Unlocking Private Credit: Tapping Unsecured Debt Markets, Demystifying BDCs & ABF Part 2
Preparing to Tap Unsecured Debt Markets: Process and Best Practices
By Thomas Friedmann and Thomas Cheeseman
Despite elevated interest rates, business development companies, or BDCs, have seen a brisk pace of issuance of unsecured debt in 2024. This rivals the frothy market conditions of 2021 and exceeds the total issuance of unsecured debt by BDCs in 2022 and 2023, respectively. Whether the furious pace will remain, or whether new issuances will taper as benchmark rates decline, spreads widen and the U.S. prepares for the fall election, asset managers with either mature or new funds should consider certain preparatory steps to best position themselves to take advantage of this attractive funding source.
For larger funds, the ultimate goal for a successful transaction is to ensure that the issuance qualifies for inclusion in the Bloomberg US Corporate Index. By qualifying, the fund ensures the securities it issues will be more likely to experience a secondary trading market. Other considerations may prevail, but all else being equal, a more liquid trading market may improve the trading price of the issuance and therefore decrease the credit spread over the applicable benchmark rate that the fund will experience in future issuances. In order to be index eligible, the issuance must have at least one rating from any of Moody’s, S&P and Fitch, must have been issued in an initial aggregate amount of at least US$300 million, and must either be registered with the SEC or must be issued pursuant to Rule 144A and Reg S under the Securities Act of 1933 and include a registration rights agreement.
As a prelude to an index-eligible transaction, for a new fund or one that is still ramping, asset managers might consider offering unsecured notes by utilizing the National Association of Insurance Commissioners’ form note purchase agreement. The advantages of these transactions include that a fund can engage a rating agency other than one of the big three, which may ease the execution of the issuance, and will begin to diversify a fund’s leverage profile. This is particularly important as the big three rating agencies generally require BDCs to have unsecured debt equal to at least 30 percent of the fund’s outstanding leverage. One disadvantage of these ‘4(a)(2)’ notes transactions (a reference to the securities law private placement exemption pursuant to which the notes are issued) is that they often have tighter financial covenants than a typical index-eligible transaction. Nonetheless, by pursuing a 4(a)(2) notes transaction and engaging a knowledgeable bank early in the process, an asset manager can position its funds to access an additional source of leverage to attain its targeted return on equity earlier in the fund’s life.
For any questions regarding index-eligible bond offerings or unsecured notes offerings, please reach out to a member of Dechert’s private credit team for more information and market insights.
The ABCs of ABF: Part 2 – Basic Financing Structures
By Sarah Milam and Meghan Redding
As investor interest in the asset-based finance (ABF) market has grown in recent years, investors increasingly access this market not only by acting as a source of private asset-backed lending to others, but also through their own ownership or management of these assets, whether acquired from originators (as discussed in Part 1 of this series) or originated through strategic partnerships. In Part 2 of our ABF series, we will discuss the basic asset-based debt financing structures that still form the core of financing, leveraging or exiting these assets.
Debt financing of the origination, acquisition or ownership of cash-generating assets allows investors to leverage capital efficiently, potentially enhancing returns while spreading risk. The core tenet of asset finance is that the assets and related contractual cash flows are segregated from operating risk and performance of the originating entity or the entity contributing assets to the facility. Debt is serviced by the cash flow generated by the assets, so lending is based on the credit risk of the underlying collateral pool and not the credit risk of the originator, contributor or any other entity. In each case, assets are ring-fenced in a bankruptcy-remote special purpose entity (SPE) and are not affected by the automatic stay in the event of a corporate bankruptcy of any other entity. On a basic level, financing facilities can generally be grouped into one of the following categories: term loans, revolving credit facilities and asset-backed securities. Funding under the former two may be provided by banks, financial institutions, investment funds or others. In the latter case, securities are issued through either private or public markets.
Term Loans
In a term loan transaction, a pool of assets is sold to an SPE that borrows a fixed amount of money from a lender or syndicate of lenders, which is repaid over a specified period with regular installments from the cash flow generated by the asset pool as the underlying assets amortize or pay off. This self-liquidating structure provides predictability in repayment schedules and interest costs.
Key features of term loans include:
- Fixed or Variable Interest Rates: Depending on the agreement, interest rates can be fixed for the loan’s duration or variable, based on benchmark rates plus a margin.
- Amortization: The loan is repaid in regular installments, which can be structured to match the cash flow from the pledged asset pool.
- Prepayment Penalties: Some term loans may include penalties for early repayment.
