Due to their long-term investment horizons, US insurance companies historically have been significant investors in alternative assets such as private equity and private credit funds. More recently, making investments in limited partner or similar equity interests issued by such funds can result in significant regulatory capital requirements for insurance company investors. To address this concern and still appeal to insurance company investors, fund sponsors have increasingly turned to issuing both rated debt instruments as well as traditional limited partner interests when launching private credit and other alternative asset funds. These dual-issuance structures are commonly referred to as rated feeder funds or rated note feeders.
Increasing regulatory scrutiny by insurance company regulators such as the National Association of Insurance Commissioners (NAIC) and other developments have altered market practice in key areas and led to an increasing distinction in the rights and obligations of debt holders versus equity holders. In this article, we outline below a number of these key structuring considerations for alternative fund sponsors who are interested in implementing the use of these structures to attract long-term, institutional capital from insurance companies. Many of the typical features of an equity investment in a fund need to be modified from their historical market standard to permit the debt instruments to be classified in a manner that would allow insurance company investors to achieve a capital efficient investment. By leveraging the characteristics and features of structured finance instruments, fund sponsors can develop debt instruments that will continue to attract these long-term insurance company investors.
1. DEBT INSTRUMENTS REQUIRE INTRACLASS PRO RATA TREATMENT
In designing any fund that seeks to issue both debt and equity instruments to investors, fund sponsors should take into account that debt instruments and equity interests operate differently.
It is common for an alternative asset fund (such as a private credit fund) to treat equity investors differently, or to have the discretion to modify key investor rights or obligations, on such matters as voting, fees, distributions and waterfall mechanics. Some investors may be entitled to receive different economic terms such as a reduction in the management fee charged or modifications to the carried interest calculation due to the size of their investment or their relationship to the fund sponsor. Moreover, depending on their status as an affiliate of the fund sponsor or a defaulting investor, certain investors may be subject to additional terms or conditions that limit their right to vote or participate in the returns of the fund. As a result of these variations, a typical fund incorporates flexible capital accounting and other provisions that recognize the differential treatment among investors.
In contrast, debt instruments of the same class are typically treated as fungible instruments, and investors who acquire such instruments are treated on a pari passu basis. As a result, except in certain instances, such as default by the noteholder, the obligation to provide debt financing and the right to take actions against the note issuer (including in the case of a default under the notes) would apply to all holders of the same class of debt instruments.
Therefore, in most rated feeder structures, like a typical asset-backed note issuance, the notes of a class are required to be drawn pro rata among all the debt holders of the same class, whereas capital calls from limited partners can be done on a non-pro rata basis, for example, in order to take into account so-called volume discounts when calling capital for management fees. Moreover, advances made by noteholders to a rated note feeder can be used for any purpose, and noteholders generally do not have an ability to be excused from funding debt financing. In contrast, limited partners typically have the ability to refrain from providing capital to an investment that would violate a law or regulation to which the limited partner is subject. Similarly, a private fund sponsor’s ability to call equity contributions may be restricted depending on whether the contributions are used to make new or additional investments during or after the investment period, or to meet certain obligations such as fees and other liabilities.
2. NO DISCRETIONARY DISTRIBUTIONS TO DEBT INSTRUMENTS
The equity distribution waterfall for a typical closed-ended fund reflects a specific investor’s participation in particular investments and the timing of the capital contributions for purposes of calculating that investor’s preferred return hurdle. Moreover, the timing of distributions for an equity investment can also be subject to a general partner’s discretion. As a result, the amount and timing of performance returns of a particular investor may vary from the returns experienced by other investors who may provide capital contributions with respect to different underlying investments or may be subject to different fees/expense charges.
However, as noted above, debt instruments are fungible instruments such that all debt holders of the same class or tranche are paid at the same time and in the same proportion (relative to their outstanding principal amounts). Thus, debt instruments of the same class have the same stated maturities and interest rate regardless of the issuance date to ensure that debt investors holding the same instruments will achieve the similar economic returns. To meet requirements to achieve the beneficial regulatory capital treatment of the debt instruments, payment of interest on specified payment dates and principal upon maturity or pursuant to a defined amortization schedule should not be discretionary. If a rated note feeder issues debt and receives distributions as a result of its ownership of the master fund equity interest, the feeder will be obligated to pay interest and, following the end of any reinvestment period, principal due with respect to the debt instruments in accordance with a pre-defined and rigid priority of payments.
For a fund that issues both debt and equity instruments, fund sponsors should note that equity investors generally only receive distributions after full payment of the interest and principal due under any outstanding notes. As a result, an equity holder in a rated note feeder may experience returns differently compared to an equity investment in a feeder fund that only issues equity interests, even if both such funds invest in the same master fund.
3. NO REBALANCING OR GIVE-BACK OBLIGATIONS FOR DEBT HOLDERS
Limited partners in a typical closed-ended fund can generally expect to be responsible for paying an “interest” charge to investors who were admitted at earlier closings, which payment would not reduce their future equity funding obligations to the fund. Moreover, limited partners are typically required to fund indemnification obligations and other fund expenses (i.e., the limited partner giveback) for some period of time following termination of the fund.
In contrast, holders of debt instruments generally would not fund more than the amount of the note commitment or provide any financing following the end of the reinvestment period. Other than in connection with the assignment of an outstanding note balance, one noteholder would not make a payment to another. Noteholders would not be expected to return interest or principal payments previously received other than in connection with a new advance for a revolving debt instrument. As a result of the different funding obligations between debt holders and equity holders, fund sponsors should evaluate the impact of such features on the fund’s economics and potential long-term risks regarding indemnification coverage.
4. ADDITIONAL CONSIDERATIONS
As these structures become increasingly popular, fund sponsors should also carefully evaluate how the unique features of debt instruments can affect the operations of the overall fund. Moreover, there are tax considerations that should be closely reviewed, including the potential debt or equity treatment of the notes for US federal income tax purposes, which may affect certain other features of the notes. To the extent that a rated note feeder invests in other types of fund structures, such as business development companies, fund sponsors should also consider taking into account the unique features of such structures in developing the terms of a rated note feeder.
