Closed-end private investment funds that focus on credit investments share structural similarities with traditional private equity funds but, rather than investing in equity, typically invest in various illiquid and hard-to-value credit instruments. In recent years, the number of credit fund managers has increased dramatically as traditional lenders reduced their lending activities and institutional investment managers diversified their strategy and fund-type offerings. As more managers sponsor private credit offerings, distinctions between private equity fund terms and private credit fund terms, while continuing to evolve, have become apparent to market participants.
In this Report, we: (I) identify common private credit fund strategies; and (II) present a comparison of private credit funds and private equity funds.
I. Private Credit Fund Strategies
Common private credit strategies implemented include: (A) direct lending, (B) opportunistic/special situations, (C) distressed credit, (D) structured credit; and (E) specialty finance. Certain of these investment strategies focus on producing income and others on capital gains, and fund terms vary as a result. For example, funds pursuing income-producing strategies, particularly direct lending, frequently provide for distributions of current income derived from investments (e.g., loan interest and fees) throughout their terms. Funds pursuing capital gains-producing strategies, on the other hand, drive returns through equity-like gains and recovery in debt prices, and, as a result, tend to provide distributions only following capital events.
II. Comparison of Certain Features of Private Credit Funds and Private Equity Funds
Private credit fund sponsors have developed fund structures primarily by re-purposing traditional private equity fund structures, such as those used to make leveraged buy-outs, real estate and similar illiquid investments. As a result, they share certain structural similarities with traditional private equity funds. For instance, both types of funds:
- solicit capital commitments and then call capital only as investment opportunities within the fund’s mandate arise;
- have initial closings and typically one or more subsequent closings for a limited period (typically 6 to 12 months);
- have investment periods during which investments are made and a harvest period during which investments are realized;
- provide carried interest to the manager or its affiliate as investments are realized through a “waterfall” mechanism; and
- lock-up limited partner capital for the life of the fund.
Taking these basic structural features as a starting point, private credit funds have evolved, leading to several key differences, driven primarily by the nature of the assets in which these funds invest. Among private credit funds, furthermore, features and terms vary based on, among other things, whether they pursue income-producing or capital gains strategies, the duration of investments, liquidity of investments, investment pace and whether a fund utilizes leverage. In the following discussion, we focus on the mechanical distinctions between the two types of funds associated with subsequent closings, recycling of capital, the use of leverage and management fee provisions.
A. Subsequent Closings
In both private equity funds and private credit funds, generally limited partners investing in a subsequent closing (i.e., a closing after the initial closing for interests) “buy in” to the existing portfolio of investments by contributing capital in an amount equal to what they would have contributed to the fund if they had invested at the initial closing, plus an additional interest payment for the benefit of the earlier partners to compensate them for bearing the cost of financing the investments during the period before the subsequent closing.
In traditional private equity funds, the subsequent closing partners typically participate in distributions (usually the result of a capital event) made to partners prior to the date of the subsequent closing, providing them the same investment exposure that they would have had if they invested in the initial closing. Conversely, a manager of a private credit fund that invests in income-producing assets must weigh a number of considerations when determining whether to provide for subsequent closing limited partners to participate in income generated prior to the subsequent closing. While most private credit funds adhere to the traditional private equity buy-in model, many funds have implemented other approaches, such as distributing income accrued prior to a closing to existing partners.
If subsequent closing limited partners participate in income produced prior to a subsequent closing, a prospective subsequent limited partner could take advantage of, or be disadvantaged by, the difference between the expected income from the fund’s investments and the additional payment owed to the earlier partners. For example, assume that a private credit fund provided for an additional payment paid by subsequent limited partners to earlier limited partners of 8% per annum and made direct loans with 10% expected interest rates. If a subsequent closing limited partner participated in income generated prior to the subsequent closing in which it invests, the limited partner would benefit from the difference between what was required to be paid to earlier partners at the time of the subsequent closing and the expected investment return to the detriment of the limited partners participating in the earlier closing. Moreover, as a result of this arbitrage opportunity, prospective limited partners would be incentivized to delay their commitment to the fund, potentially harming the manager’s fundraising efforts.