Traditionally, originators use term loan structures as an alternative to securitization for a fixed pool of assets. For asset purchasers, the term loan structure is most useful for financing a portfolio acquisition or a pool of seasoned loans moved from a revolving credit facility.
Revolving Credit Facilities
In a revolving credit facility, assets are sold to an SPE not in a single transaction but from time to time over the life of the facility as they are originated or acquired. The SPE enters into a revolving loan agreement with lenders that allows the SPE borrower to draw funds to make additional asset purchases. The assets acquired are pledged to the lenders as collateral for the loan. This provides a more flexible financing option than a term loan.
Key aspects include:
- Flexibility: Borrowers can draw and repay funds multiple times within the credit limit, providing liquidity for portfolio management.
- Interest Rates: Typically variable, based on benchmark rates plus a margin.
- Commitment Fees: Lenders may charge fees for the unused portion of the credit line.
- Borrowing Base: The amount that can be borrowed under a revolving credit facility will typically be the lesser of a dynamic borrowing base calculated by reference to the aggregate outstanding balance of assets owned by the borrower that meet specific eligibility criteria and a predetermined maximum facility amount.
This structure is particularly useful for managing cash flow and funding ongoing acquisitions through forward flow agreements. Traditionally, originators use revolving credit facilities to “warehouse” originated loans prior to securitizing or contributing the assets to a term loan SPE. Similarly, investors can use these facilities to fund ongoing acquisitions under forward flow agreements either on a long-term basis or prior to “taking out” these assets to a term loan or ABS issuance.
Asset-Backed Securities (ABS)
In an ABS issuance, an SPE will generally purchase a pool of assets and issue securities backed by such pool. As with a term loan, the collateral pool will generally self-liquidate over time (although in the case of short-term revolving assets such as credit card receivables, a master trust structure may be used whereby a continuously replenishing asset pool backs multiple series of notes). Compared to a term loan or revolving credit facility, ABS allows risk to be spread among multiple investors distributed through the capital markets, allowing a broader range of investors to participate and potentially providing greater liquidity. ABS may be distributed broadly in a public issuance or to a limited number of sophisticated investors through a private issuance. Note that in each case, as securities, the issuances are subject to applicable regulatory requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934, including disclosure and risk retention requirements.
Key elements include:
- Tranching: The portfolio is divided into tranches with varying risk and return profiles, attracting different types of investors.
- Credit Enhancements: Techniques such as over-collateralization, reserve accounts or third-party guarantees can improve the credit rating of the securities.
- Greater Liquidity for Investors: Notes issued in an ABS transaction, particularly one where the securities are rated, are more liquid than loans advanced in connection with a term loan or revolving credit facility.
Traditionally an important funding source for asset originators, ABS is also an attractive and important financing channel or exit option for asset owners. Additionally, asset managers may work with one or many originator platforms to pool collateral for sponsored ABS transactions, for which they may receive a management fee as well as residual returns.
Long-Term Asset Funds: A New Gateway to Private Credit for UK Investors?
Investment in private credit has traditionally been the domain of closed-ended private funds. However, following its launch in November 2021, there has been discussion in the market about the UK Long Term Asset Fund (“LTAF”) as an access point to private credit strategies for UK investors who may not typically have direct access to such opportunities.
The LTAF has been developed as a new structure for professional and sophisticated investors, including Defined Contribution (DC) pension schemes, to allocate capital to less liquid long-term investments with the potential to offer superior returns due to the illiquidity premium.
To date, manager uptake of the LTAF has been slow, in part due to the length of the Financial Conduct Authority (“FCA”) approval process and also unfamiliarity in the market. Since March 2023, twelve LTAFs (including sub-funds) have been authorized by the FCA, some of which include a private credit component as part of a diversified strategy. However, the first LTAF with a dedicated private debt strategy has only just been launched, receiving FCA authorization in June 2024.
Establishing and investing in an LTAF requires a change in mindset from private fund managers and investors respectively in order to make it a viable option for private credit (or any other long term asset) investment.
As an open-ended fund, and given the illiquid nature of the underlying assets, liquidity management may seem a stumbling block to managers more familiar with closed-ended funds. However, apart from redemptions being no more frequent than monthly and subject to a minimum notice period of 90 days, managers can align the redemption frequency and notice periods with the liquidity of the underlying asset to meet redemption requests without compromising the fund's stability.
Target investors may be used to investing in vehicles with greater liquidity and may need to be satisfied that an LTAF investment can align with their investment strategy, risk tolerance, and regulatory requirements.
