Initial and Structural Considerations:
Can a rated note feeder work on an open-ended fund?
- It is more common for this structure to be used on closed-end funds, as the finite term and lack of redemption rights correspond well to a note with a fixed maturity.
- However, we have seen this structure used on open-end funds, typically by hardwiring the redemption terms into the documents (i.e., insurance investors cannot make individual redemption decisions).
Can we do a standalone rated note fund instead of a feeder product?
- Yes. A standalone product may be more expensive and take more time to establish, but it can be more easily customized to address the specific needs of insurance investors and ratings agencies.
- By contrast, a feeder may be quicker and cheaper to set up, but it features less flexibility to vary the strategy and terms, since it is part of a broader fund structure with non-insurance investors.
Can we submit a model or hypothetical portfolio to the rating agency for purposes of evaluating a new fund we are getting rated?
- Yes although the rating agency may take a more conservative view of the rating than would be the case if there were an actual prior portfolio.
Do non-insurance company investors in the structure express concerns with the rated note feeder?.
- Typically, they do not. The structure is usually not very visible to other investors, and it is standard for structure-related expenses to be borne solely by the participating insurance investors and not the broader investor base.
Can I use this structure in a levered fund?
- Yes, this structure can be used with both subscription facility and asset-based leverage. However:
- It can be easier for unlevered funds to obtain the desired note rating
- There are typically challenges with including the note portion of the commitment within a subscription facility base
- The notes are typically subordinated to third-party (bank) leverage
Can the rated feeder be structured entirely as debt?
- We generally see some equity, since:
- Certain insurance investors prefer equity/note structures on the basis that they have more substance
- A higher equity proportion can help increase the note rating
- There are mechanisms of typical fund structures (such as the LP clawback) that are more typically associated with equity interests
- Certain South Korean insurance companies prefer debt-only structures, however.
Are the notes typically debt or equity for U.S. tax purposes?
- Equity classification for U.S. tax purposes is more common.
- In our experience, the tax classification of the notes has not been a major issue for insurance investors.
Terms and Function:
How is capital called?
- Typically, debt and equity are called in proportion to the commitments, but we have seen variations on this, including:
- Only drawing on the equity commitment to make equity investments in the underlying portfolio
- Drawing on the equity commitment before the debt commitment to push out the date on which the fund will need to start making interest payments
How do I determine the note maturity date?
- The note maturity typically aligns with the fund term, although managers sometimes opt for a longer maturity if they expect the fund’s investments will take longer than term to liquidate.
- Since this can be difficult to forecast at the outset, there is sometimes an ability to unilaterally extend the maturity date.
What interest rate should be used for the notes?
- The rate often approximates the expected income distributions from the fund, and is also sometimes aligned to the fund’s preferred return out of convenience.
- Typically, if two notes are issued, the junior note will have a higher interest rate than the senior note.
- Interest can typically pay-in-kind or "PIK", which can address potential cash flow shortfalls because the interest accrues to the principal.
Why do some rated note funds use an A/B note structure?
- Multiple debt tranches can produce an overall better regulatory capital result for insurance investors, as the senior notes typically have a higher rating than those in a unitranche structure.
- However, this can increase the complexity and the burden of administering the notes.
Can the fund pre-pay the notes?
- Yes. Sponsors may find it advantageous to pre-pay the notes and have insurance company investors hold only equity in the later life of the fund, and, at that point in the fund's lifecycle, insurance investors at that stage may not be as concerned about holding their remaining investment through notes.
What equity/debt proportion do you typically see?
- This varies depending on a range of factors, including the fund's strategy, targeted investments, use of leverage, and fund terms.
- In general, we typically see a debt percentage between 70%–90% and an equity percentage between 10%–30%.
What should the priority of payments be?
- There is not a set requirement for how payments (or distributions) should be made, although adding more substance around the priority of payments to the notes, either generally or only in certain circumstances (e.g. post-investment period, after default, if the portfolio becomes concentrated, etc.), can help improve the rating.
- There is typically an ability to make some distributions in respect of the equity interests early in the life of the fund, so long as the notes have some waterfall priority.
- An example of a relatively straightforward waterfall formulation is as follows:
- During investment period: Income proceeds from the master fund are used to repay note interest; principal repayments from the master fund are used to repay note principal; and remaining proceeds are distributed to LP interests
- After investment period: All proceeds used to repay note interest/principal before payments are made to LP interests
- If there is an EoD or if the LTV ratio exceeds a certain threshold: Proceeds are distributed per the terms of the post-investment period waterfall
How are rating and other note feeder expenses typically paid?
- These expenses are typically borne solely by the note feeder, and are outside of any cap on organizational expenses on the basis that the structure is bespoke and created for the benefit of the insurance company investor base.
How is the uncertainty relating to the treatment of the notes for insurance regulatory capital purposes addressed in the documents?
- There is often broad ability to redeem out the notes for equity interests and/or amend the terms to reflect future regulations by the National Association of Insurance Commissioners (NAIC) or other regulatory developments.
Click here to listen to Jessica and Jason further discuss these structures in their podcast episode, Rated Note Feeder Structures: 2023 Update.
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