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GUIDE TO

Private Equity Debt Funds

BVCA Guides

Debevoise has been a pioneer in private equity for over

30 years. In both funds and M&A/transactional work,

the firm’s practice is one of the largest in the world,

and regularly crafts innovative solutions for some of the

largest and most complex transactions and fundraisings

in the industry.

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including unrivalled knowledge of fund structures

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Debevoise to provide “one-stop shopping” for fund

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worldwide, our private equity practice has successfully

developed a global market leading position. In the U.K.,

Debevoise is one of the few firms to have senior English-

and U.S.-qualified corporate, tax, and fund formation

practitioners on the ground in London.

connectedLondon 65 Gresham Street London, EC2V 7NQ

E. Raman Bet-Mansour rbetmansour@debevoise.com +44 20 7786 5500

Geoffrey Kittredge gkittredge@debevoise.com +44 20 7786 9025

Matthew D. Saronson mdsaronson@debevoise.com +44 20 7786 9167

John Forbes Anderson jfanderson@debevoise.com +44 20 7786 9183

Nathan Parker nparker@debevoise.com +44 20 7786 5524

May2014_BVCA_PE_ad_210x297mm.indd 1 5/6/2014 11:03:36 AM

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Contents

Introduction 4

Foreword 5

Structuring issues for debt funds 6

Tax topics for debt funds 8

High yield notes – who are you investing in? 10

Regulation – is there a map through the shadow lands? 12

Q&A with Robin Doumar, Managing Partner, Park Square Capital 14

Q&A with Dagmar Kent Kershaw, Head of Credit Fund Management, ICG 15

4Private Equity Debt Funds

Introduction

Welcome to the BVCA Guide to Private Equity Debt Funds, part of the BVCA series of guides which has been designed to serve as an introduction to investment strategies and markets, and provide a top-level overview of the latest trends and developments.

It is no exaggeration to say that the global leveraged loan market has undergone a severe upheaval over the course of the last decade. From the highs of the boom period to the lows of the financial crisis, the lending community has been placed under severe strain due to economic turmoil and resulting regulatory pressure. And, just as nature abhors a vacuum, so too do the financial markets, with new entrants and new products emerging and proliferating.

Debt funds are not new of course – there have been numerous such offerings around since well before the banking crisis, provided by specialists and more general investment houses alike. What is new, however, and what makes this guide particularly relevant, is the sheer number and diversity of funds on offer and the range of assets they now invest in. Once seen as an off-shoot, debt funds are now firmly established as a key component of the financing marketplace.

In this latest guide, we will be taking you on a top-level tour of the latest trends and developments, looking at taxation and regulation, to investor protection and fees. The increase in both supply and demand is having a significant impact on how debt funds are being used. It is a dynamic area and one where interest has accelerated dramatically in recent years and is only going to increase as more assets come onto market.

The guide would like to thank our sponsors, Debevoise & Plimpton LLP, for their support in producing this booklet, and also a special thanks to Robin Doumar of Park Capital and Dagmar Kent Kershaw of ICG for their participation in two particularly insightful interviews in chapters five and six.

Tim Hames Director General BVCA

5Foreword

Foreword Debt funds are no longer a niche. They are occupying a large and expanding terrain in the financing markets. Of course, money market funds and other funds investing in commercial paper and other high-grade, highly-liquid instruments have been around for a long time. But now debt funds, along with their substantial growth, invest across all classes of debt assets. Interestingly, there is even more interest in non-traditional asset classes. For example, Thomson Reuters reported in its latest annual European Fund Market Review that in 2013 there were net inflows of €96 billion into bond funds, and €93 billion of net outflows from money market funds.

Today there is rarely a large financing in which debt funds do not play an important role. This activity has resulted from a confluence of developments on both the supply and demand sides. This guide, whilst not an exhaustive survey of the sector by any means, will explore some of these developments and their ramifications, as well as point towards some of the main characteristics of the debt fund market today.

On the supply side there has been a dramatic jump in investor appetite in debt funds. This interest started before the 2008 financial crisis, but it has increased significantly in the last few years as returns offered by banks on deposits, money market rates, and often more traditional forms of financing remain minimal and investors seek higher yield on fixed income instruments.

As this interest has gathered pace so has the diversity and complexity of these funds. They have had to address concerns from a wider array of investors from different jurisdictions, broader and more diverse investment strategies, and issues confronting a larger and more divergent group of fund managers. In this guide we will touch upon the intricacies of their structures and some of the considerations that arise in their formation.