Unlike its European counterpart, the European Long-Term Investment Fund (“ELTIF”), the LTAF does not have access to the EU passport under the Alternative Investment Fund Managers Directive (“AIFMD”). However, it can invest in non-UK assets including non-UK funds and, subject to certain requirements, act as a feeder fund. An LTAF does not therefore need to be considered as a standalone fund, but could also provide an alternative access point for UK investors into a manager’s existing credit strategy (provided of course that the specific regulatory requirements and investment strategies of both the LTAF and the underlying fund align).
As the market becomes more familiar with the LTAF and the necessary operational framework continues to build, we should expect to see more LTAFs launching to access a wider base of investors and tap into the benefits of private credit as an asset class.
Demystifying the Three Main BDC Structures
The private credit market has grown rapidly in recent years, becoming an estimated US$1.7 trillion to US$2 trillion industry. Business development companies (BDCs) continue to be an appealing investment vehicle option for asset managers focused on private credit investments. In fact, BDC assets under management reached more than US$300 billion in early 2024, according to LSEG LPC.
BDCs are a hybrid type of closed-end funds that invest a majority of their assets in private U.S. operating companies – typically via debt investments – and share similarities with both operating companies and registered investment companies. There are three main types of BDCs: (1) publicly traded BDCs, (2) publicly offered, non-listed BDCs (non-traded BDCs), and (3) privately offered BDCs. The selection of which type is primarily determined by asset managers’ preferences for timing to market and target investors, including investors’ needs for liquidity, and the receptiveness of the various distribution channels to the asset managers’ product offerings. All BDCs, regardless of type, must be Securities and Exchange Commission (SEC)-reporting entities (e.g., filers of 10-Ks, 10-Qs, 8-Ks, etc.) and are subject to the same rules and regulations as one another under the federal securities laws.
Publicly Traded BDCs
There are approximately 50 publicly traded BDCs with over US$140 billion in assets under management in the aggregate according to the LSEG’s BDC Collateral. These BDCs are generally listed on NASDAQ and/or NYSE and have historically completed traditional IPOs, although a number have opted for direct listings. This type of BDC offers the most liquidity for investors, which can be both institutional and retail.
Non-Traded BDCs
Non-traded BDCs, which have over US$130 billion in assets under management in the aggregate, conduct continuous public offerings priced at net asset value per share. They are not listed on an exchange and thus generally have limited liquidity (e.g., via discretionary share repurchases) prior to conducting a liquidity event, such as an IPO. Liquidity events are generally scheduled to occur 5–7 years after launch. In the past two years, however, there has been significant growth in “perpetual-life” non-traded BDCs, which are designed to have an indefinite duration and reduce the risk of such BDCs being forced to liquidate assets during market downturns.
In addition to the federal securities laws applicable to all BDCs, non-traded BDCs are subject to state “Blue Sky” laws. Shares of non-traded BDCs are not listed on a national securities exchange, like publicly traded BDCs, or sold in accordance with the private offering rules of Rule 506 of Regulation D under the US Securities Act of 1933 (the Securities Act), like privately offered BDCs. Accordingly, shares of non-traded BDCs are not “covered securities” under U.S. federal securities laws, which requires non-traded BDCs to register their offerings in each state in which offers and sales are made, which process usually takes from nine to 12 months to complete in all relevant states. Despite the additional state registration and review process, asset managers may still find the non-traded BDC option appealing; the SEC has historically granted non-traded BDCs exemptive relief to offer multiple classes of shares, which may be made available to retail investors through multiple distribution channels. Varying sales charges and/or service fees cover the costs of selling shares and the particular features of each distribution channel.
Privately Offered BDCs
Privately offered BDCs, which have over US$40 billion in assets under management in the aggregate, are not listed on an exchange and thus also have limited liquidity. Unlike publicly traded and non-traded BDCs, privately offered BDCs do not register their equity offerings with the SEC under the Securities Act. Instead, privately offered BDCs complete their equity fundraising via “private placement” exemptions from the registration requirements under the Securities Act, typically via Rule 506 of Regulation D. As a result, asset managers often find that the time to market for privately offered BDCs is shorter than for their publicly traded and non-traded brethren due to the fact that privately offered BDCs avoid both the longer SEC review process for Securities Act registration statements and the state “Blue Sky” review process.
