Jeff Haas on Private Credit Fund Structures & Matching Assets & Liabilities - Old Hill Partners Inc

Jeff Haas on Private Credit Fund Structures & Matching Assets & Liabilities

May 17 2021

A few years ago, I wrote a white paper about “closed” and “open”-ended fund structures and the characteristics of both in private credit investing (see my commentary dated April 8, 2018).  Over the last few years, the landscape for private credit fund structures has changed due to the increasing focus on private credit investing from an expanding investor base looking for yield in a low yield environment. I thought it would be worthwhile discussing this shift in fund structure and one innovative solution in more depth.

Post financial crisis many private credit investors have become comfortable investing in a more traditional private equity closed-end structure.  Over time, as the private credit investor universe has expanded, other investors, namely family offices and the wealth management community, have expressed a desire for evergreen or open-ended structures for operational reasons. Some of the operational challenges cited include managing capital commitments, executing subscription documents for subsequent investments and/or rollover investments, subsequent fund diligence, among others.  These newer investors are attracted to investing in the asset class due to floating rates, high cash coupons, strong yield and downside protection.  However, earlier attempts at evergreen or open-ended structures used for private credit investing were flawed and many created a significant asset-liability mismatch.

Closed vs Open:

Closed-End Fund – A fund that has a closed-ended structure will have a finite life and the amount of capital raised is capped by either the passage of a defined amount of time or upon meeting the capital raise target. Under this structure, the life of the fund is generally known and does not continue 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. Most have some type of capital commitment and call feature. The life of these funds usually ranges from 4 to 7+ years to correspond with the lifetime of the underlying investments. This directly addresses the concerns of fund asset-liability mismatch. Generally, there are no redemption provisions in a closed-ended fund; once the capital is deployed, it will only be returned to investors once the underlying transactions monetize. In this structure, all investors are on equal footing as it relates to the distribution of capital.

Open-End Fund – A fund that has an open-ended structure, or what some refer to as an “evergreen” fund, has no maturity and can raise capital indefinitely.  Most evergreen funds have monthly or quarterly capital raise periods based on a closing NAV.  Historically, most private credit funds established as an evergreen fund had redemption features that would allow investors to exit the fund before the underlying investments monetizing.  Those features generally included meeting some type of “lockup” period, i.e., a one-year investment horizon.  Once the lockup period was satisfied, an investor could redeem their capital on a monthly or quarterly basis.  When the underlying fund investments are illiquid with a multi-year maturity, as frequently seen in private credit, using a traditional evergreen structure proved to be problematic.  The flaw in the traditional structure is a mismatch created between the time investments can be monetized and the time required to satisfy a redeeming investor commonly referred to as a fund asset and liability mismatch.  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 this case, the manager may find it difficult to liquidate positions at favorable prices or may even have to dump well-performing positions in order to generate liquidity.  To make matters worse, private credit investors in a “cookie-cutter” evergreen fund structure can find themselves at the back of the line in terms of distribution of capital as investors are redeemed on a first-come, first redeemed basis.  The priority of paying redemptions and the mismatch of assets and liabilities described above resulted in many funds which focused on illiquid investments being “gated” when redemption requests overwhelmed the available capital.  In some instances, managers opted to place the fund in a liquidator’s hands to manage the unwind process rather than dealing with the messy unwind of the fund themselves creating a very unfortunate outcome for all parties involved.

The Evergreen Fund 2.0:

Post financial crisis, most private credit funds were structured as a closed-end fund, however, there was a segment of investors, mainly family offices and members of the wealth management community, who desired a different structure.  Over the last few years, there have been some innovative hybrid evergreen structures that have been created which address one of the biggest flaws of a traditional private credit evergreen structure.  The birth of the “Evergreen Fund 2.0” or as we call it a hybrid evergreen structure has created an opportunity for us as a manager to offer certain investors the ability to invest in private credit in a fund without a maturity date, thereby eliminating the investors need to go through the subscription process of a new fund every few years while at the same time addressing one of the biggest flaws of a traditional evergreen structure used in private credit investing.

The new hybrid evergreen structure allows capital to be raised on a monthly basis at NAV and provides for two forms of liquidity; optional quarterly distributions of income and redemption of principal. The option of income distributions is an important structural feature for many of our investors searching for yield in our ABL strategy.  A more interesting structural feature is the flexibility given to investors to redeem their investment while at the same time addressing the matching of fund assets and liabilities for the remaining fund investors.   This is accomplished by creating an initial hold or lockup period of one year, whereafter the investor may make quarterly redemption requests.  However, the key difference in this structure versus a more traditional evergreen structure is that when a redemption request is granted the manager essentially creates a pro-rata distribution of the existing portfolio (at the then NAV) and places that in a liquidating account for each redeeming investor.  As the investments in the liquidating account monetize, which could take place over a few years, the redeeming investor receives their proceeds in line with the natural liquidity of the investments. This monetization process is very similar to the process that occurs during the normal harvest period of a traditional closed-end fund.   Thus, this new structure shifts the decision of when the harvest process begins from the manager to the investor. At the same time, this structure avoids a situation where there could be forced sales of illiquid investments to satisfy a redemption and ultimately aligns fund assets and liabilities.  Now investors have the flexibility to invest in a private credit fund for one or more years before starting the harvest process. The decision as to when to start the harvest period is in their own hands.

In order to capture the illiquidity premium inherent in an asset-based lending strategy, investors should consider a hybrid evergreen fund. This type of structure is open-ended and attempts to match the underlying transaction duration with investor capital commitment periods while at the same time giving the investor flexibility to influence the investment time horizon.