As banks have been constrained in their ability to lend for many often-discussed reasons, there has been a greater need for the capital provided by these debt funds. Asset classes that have drawn, and continue to draw, tremendous interest from debt funds are in the leveraged finance area, both in syndicated loans and high yield notes. Debt funds have both contributed to and benefited from the tremendous run of high yield issuances by European companies in the last three years.

Growth leads naturally to maturity. A key consequence of the maturity of a financial product is often that it becomes subject to tighter regulatory oversight. We are starting to witness this phenomenon with debt funds. Perhaps most ominously they are being referred to as amongst the raft of ‘shadow banking entities’ which have sparked a great deal of regulatory discussion in recent years. We will touch on some of these regulatory initiatives in this guide, in particular by the UK’s Financial Stability Board.

We will also benefit from the views from within two of the most prominent European debt funds through Q&As with Dagmar Kent Kershaw, head of credit fund management at ICG (Intermediate Capital Group), and Robin Doumar, managing partner of Park Square Capital. They will discuss recent trends and developments, and, for the wary, some possible clouds on the horizon.

There are no signs that the continued expansion of debt funds in the financing markets will abate. We expect that the next stages of the development of this sector will be fascinating to observe, but we are even more excited to be a part of them.

Raman Bet-Mansour Partner Debevoise & Plimpton LLP

6Private Equity Debt Funds

Structuring issues for debt funds Geoffrey Kittredge, Partner, Debevoise & Plimpton LLP

Private funds that invest in credit strategies - whether by focusing on senior debt, mezzanine finance or special credit opportunities - employ structures and key terms that are broadly similar to those of private equity funds. These types of debt funds often take the form of Limited Partnerships in any of a handful of commonly used jurisdictions, and, like their private equity counterparts, compensate fund managers with either an annual management fee, a performance-based incentive (e.g., carried interest or ‘promote’) or a combination of the two.

There are, however, a number of debt fund terms, including aspects of the fee and other economic issues, that differ in material ways from the approach typically adopted by private equity funds.

Investment allocation As a general matter debt funds tend to invest in a larger number of transactions and in amounts

that may be subject to significant variation depending on the number of other lenders in a transaction. The potential range in ticket sizes for investments, particularly at the larger and more complex end of the market, is one of the reasons that an absolute cap on total programme size is less likely to be imposed.

Many credit investment programmes are comprised of multiple overlapping credit fund products (including separate accounts or ‘funds of one’) that are co-investing together. Where these programmes combine investments of a variety of accounts and other fund vehicles, investors and managers must pay particular attention to investment allocation policies that recognise co-investment in certain (but not necessarily all) transactions, and that strike an appropriate balance between giving investors comfort against ‘cherry picking’ concerns and allowing sufficient flexibility to respect any differences among the investment strategies of the various fund vehicles and accounts that make up the overall programme.

7Structuring issues for debt funds

Hybrid terms Debt funds may acquire or sell positions through the secondary market in more divisible lots and at more readily obtainable fair market values than the average private equity fund. Accordingly, debt funds are better suited to so-called ‘hybrid’ features that are sometimes introduced to accommodate periodic redemptions of existing investors, ‘evergreen’ investment, and open-ended fundraising to prospective investors.

The potential for early repayment by underlying borrowers in some instances, or exiting an investment on the secondary market, gives debt fund managers and investors additional flexibility to design reinvestment provisions and investment periods that work in tandem to create fast ramp-ups of portfolios with finite hold periods, or in other cases perpetual investment periods with full reinvestment accompanied by investor suspension and liquidation rights.

Leverage and fees Many debt funds employ leverage at the fund level which is obtained from banks through credit facilities, total return swaps or other derivative contracts to enhance returns and increase their portfolio purchasing power. Such leverage is often taken into account in determining the management fees charged on leveraged funds. Management fees on leveraged funds may be based on invested capital during the investment period - instead of the standard committed capital model in private equity funds - and calculated as a percentage of either the net asset value of the portfolio or the acquisition cost of portfolio investments (including the leverage). The overall management fee charged on debt funds tends to be lower than the management fee charged on similar amounts of capital under management in private equity funds.

The ‘upside’ incentives for debt fund managers vary widely across products and strategies, from a full 20% carried interest with a ‘soft’ hurdle and full catch-up on funds with higher return targets

(e.g., mezzanine), to ‘promote’ percentages and performance fees that are lower and subject to ‘hard’ hurdles (i.e., without a catch up). In some debt funds or accounts with single digit target returns there may not be any profits-based fee or incentive, with the manager receiving only an annual fee that is largely fixed.