Privately offered BDCs may conduct their private offerings at net asset value per share, via a capital call model or via monthly “immediate funding” closings, which have become more popular with the rise of the “perpetual-life” BDC offerings to high-net-worth investors. This trend has risen in part to address liquidity concerns – moving away from being structured similarly to private credit funds (i.e., finite life investment vehicles with an investment period and wind-down period), which generally provide the least liquidity of the options described here. The privately offered BDCs that have adopted the perpetual-life model typically provide quarterly liquidity via discretionary share repurchases. Over time, privately offered BDCs may change their structure to non-traded or publicly traded BDCs described above.
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Private Credit – Amend and Extend – or More?
By David Miles , Phil Butler and Sarah Moffat
In the more challenging economic conditions facing the market, with new financings currently fewer and further between, borrowers are increasingly looking to amend and extend their existing financing arrangements. As consideration for extending the maturity date and, in some cases, providing additional debt, lenders may seek to negotiate amendments to the commercial terms to strengthen their position and preserve certain protections afforded to them in the existing financing.
Points lenders consider in this context include:
Prepayment protection: resetting of non-call/prepayment periods from date of amendment for all Unitranche facilities or (if applicable) new Unitranche facility(ies) only.
Margin/Margin ratchet: repricing of facilities, changes to leverage ratios in applicable Margin ratchet and resetting of any Margin ratchet 'holiday' from date of amendment for all facilities or (if applicable) new facility(ies) only.
Incremental debt headroom: reducing vs resetting incremental debt capacity following provision of any incremental debt pursuant to amend and extend.
Guarantee/Security refresh: requirements for additional or supplementary security to secure extended and/or increased/new facilities.
Financial covenants: resetting of financial covenant levels following provision of further debt (if applicable).
Fees: amendment/consent fee requirements.
Maturity Date extension: in capital structures with competing or junior debt, potential requirement for 'springing' maturity concept to protect senior facilities from temporal subordination.
Borrowers may too though look to negotiate amendments to existing terms to make them more favourable than those agreed on the original deal with a range of market pushing concepts debated. Lenders should be wary of attempts in term sheets or amendment documentation to utilise the "snooze-lose" concept to either drag non-responsive lenders into an amendment or deem their non-responsiveness as acceptance of an amendment.
Focus on Funds for G20 Securitization Reform
By Aaron Scott and John McGrath
The Financial Stability Board (FSB) has published a consultation report on the impact of the G20 regulatory reforms on securitization. The report finds that these reforms have shifted securitization issuance from banks to non-bank financial intermediaries (NBFIs) in Australia, Europe, and the U.S. since 2011.
For the FSB, the growing role of NBFIs in securitization is a double-edged sword. Transferring risk outside the banking sector could diversify and strengthen the financing ecosystem if managed prudently. However, the FSB questions whether NBFIs can handle securitization risks given their funding structures and ability to withstand losses during stress events. It acknowledges that the diverse nature of these entities and their regulatory and funding frameworks suggests there is no one-size-fits-all answer. The FSB plans to continue its work on NBFI resilience and apply these principles to the securitization sector.
Likely impact on CLO market of an increased focus on funds
The FSB’s analysis of the CLO market shows the likely impact of an increased focus on funds.
First, NBFIs are seen as responsible for increased complexity and opacity in both the leveraged loan and CLO markets. In particular, the FSB finds that weaker underwriting standards in the leveraged loan market may lead to higher defaults on loans held by CLOs, which will ultimately lead to lower CLO recovery rates. To address this, the FSB encourages the adoption of the recently published IOSCO good practices for leveraged loans and CLOs.
Second, CLO managers’ preference for “light balance sheets” has led to the creation of risk retention vehicles to attract third-party investors. The FSB’s main concerns are that this practice may:
- Not fully align with the goals of risk retention regulation, as the vehicle often isn’t part of the CLO manager’s corporate group, thereby shifting risk to parties not originally envisioned.
- Complicate authorities’ efforts to determine who is exposed to risk retention-related losses.
- Result in leveraged risk retention vehicles subject to high asset volatility, especially where the retained risk consists of first-loss tranches.
- Lead to concentration risk given the niche nature of these vehicles.
The FSB does not propose any specific remedy for this issue. In this context, it is noteworthy that the FSB finds no material adverse effects from the lack of retention in U.S. open-market CLOs. It may be that the larger concerns are opacity and concentration risk.
Critique of regulatory regime for securitization in Europe
Another focus of the report is the regulatory regime for securitization in Europe. In Europe, some FSB stakeholders attribute a perceived decline in issuance to the implementation of the securitization regulatory regime, which has increased costs for issuers and investors. Although the FSB says there is no empirical evidence to support this claim, it highlights several issues with the European regulatory regime:
- Burdensome due diligence and disclosure requirements.
