Credit funds: hybrid and other evolving structures

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Stephanie Breslow’s practice covers liquid fund strategies (including hedging) and private equity, and often strategies at the intersection of the two: credit, litigation finance, activism and blockchain assets, where skills and hybrid knowledge – as well as several other expert practices within the company – come into play. Breslow is a partner at Schulte Roth & Zabel who is co-head of the investment management group and a member of the company’s executive committee .

Credit funds have become “the new banks” since the 2008 crisis, as traditional banks lent less and a non-bank lending industry flourished. Strategies range from mezzanine credit funds with lower risk and return objectives, to loan origination funds and distressed debt funds that engage in non-performing loans, and to entities entering or exiting processes. insolvency or bankruptcy. Specialized credit funds can focus on areas such as litigation financing or life settlements, also known as vii settlements. CLOs (Secured Loan Bonds) containing business loans are all the rage again, and in fact anything that has recurring cash flow like student loans, credit card loans, auto loans, etc. aircraft rentals, film or music rights, can be securitized.

Although a variety of credit strategies have mushroomed, it has been difficult for some funds to raise assets as compression of returns reduces their returns while strong stock markets also make comparisons difficult. A market dislocation could increase the opportunities offered to certain credit strategies, allowing them to earn higher interest rates and increasing the supply of distressed opportunities.

The question is how investment vehicles should be structured to capitalize on these opportunities while aligning interests between managers and investors and mitigating conflicts of interest. Managers should choose a law firm that understands credit and knows the unique characteristics and differences that apply to closed-end private equity, liquid evergreen funds, and hybrid structures.

Structuring choices

Breslow, who was featured in the Hedge Fund Journal’s “50 Leading Women in Hedge Funds” report in association with EY, recalls how, “even before the crisis, some credit fund managers proposed investment strategies focused on credit in different vehicles to meet investment needs. preferences. A hedge fund style variable capital structure with periodic liquidity has been offered to some investors while others have opted for a private equity style closed end fund. Side pockets were used to hold less liquid credit instruments within the evergreen structure, creating flexibility. “

“Over time, credit fund structures have increasingly adopted a hybrid approach in which a single credit fund vehicle can now contain elements of both hedge fund and private equity structures. This makes sense because credit funds that do not invest in freely tradable credit instruments are halfway between private equity and hedge funds. They don’t have typical five- to ten-year private equity holding periods with no market prices, nor do they have assets that can be sold in a matter of weeks. Instead, they can hold level three assets, valued by pattern marking, which can typically be liquidated in two or three years.

“Preferences vary between managers and strategies, but overall, credit hedge funds that do not reverse into freely tradable instruments have drifted into overflowing private equity and / or co-investment style structures. . They can, for example, choose a closed hybrid structure that has a fixed investment term, uses capital, and charges performance fees above a minimum rate of return, but which also contains aspects of hedge fund models, such as than commission calculations based on net asset value rather than cost, and “soft locks” allowing intermittent redemption opportunities, possibly at a discount. ”

Co-investments and side pockets

After the financial crisis, investors in open-ended funds were less accepting of side pockets. As a result, fund sponsors who previously ran credit strategies using open-ended funds with a side pocket allowance had to think of other ways to manage their less liquid investments. This has led some managers to create sidecar vehicles with private equity structures, or one-off co-investment vehicles, to hold concentrated or otherwise illiquid positions.

Separating less liquid investments in their own vehicle can provide more scalability than funds can with side pockets only. “The caps on the size of the side pockets at the fund level were often full and could easily be reached if redemptions lowered the denominator, as there was no redemption from the side pocket. This deprives new investors of the opportunity to invest in less liquid opportunities, ”Breslow explains. Another reason is that “investors prefer to wait on the sidelines until good opportunities are found, without paying a fee on the dry powder. A classic hedge fund structure may not be ideal for such opportunistic vehicles, as it would charge a fee on unused cash, whereas a private equity style or co-investment vehicle would rarely charge for committed capital. ”

Distressed credit strategies thrive during market disruptions, but may experience yield problems and a lack of attractive investment opportunities during times of market stability. To attract investors to these strategies in a timely manner, “some funds have set up opportunistic drawdown structures which can come to life as broad-based or idiosyncratic investments are identified.”

Breslow notes that “Private equity or co-investment type vehicles will tend to have a rate of return trigger for performance fees, typically around 8% with catch-up, whereas hedge fund strategies often don’t. than a high point. But it varies by strategy, and a lower octane mezzanine debt fund is unlikely to charge a performance fee above 15%. “Beyond that,” larger funds may also have lower management fees. Discounts may be offered for one or more of the following: Early Bird Founders Course, larger investments, or longer lockouts. Expenses other than fees have not changed much, although care should be taken to determine whether the items are properly charged as fund or management company fees.

Conflicts of interest

Indeed, fees are a possible flashpoint for conflicts of interest, which can also arise when managers have different products or strategies that can invest in different parts of the capital structure, such as a more or less senior paper. . Sometimes this is intentional because a fund has a higher or different risk mandate. Sometimes this can even be an accidental function of cash flow timing issues that force a fund to buy a particular issue just because it can’t get hold of the same paper as a sister fund. Unlike public stocks, which typically only have one or two classes of shares, corporate bond markets can offer hundreds of issues and ISINs from a single issuer. Sometimes a fund can hold stocks and other credit. Another controversial issue is the ownership of the safety hub, which holds the key to controlling rights in difficult situations (and which can also change over time).

“There is no perfect solution to managing and mitigating these potential and actual conflicts of interest, but transparent disclosure is the absolute minimum that regulators and investors expect from managers. Regulators may also look favorably on the Investor / LP approvals sought in these situations, but in fact, regulators do not provide the most prescriptive advice. Other options include establishing policies on the types of paper purchased by different funds, or on how to prioritize funds between funds; one possible criterion, although imperfect, for doing so is to favor the highest position. Policies can also be developed on voting when a fund has a position on a creditors committee. “

“Some funds use an advisory board or other hired independent party to act as an arbitrator, and others will seek legal advice. A general rule of thumb is the “arm’s length” approach: general partners should act for each fund as they would if the counterparty were a third party rather than another fund managed by the same general partner. »THFJ

First published in The hedge fund journal.

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