SummaryThe relative depth and liquidity of the European and US credit markets, and the range of senior and subordinated debt fund products offered to the international institutional investor community, provides a highly diverse marketplace for private fund managers and investors to craft a customised set of economic and investment-related fund terms to match their commercial objectives. These terms generally follow the broad outlines of the private equity fund market, but depart from those norms to a greater or lesser extent based on the debt fund’s specific investment strategy.

“ The relative depth and liquidity of the European and US credit markets, and the range of senior and subordinated debt fund products offered to the international institutional investor community, provides a highly diverse marketplace”

8Private Equity Debt Funds

Tax topics for debt funds Matthew D. Saronson, Partner, Debevoise & Plimpton LLP John F. Anderson, International Counsel, Debevoise & Plimpton LLP

Debt funds need to take into account, through proper diligence and structuring, tax issues relating to portfolio investments that can affect overall returns as well as tax issues that can affect particular types of debt fund investors.

Withholding taxes on payable interest in a target investment jurisdiction can meaningfully affect returns on a debt investment where margins may be slim to begin with. It is unusual to make debt investments in Europe, and elsewhere, that are not structured to pay interest free of withholding taxes.

These taxes, if they arise, often represent investment return ‘leakage’, which means even if the fund’s investors may in principle qualify for exemptions from relevant withholding taxes (e.g., as tax-exempt or treaty-protected investors) or for relief under a foreign tax crediting system (e.g., as taxable investors), in practice it may be difficult to utilise those exemptions or credits.

A debt fund thus prefers, where possible, to have a strategy to minimise or eliminate these taxes without having to look to the particular status of its investors, and to back this up with a contractual gross-up in the deal documents for withholding tax on interest.

Holding companiesA common approach for European debt investments is for the fund to establish a holding company through which it invests. The holding company is established in a jurisdiction that seeks to optimise (i) the ability for the holding company itself to qualify for exemptions from withholding taxes, either pursuant to investee country domestic law or under a double tax treaty and (ii) if structured appropriately, efficient internal taxation in the holding company jurisdiction.

Countries with a broad double tax treaty network and flexible local structuring tools to minimise internal taxation are thus favoured for this purpose - for European investments, Luxembourg is a typical choice.

9Tax topics for debt funds

The particular structure, however, needs to be carefully considered for each debt investment. Investee jurisdictions have varying requirements for a holding company to qualify for potential treaty benefits or other withholding tax exemptions, and the internal taxation considerations in the holding company jurisdiction may also vary from deal to deal.

Certain fund investors may face particular tax issues relevant to their status in their home jurisdiction depending on how the fund and its investments are structured. For example, a US tax-exempt investor may recognise ‘unrelated business taxable income’ if the fund is considered engaged in a lending business or where the fund leverages its investments.

The fund’s activities in jurisdictions in which it invests or operates can also subject non-resident investors to taxation. In this regard, a fund’s debt investment activities being viewed as a lending business remains the most significant issue faced by non-US investors in debt funds that operate from the United States, as it can lead to taxation on US trade or business income (aka ECI) for non-US investors generally and ‘commercial activity income’ for non-US governmental tax-exempt investors (aka ‘892 investors’).

Many other jurisdictions have similar ‘trading income’ issues for non-resident investors, although some provide safe-harbour exemptions in certain cases or have structural solutions available. In the UK, for example, it is possible the ‘investment manager’s exemption’ may be available to a fund, and in any event a fund can mitigate trading risk by investing through a non-UK holding company structure. Careful structuring of the fund’s investments and activities is needed to help mitigate these issues.

Other issuesDebt investments, and particularly those made by mezzanine debt fund, frequently come with equity ‘kickers’ or co-investment components.

These equity components usually involve a separate set of tax considerations in addition to those relevant to the debt investment, and may require a separate structure in order for a fund to invest efficiently and manage other particular tax issues of its investors. For example, a fund may need to take into account a range of US tax issues relevant to non-US, tax-exempt and taxable investors when making equity investments.

“ Certain fund investors may face particular tax issues relevant to their status in their home jurisdiction”

10Private Equity Debt Funds

High yield notes – who are you investing in? Raman Bet-Mansour, Partner, Debevoise & Plimpton LLP Nathan Parker, International Counsel, Debevoise & Plimpton LLP

Debt funds are investing across an even wider range of assets and asset types. Last year saw renewed interest in the EMEA market and project bonds, which has continued into 2014. In this article we focus on a more traditional investment, high yield notes, and more specifically, who controls the issues.

The high yield market has increasingly become a focus for investors as they continue to search for yields, and, on the other side of the coin, is increasingly attractive for corporates and sponsor-led portfolio financings as they seek to lock-in interest payment obligations for longer periods. The resurgent market in Europe in the last 12 months has seen issuers increase their flexibility at the cost of investor protections.