- Overly restrictive Simple, Transparent and Standardized ("STS") securitization regime.
- Adverse treatment of securitizations under the capital framework for insurers.
- Bank capital calibration for securitization exposures, which is viewed as overly prudent and exhibiting too high a degree of non-neutrality.
Fund industry organizations such as AIMA have been vocal lobbyists for changes to the EU disclosure regime and for an expansion of the STS label to CLOs. It may be that with the increased focus on funds there is now an opportunity to reset these parts of the framework.
Invitation for feedback
The FSB has invited feedback by September 2, 2024, and plans to publish its final report by the end of the year. Proposals adopted following the consultation will likely shape the next round of G20 securitization reform.
BHS Decision: To Trade or Not to Trade?
That Is Now the Question for Directors of Distressed Companies Following the Recent High Court Ruling of British Home Stores.
Two former directors of British Home Stores (“BHS”) have been found personally liable for wrongful trading and ‘misfeasance trading’ in a decision made by the English High Court which will undoubtedly cause directors of distressed companies considerable discomfort whilst trading in the zone of insolvency. The case highlights the importance of directors seeking independent legal advice and ensuring that each director takes personal responsibility for ensuring compliance with its statutory and fiduciary duties.
Background and Timeline
1990s: BHS, under the ownership of Arcadia and Sir Philip Green, was a highly successful retailer and stalwart of the UK high streets.
Early 2010s: As consumer tastes evolved, BHS lost its competitive edge and by 2015, had accumulated losses of £442 million. In the seven months prior to the collapse of the company BHS had received £72 million by way of shareholder support. March 2015: BHS was acquired for £1 by Retail Acquisitions Limited (“RAL”), an entity ultimately controlled by Mr. Dominic Chappell. Legal and financial due diligence prior to the sale identified that £120m of working capital was required to fund the business and trade credit insurance had been withdrawn, with little prospect of it being restored in the short-term given the financial status of the group.
June 2015: RAL entered into certain financing arrangements and approximately £50 million of new money was made available to RAL. The financing was on onerous terms, described by a senior employee as a ‘wonga loan’ and did not adequately address the financial needs of the company.
September 2015: The court held that the companies in the BHS group were cash flow insolvent. March 2016: RAL proposed a company voluntary arrangement (“CVA”) to restructure its leasehold liabilities. The CVA was approved by creditors, but as a condition to the CVA becoming effective, the company was required to raise certain additional finance for the group.
April 2016: Despite having an offer of finance, the company was unable to complete this financing as a prior ranking secured creditor (owned/controlled by Sir Philip Green), was unwilling to subordinate its security in favour of the new lender. The BHS companies filed for administration.
Personal liability claim for directors in excess of £18 million
The Joint Liquidator of the BHS companies commenced certain proceedings against the former directors of BHS for wrongful trading and misfeasance. In June 2024, the court held two of the former directors liable in respect of both claims, imposing record liability of over £18 million in respect of the wrongful trading claim alone. The court held that the directors knew or ought to have known that there was no reasonable prospect of the companies avoiding an insolvent liquidation or administration from September 2015. This pre-dates the CVA which was approved by the company’s creditors. The directors were found liable for a novel claim described as ‘misfeasance trading’, which relates to a series of breaches by the directors of their statutory duties, including, failure to promote the success of the company, to avoid conflicts of interest, to exercise independent judgment, to exercise reasonable care and not to accept benefits. The court found that because of these breaches, the directors should be held personally liable for certain losses of the companies from June 2015 (i.e. prior to the date from which the directors were held liable for wrongful trading and at a time when the companies were cash flow solvent). The quantum of liability in respect of the misfeasance trading claim has not yet been determined.
Time to file?
The decision in BHS is arguably highly fact specific. The business was under capitalized with inexperienced management from day one of the acquisition. However, the case serves as a useful reminder as to the duties of directors in the zone of insolvency and the real risk of personal liability if directors fail to discharge such duties and act in the best interests of creditors and other stakeholders. The court emphasized that honest, rational directors acting in good faith with the benefit of professional advice have nothing to fear. There is now a real concern that because of the BHS decision, even honest and well-advised directors will not be prepared to incur the risk of personal liability. Consequently, we are likely to see more companies file for insolvency to the potential detriment of creditors, employees and other stakeholders. Sponsors and private credit funds may also be increasingly reluctant to take board appointments and may prefer to appoint independent directors, particularly in the event of financial distress.
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