Credit Funds: Rated Note Feeders FAQ – Fund Finance

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.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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