APRIL 8, 2018
This month, Old Hill’s COO, Jeff Haas, discusses private credit fund structures.
The fund structure used to execute private credit investments is a fundamental element that investors should consider when evaluating a private credit fund.
The fund structures that are most prevalent and that should be evaluated are the “closed” vs “open” ended fund structures. A fund that is closed-ended will have a finite life and the amount of capital raised is capped by either the passage of time or upon meeting the capital raise target. Under this structure, the life of the fund is generally known and does not continue on indefinitely. Contrast this with an open-ended structure, or what some refer to as an “evergreen” fund, which can raise capital indefinitely.
Most closed-ended private credit funds will be structured as a private equity or a hybrid private equity structure with clearly defined capital raise, investment and harvest periods. The life of these funds usually ranges from 4 years to 7+ years in order to correspond with the lifetime of the underlying investments. Generally, there are no redemption provisions in a closed-ended fund; once the capital is deployed it will only be returned to investors, subject to recycling provisions, once the underlying transactions either amortize, mature, or prepay. In this structure, all investors are on equal footing as it relates to the distribution of capital.
Private credit funds established as evergreen funds may or may not have a “lockup” period where redemptions are prohibited. After the lockup period, redemptions are normally honored on a monthly or quarterly basis with some form of a notice period. In such a structure, not all investor capital redemption requests are treated equally. Redemptions are honored based upon the date received; everyone gets into a queue. If there is a significant surge in redemption requests, the fund manager may be forced to “gate” the fund thereby suspending redemptions. Once a fund is gated, investors are treated either as creditors or investors in the return of capital. Oftentimes, the fund is turned over to a liquidator which typically does not bode well for investors.
In the private credit world, the liquidity for most private credit transactions is inherently limited at best and nonexistent at worst. Accordingly, if those transactions are held within a vehicle that offers frequent redemption periods, a mismatch can easily occur between the liquidity of the fund and the liquidity of its underlying portfolio investments. As any veteran of the financial crisis can attest, this mismatch can quickly place managers in the unenviable position of becoming forced sellers of illiquid assets; in which case the manager may find it difficult to liquidate positions at favorable prices or worse, they may have to dump well-performing positions in order to generate liquidity.
This can cost investors real money. Private credit investors would be wise to only consider an evergreen fund structure if the underlying private credit transactions have a relatively short duration. Some of the activities that come to mind are trade finance, short term bridge loans or accounts receivable factoring. Outside of these examples, the vast majority of the remaining private credit opportunities will have longer terms and therefore should, more appropriately, reside in a closed-end private equity style structure.
At Old Hill, we thought long and hard about the structure before we launched our funds by attempting to match fund assets (investments) and liabilities (investor capital) so that the portfolio was aligned appropriately. With the majority of our transactions having a one to three-year maturity the choice was obvious, a closed-ended structure made the most sense. We describe our structure as a hybrid private equity structure because it does not have a capital call feature and it has a much shorter life when compared to your typical private equity fund tenor. However, the fund does contain a two-year capital raise period, during which we are accepting capital and deploying capital simultaneously. The capital raise period is followed by a one-year investment period and a two-year harvest period. We think this structure is appropriate because it matches fund assets and liabilities. Additionally, as an asset-based lender, we have found that this structure can help when a potential economic contraction occurs and asset prices decline. With no redemption pressures, the manager can re-lend on more favorable terms while asset prices stabilize and recover, which historically has been the case.
Investors that are new to private market assets may have been enticed by “liquid” funds that offer attractive returns while investing in longer-term transactions, using an evergreen structure. As discussed above, such funds will have an inherent asset/liability mismatch. It’s not a matter of “if there could be a liquidity problem” but “when”, and when usually occurs as soon as there are significant investor redemption requests.
In order to capture the illiquidity premium inherent in an asset-based lending strategy, investors should select funds with structures that attempt to match their transaction durations with investor capital commitment periods, such as those offered by Old Hill Partners.