A manager could eliminate this arbitrage opportunity by providing that subsequent closing limited partners not participate in income produced prior to the subsequent closing, and instead allocate and distribute that income solely to the partners invested prior to the closing. However, doing so requires that that income be tracked separately for the life of the fund, which may be administratively burdensome, particularly if that income is later reinvested (see subsection B.-“Recycling” below). A manager would also need to consider the appropriateness of requiring subsequent limited partners to pay (i) an additional payment to the earlier closing partners and (ii) management fees for the period prior to the subsequent closing, as the subsequent closing limited partners would not have participated in income generated prior to the subsequent closing.
Many private equity funds provide the manager the ability to reinvest, or “recycle,” certain amounts that would otherwise be distributable to limited partners during the investment period. Often, the principal from prior investments may be recycled, but amounts representing profits must be distributed. Private credit fund managers, on the other hand, particularly funds that pursue capital gains strategies and have shorter investment periods than private equity funds, are more commonly provided with greater flexibility to reinvest and are often permitted to recycle both the principal and any profits or income from an investment during the investment period. Some private credit funds have separately defined reinvestment periods, which are shorter than investment periods, during which the manager is afforded greater flexibility to recycle capital.
Both private equity and private credit funds frequently utilize subscription financing facilities with limited partners’ undrawn capital commitments serving as the lender’s security interest to bridge capital calls. However, unlike most private equity funds, private credit funds-particularly funds originating senior, secured loans-are often permitted to utilize some amount of leverage, secured by the fund’s assets, as part of their investment strategies in an effort to enhance returns. These funds often have leverage limitations reflected as a percentage of aggregate capital commitments, cost or value of fund investments or a combination of these approaches.
D. Management Fees
Private equity funds typically charge each investor a management fee during the investment period equal to a specified percentage of the fund’s total capital commitments. Following the investment period, private equity fund management fees are typically based on invested capital or the cost basis of then-held investments. While some private credit funds utilize this traditional approach, management fee provisions among private credit funds vary significantly. For many private credit funds, particularly those investing in more senior assets, management fees are based on the cost basis, or sometimes net asset value, of investments held by the fund both during and following the investment period. Other private credit funds utilize a blended approach where a fee (at a lower rate) is charged on both capital commitments and the cost basis (or net asset value) of investments.
Although a committed capital management fee base may be viewed more favorably by managers, since the entire amount of the commitment will serve as the management fee base even if the manager has called a fraction of the committed capital, a management fee on the cost basis of investments or net asset value may not be as disadvantageous as it would seem, and, in fact, can be more manager-friendly in certain circumstances. First, private credit fund managers tend to call capital from limited partners at a more rapid pace than private equity fund managers, minimizing the early advantage of the capital commitment approach. Second, for funds that permit recycling of principal and interest, as proceeds from the sale of investments or the receipt of income are reinvested, invested capital or net asset value may be higher than aggregate capital commitments in a relatively short period of time following the initial closing causing a manager to be entitled to a fee based on a higher amount than from the capital commitment model.
Invested capital or net asset value management fee bases have the potential to be even more manager-friendly in credit funds if the provision is drafted in a manner permitting fund-level leverage to be included in the management fee base. While an investor may argue that including leverage in the management fee base unacceptably incentivizes a manager to cause a fund to take on leverage, from the manager’s perspective, including borrowed amounts in a management fee base may serve as a better proxy for the manager’s cost in managing a larger portfolio. As a result of this issue, limited partners sometimes seek to negotiate caps to the management fee basis when it is based on invested capital or net asset value.
In deciding on investment and other terms to offer prospective limited partners in private credit funds, managers should consider how the asset class and expected return profile informs the economic arrangement among a manager and the limited partners. As the market for private credit funds continues to grow and evolve, managers should also be mindful of how the terms of these funds are interrelated.