Rated Note Feeder Structures

June 7, 2021
9:29 minutes

In this Ropes & Gray podcast, asset management partner Jason Kolman and finance partner Patricia Lynch discuss rated note feeder funds, a new product that is becoming increasingly popular in the credit fund space. They discuss how these products meet the regulatory needs of insurance company investors, key differences compared to traditional feeder funds, and navigating the ratings agency process.


Patricia Lynch: Hello, and welcome to this Ropes & Gray podcast. I’m Patricia Lynch, a partner in Ropes’ finance practice, and today we’re going to discuss a new product that is becoming increasingly popular with private fund managers—a rated note feeder fund. A rated note feeder allows insurance company investors to access a private fund’s investment strategy in a manner that helps them meet their regulatory capital requirements.

I have with me here Jason Kolman, a partner in our asset management group. Jason, why don’t you give us a very quick summary of this product?

Jason Kolman: Sure—thanks, Patricia. Investors in credit funds often invest through feeder funds designed to address certain tax or structuring needs of particular types of investors. A rated note feeder is essentially just another feeder fund designed for investors that are insurance companies. The main difference from a traditional feeder fund is that while most funds typically issue only equity interests (in the form of LP interests), the rated note feeder issues both notes and equity, with the note portion typically representing a larger piece of the investment.

So, for example, instead of making a $100 million capital commitment to invest in equity interests, an insurance company investor would buy $80 million worth of notes and also make a capital commitment of $20 million, so that its overall investment is comprised of 80% debt and 20% equity. 

Investing in rated debt typically provides insurance companies with more favorable regulatory capital treatment than investing directly in equity. The repayment protections that will exist in a debt structure provide comfort that debt is a safer investment for insurance companies to invest premiums in until they need to pay out claims. Involving rating agencies to review the structure and cash flows and provide a rating on that debt adds a further level of comfort.

Patricia Lynch: How does the documentation for this product differ from what you’d see for a more traditional feeder fund?

Jason Kolman: The main documents aren’t significantly different. You’d still have a partnership agreement and subscription agreement, which would resemble the “normal” documents, but with targeted changes to reflect the debt structure. There would also typically be a PPM supplement with risk and conflict disclosure targeted to the product, such as the risk of the ratings not being maintained during the life of the product.

There are also ways to streamline the documents for investors to reduce complexity. For instance, it’s fairly common to have a single PPM supplement covering both debt and equity, and a single sub doc where an investor’s subscription is automatically divided in the desired debt/equity ratio. The primary difference is the note purchase agreement, which I know you’re very familiar with.

Patricia Lynch: That’s right. The notes will be issued pursuant to a note purchase agreement, which will include the mechanics for the issuance to the investors of notes and for the funding of advances under the notes (which are the functional equivalent of capital calls on an equity commitment). It will contain representations, warranties, covenants, and events of default that are typical for debt structures. There’s a bit of a learning curve with the administration of the notes, but the goal is to get over this curve quickly and have that administration run relatively seamlessly together with administration of the equity interests.

Ironically, I think this seamless administration can sometimes cause confusion to investors. When investors think about debt investments, they tend to think about strict repayment schedules and a very structured product. But this product is very fluid in order to make it work within the overall fund structure, so it can surprise investors to learn, for example, that there often are no regular cash pay interest payments. Interest is usually paid in kind until the fund manager decides to send proceeds to the investors, or if income distributions from the underlying fund aren’t sufficient to make cash interest payments on the notes. There is also often flexibility in extending or shortening the initial maturity of the notes, which allows the maturity date to synch up with extensions or reductions of the term at the fund level.

On the subject of distributions, one aspect of these structures that can surprise people is how much variety there can be in terms of repayment. These terms are often bespoke to the particular needs of the fund manager and its relationship with investors. There are structures where repayments are made exactly in the percentage of debt vs. equity invested at all times. There are structures where you’ve got separate investment periods and repayment periods, with the debt portion of the investment not being repaid until the repayment period starts. And then, you’ve got structures with even more flexibility where all proceeds can be applied to the equity until maturity. On the actual percentages of debt vs. equity, while there is also variance, the debt portion usually ends up being much larger than the equity. We see structures like a 90% debt/10% equity ratio, 80/20 and sometimes the ratio of debt can be as low as 65/35. 

Jason Kolman: Thanks, Patricia. And what determines exactly what that debt-to-equity ratio will be?

