Rated Note Feeder Structures: 2023 Update
In this Ropes & Gray podcast, asset management partners Jason Kolman and Jessica Marlin discuss the latest market trends in rated note structures. They discuss how these feeders into private credit funds respond to regulatory capital preferences of insurance company investors, key differences compared to traditional fund structures, the latest terms in the market, and navigating the ratings agency process.
Jessica Marlin: Welcome to this Ropes & Gray credit funds podcast covering rated note feeders. I'm Jessica Marlin, a partner in our New York office, and today, I’m joined by my colleague Jason Kolman who is a partner in our Boston office. Today, we’re going to discuss a product that is becoming increasingly popular with private credit fund sponsors—the 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. So, for U.S. sponsors, we typically see these being set up for both U.S. insurance company investors and certain South Korean insurance companies.
As a general matter, investors in credit funds often invest through feeder funds designed to address certain tax or structuring needs. So, a rated note feeder is essentially just another feeder fund in the structure, but specifically 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 an 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. The debt/equity split can also vary across rated note feeders based on a range of factors.
Insurance companies, by regulation, have certain capital requirements so that they have sufficient assets to pay out claims they are insuring. Investing in rated debt typically provides insurance companies with more favorable regulatory capital treatment than investing directly in equity, because debt is repaid before equity in the event of a bankruptcy. And, as such, the specific repayment protections that are built into a debt structure provide comfort that the debt is a safer investment for insurance companies to invest premiums in the event that they need cash 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.
Jason, how does the documentation for these products differ from what you’d see in a more traditional feeder fund?
Jason Kolman: Thanks, Jess. The main documents aren’t significantly different—you’d still have a partnership agreement and a 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 specific to the rated note product, such as the risk of the ratings not being maintained during the life of the product and of the regulatory treatment of these products changing.
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 the debt and the equity, and a single sub doc where an investor’s subscription is automatically divided in the desired debt-to-equity ratio—the primary difference is the addition of the note purchase agreement.
The notes are issued pursuant to the note purchase agreement, which 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 typically 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 the administration of the equity interests. Ironically, I think this seamless administration can sometimes cause confusion to investors. Jess, can you tell us more about the mechanics of the notes?
Jessica Marlin: Sure, Jason. As discussed, the debt-to-equity commitment is often about 80 to 20—so, 80% of the commitment is in the form of a note and 20% is in the form of a regular equity commitment. As a general matter, capital is typically called “pro rata” between the debt and equity, but we’ve recently seen some pressure on calling the note for purposes of making underlying equity investments in the master fund. For underlying debt investments, the note and equity commitment are called “pro rata.” Further, to the extent you’ve called “just equity” for making equity investments—and so, you have the debt and equity split no longer at 80/20—when you next call for debt, you’ll call on a non-pro rata basis in order to keep the uncalled split at 80/20.
Then, the next step is how income and proceeds are used to repay the note and make distributions in respect of the equity commitment. There is a lot of variation on the waterfall, however, one relatively straightforward example goes like this: during the investment period, current income is first used to pay the accrued interest on the notes until all of the interest is paid off, and only then to make distributions in respect of the equity commitment. And then, other proceeds are split pro rata based on the debt-to-equity ratio—so, if it’s 80/20, 80% goes to repay the principal on the notes and 20% as a distribution in respect of the equity commitment. And then, after the investment period, the waterfall is agnostic as to the type of income—so, current income and principal proceeds are aggregated, then paid out first to pay interest, and then to pay the principal on the notes, and lastly, to make distributions in respect of the equity commitment. Different waterfalls during the investment period and following it are common. We also frequently see acceleration events whereby all of the income or proceeds are swept to repay the note if there is an event of default, an LTV test is breached, or the fund is past its term.
Jason Kolman: This is also where we should introduce the ratings agencies into the whole process. The notes must be rated by a rating agency in order to get the regulatory capital treatment that we spoke about earlier. 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. And talking about the rating agencies, Jess, what is that process like for a manager?
Jessica Marlin: As I’ll discuss further shortly, the term sheet is often first reviewed by an anchor investor to make sure it meets their expectations. Once a draft is together, the sponsor should approach the rating agency with a term sheet and usually a model portfolio. As part of the model portfolio review, the rating agency will want to look at the types of investments the manager intends to make or has made in the past—they’re especially going to look at the credit quality of the borrowers—and it’s helpful if the manager has a recent predecessor fund to demonstrate what the final composition of the strategy’s portfolio typically looks like. If there isn’t a recent portfolio, they may accept recent stand alone deals. The rating agency will also be interested in whether and how many equity investments will be in the portfolio. Even direct lending funds often have a small bucket for equity, and that can make rating agent nervous because it is a riskier investment. The rating agency will also want to know whether or not the fund employs leverage, and there will be downward pressure on the rating because of the use of leverage. There are also usually questions about the repayment terms of the notes and the protections available to the noteholders. Getting the terms to fit the portfolio is essential—knowledgeable fund counsel can help you work through this process and examine market approaches and bespoke alternatives. As an example, some fund sponsors will create multiple tranches of notes, understanding that some of the notes will receive a higher rating than others. There is often a back and forth with the rating agency around the terms and rating. The rating agent can even provide feedback on the fund documents. That process can take several months, and requires the payment of an upfront fee. Once that process is complete, assuming the fund closes on commitments, the agency issues a closing rating. As part of this, certain investors will require the sponsor to undertake to maintain that particular rating or will request an annual update to the rating, but that’s driven by the specific investors and their concerns around the structure. Jason, can you tell us more about the rating?
Jason Kolman: Yes, the issue of undertaking to maintain the rating is 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 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 would allow them to manage the fund to maintain a rating without raising fiduciary issues relating to other non-insurance investors. The issue with the standalone fund is that it may be more costly and time-consuming than setting up a feeder as part of a larger fund raise.
Jess, what are some of the issues that managers should be thinking of at the outset of this process of setting up a rated note product?
Jessica Marlin: Sure, Jason. So, I think given the differences between this and a more traditional structure and the upfront fee charged by the rating agents, a sponsor 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 rating agent, and which the insurance company investors typically bear these expenses without a cap. Separately, the sponsor should have a plan in place to administer the notes, whether in-house or externally, as needing to manage both the debt and the equity obviously adds some complexity. Lastly, this is a fairly new product and the insurance company regulators are actively looking at this space, so while these products currently address the regulatory capital needs of insurance companies, sponsors should think about adding flexibility to revise the terms or collapse the structure if the regulatory landscape changes in the future.
Jason, what other complexities around rated note feeders might sponsors want to consider?
Jason Kolman: I would also mention that it provides an additional challenge if there’s a subscription facility in place for the main fund. Sub-lime 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 investors’ 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 sub-lime lender on these points can unfortunately sneak up on people at the end of the process. If a sponsor’s heading down the path of creating this structure, it’s a good idea for it to speak with its sub-lime lender early on to ensure that any note commitment will be counted towards the borrowing base under the facility.
Jessica Marlin: Thanks, Jason. There is much more we could discuss about rated note feeders—feel free to reach out to either one of us or any of our colleagues to discuss this product or other credit fund strategies further. We appreciate you tuning into the Ropes & Gray’s credit funds podcast series. Please visit our website at www.ropesgray.com/credit-funds, or feel free to reach out to any of us at Ropes & Gray via email or phone for more information. You can also subscribe to this Ropes & Gray series wherever you typically listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.