximum market capitalization of no more than EUR1.5bn or (c) are an EU Regulated entity authorized in the last 5 years.

In addition to P-ELTIFs providing an exciting new vehicle for private credit, the ELTIF offers private credit managers the opportunity to broaden their investor base and target retail and high net worth investors by establishing private credit ELTIFs that may be marketed across the EU to these categories of investors (though certain diversification rules will apply to ELTIFs offered to retail investors). The ELTIF also offers managers a pan-European marketing passport for their private credit ELTIFs, for marketing to both retail and professional investors, allowing private credit managers to efficiently access and sell their ELTIF throughout Europe.

Interestingly, the view that the Irish ELTIF will be a good fit for private credit funds is emphasized by the fact that since the Irish ELTIF became available in March, more ELTIFs have been launched in Ireland with private credit strategies than any other investment strategy. Watch this space.

How Customization and Liquidity are Shaping the Future of Private Credit Fund Structuring

By Gus Black , Mikhaelle Schiappacasse and Marianna Tothova

Are you prepared for increasing demand for customized investment structures and greater liquidity?

Recent private credit fund manager research conducted by the Alternative Credit Council and Dechert LLP has revealed a number of significant trends driving change in private credit fund structuring. The study found that 80% of respondents manage capital through a combination of commingled funds and other vehicles. While these commingled structures remain popular, 95% of managers say they now offer managed account structures for single investors, with SMAs being available at a range of allocation levels. Although 44% of respondents stated that they are only able to offer managed account structures for $100 million+ allocations, 51% of respondents offer managed account structures for single investors below $100 million, indicating that there is a high degree of willingness to consider such structures at lower allocations.  

While maintaining these structures entails greater costs for private credit managers, there is growing investor demand for tailored investment structures. Private credit managers acknowledge that it’s strategically important to be able to meet this demand.

Liquidity is another area of product design where practices are evolving: 48% of respondents expect investor demand for liquidity to increase. These demands can be met with continuation vehicles or fund structures such as evergreen or hybrid structures (typically combining elements of open and closed-ended structures). These structures offer benefits to both investors and asset managers. For investors, these structures can provide important efficiencies that improve their returns (for example, by permitting investors to remain fully and continuously exposed to the strategy over a longer period) and offer them more control over their capital allocations to private credit strategies. For asset managers, well-designed evergreen structures help strengthen their relationships with investors and provide them with a more permanent and renewable source of capital to pursue their investment strategies.

Key Issues To Consider Now

1. There is no one-size-fits-all approach to private credit fund structuring – managers need to be prepared to offer investors customized way to execute their investment strategy.
2. Evergreen/hybrid structures can be an attractive solution for both investors and asset managers alike but any liquidity and flexibility that can be offered remains limited by the liquidity profile and ease of exit from the underlying asset.

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