Patricia Lynch: There isn’t an exact formula for this, but this is where we need to introduce the rating agencies into the whole process. These notes must be rated by rating agencies in order to get the regulatory capital treatment that we spoke about earlier. Each of the business terms of these notes, including items like the debt-equity split, how quickly the debt is repaid, the interest rate on the notes, and the nature of the underlying investments of the main fund—all of these will factor into how the rating agencies rate the notes.

Jason Kolman: Thanks. And talking about the rating agencies, what is that process like for a fund manager?

Patricia Lynch: Well, at the beginning of the process, the manager should approach the rating agencies with a term sheet. The agencies will want to look at a sample portfolio of investments and at any predecessor funds, and will have questions about the debt. These are usually questions about the repayment terms of the notes and the protections available to the noteholders. Some fund managers will create multiple tranches of notes, understanding that some of the notes will receive a higher rating than others. After all is said and done, the agencies issue a closing rating. Some investors will want a requirement to maintain a particular rating or a requirement for an annual update to the rating, but that’s a conversation between the investors and the fund manager.

Jason Kolman: Yes, that’s an issue that can raise tricky fiduciary considerations for fund managers. It’s important to keep in mind that the feeder structure is often a single feeder fund in an overall larger fund structure. A manager would need to be careful not to agree to requirements to maintain particular ratings if doing so would interfere with its duties to the other investors in the main fund, who aren’t subject to the same regulatory capital issues and may not want the fund managed to maintain a rating. Managers sometimes explore a standalone or parallel fund for insurance company investors, which will allow them to manage the fund to maintain a rating, but would generally be more costly and time-consuming than setting up a feeder on an existing product.

Patricia Lynch: Okay, so can you guide me through the process of creating one of these. What are the questions that a fund manager should be asking at the outset of the process?

Jason Kolman: Sure. I think given the differences between this and a more traditional structure, a manager should start by having some threshold conversations with its insurance company investors, in particular, to determine if the investors are willing to bear the costs of setting up the product, which can be significant given the complexity and the need to engage a ratings agency. Separately, the manager should make sure to have a plan in place to administer the notes, and also that the timing synchs up with the overall time frame of the underlying fund. The manager should also start to think through how ratings agencies will be able to rate the portfolio, and what comps would make sense if the fund is newly formed and hasn’t invested significantly yet. Lastly, this is a pretty new product, and insurance regulators are actively looking at this space, so while these products currently address the regulatory capital needs of insurance companies, managers should think about adding flexibility to revise terms or collapse the structure if the regulatory landscape changes.

If everything checks out and you get past those stages, you would typically start drafting the term sheet and opening the door to discussions with the rating agencies.

Patricia Lynch: That’s right, and at this point, the work stops being as linear. Once the rating agencies receive the term sheet, they’ll ask some questions about the terms and want to see an example portfolio of the underlying assets as we’ve discussed. They’ll also send a formal engagement letter. At this point, the lawyers will start drafting the primary documents, such as organizational documents for the fund, an offering document, a note purchase agreement and a subscription agreement. And while the debt documentation generally does dovetail well with the core fund documents, there are still going to be several details that the fund manager will need to work out. These include what happens if an investor defaults, the procedure for calling advances on the notes and how to manage transfers. Once the documents are in good form, they’re sent to the investors and the rating agencies for their review. The rating agency will then issue their final rating. The whole process typically ends up taking about six to eight weeks, although it’s wise for first-time managers to build in a buffer given the learning curve. 

I would also mention that it provides an additional challenge if there’s a subscription facility in place for the main fund. Subscription facility lenders are used to dealing with feeder funds, but given this new structure, it may take time for them to understand that some of the LPs’ investment will be in the form of debt. Their concern from a legal perspective is in the scenario of a default of the main fund. Will they be able to step into the shoes of the general partner and call on both the debt and the equity commitments of the investors? Interfacing with a subscription facility lender on these points can unfortunately sneak up on people at the end of the process. If a fund manager is heading down the path of creating this structure, it’s a good idea for it to speak with its subscription facility lender early on to ensure that any note commitment will be counted towards the borrowing base under the facility.

Jason Kolman: Thanks, Patricia. That’s all we have time for today. If you have questions about rated feeders, feel free to reach out to one of us or to another contact at Ropes & Gray. You can also subscribe and listen to the series of podcasts wherever you regularly listen to podcasts, including on Apple and Spotify. Thank you again for listening.

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