PortabilityA key change in the European high yield market has been the development of the so-called ‘portability’ feature. With portability appearing in more and more high yield offerings, can a debt fund really know who it is investing in?

Typically, if a change of control occurs (generally when a third party acquires a majority of the issuer’s voting shares) the issuer must make an offer to repurchase the notes at 101%.

During the last year a trend emerged where an additional limb was added to the change of control test, such that even if a change of control occurred an issuer was not required to make a change of control offer unless an additional condition is also satisfied, namely that the leverage was higher than a specified level or the change of control caused a ratings downgrade. If these criteria are not met a sponsor can exit a deal and leave the issuer with new ownership without the noteholders having any ability to put their notes back to the issuer.

The prevalence of the portability feature increased during 2013, and 11% of European issuances in Q4 contained a portability concept.

The trend continues in 2014 with around 17 deals during Q1 (approximately 33% of Q1 deals) containing a portability feature. Certain deals have come to market with a further erosion of the change of control protection by testing leverage for the purposes of the portability test calculated net of cash and cash equivalents, making the ratio easier to meet.

Changing controlCommentators have noted that a relaxation of the change of control test leaves the investor at the mercy of the new owner with respect to

“ A relaxation of the change of control test leaves the investor at the mercy of the new owner”

11High yield notes – who are you investing in?

use of the cumulative credit under the restricted payments basket. One has also observed that a sponsor could inject equity into the structure in order to meet the portability leverage test (gaining credit under the cumulative credit) and then the purchaser could immediately dividend this out once the change of control is complete. An adjustment to the purchase price under the purchase agreement could neutralise the position between buyer and seller, and the investor in the notes would be left without any ability to put the notes back to the issuer in circumstances where the leverage has been artificially deflated to meet the portability test.

This year has already seen other approaches to deal with portability, with one issuance coming to market with a portability feature and also an expanded definition of eligible acquirer which allows a purchase by a buyer meeting certain criteria without triggering a change of control regardless of leverage or ratings. At least in this context an investor has some ability to assess the likely value of the purchaser to them, but investors would need to be aware of this additional flexibility and satisfy themselves with respect to the criteria.

High yield investors, and particularly funds that are looking to the quality of the sponsor when making their investment decision, need to be aware of portability features and have a clear understanding of how the ratio is calculated to be sure they know who they are investing in.

It seems that this trend will continue to develop over the coming year and it is important for investors to be aware of how their traditional change of control rights are changing. Conveniently, this portability feature has not yet been seen on the other side of the Atlantic.

12Private Equity Debt Funds

Regulation – is there a map through the shadow lands? Raman Bet-Mansour, Partner, Debevoise & Plimpton LLP Nathan Parker, International Counsel, Debevoise & Plimpton LLP

Since the financial crisis there has been increased attention from regulators towards ‘shadow banking’. As debt funds become increasingly active in the LBO market and other traditional bank lending spaces, we are seeing initiatives and increased demand for shadow banking regulation.

The Financial Stability Board (FSB) describes shadow banking as “credit intermediation involving entities and activities (fully or partially) outside the regular banking system”. Or, put more simply, the engagement of non-banks in bank-like activities.

Of necessity this is a broad definition, which can make it difficult for a non-bank to assess whether it is likely to be subject to shadow banking regulation. For the time being at least, debt funds would seem to fit the definition, and so it is a regulatory debate worth keeping a close eye on.

FrameworkThe FSB is empowered by the G20 to establish a framework to regulate shadow banking. It is set to report back to the G20 in November 2014 and has focused on five particular areas to mitigate potential systemic risks resulting from the increased prominence of shadow banking entities:

13Regulation – Is there a map through the shadow lands?

1. Mitigation of risks in banks’ interactions with shadow banking entities – essentially concerning the ‘spill-over’ effect between the regular banking system and the shadow banking system.

2. Reduction of the susceptibility of money market funds to ‘runs’ – current proposals from the EC and SEC in this area have gained a lot of attention recently. The SEC proposal contemplates either funds being divided into individual and institutional funds (with an institutional fund having a floating NAV based on the value of its investments) or implementing a series of ‘gates’ to limit withdrawals, or a combination of these two measures.

3. Improvement in transparency and aligning incentives associated with securitisation - the IOSCO has introduced a number of policies endorsed by the FSB to address retention of economic interests by revised classes of originators, sponsors and original lenders, and to improve transparency in securitisation transactions.

4. Reduction of risks and pro-cyclical incentives associated with securities financing transactions – these include repos and securities lending that may exacerbate funding strains in times of market stress. The FSB has finalised most of its policy recommendations in this area, with further policies expected to be approved during 2014.

5. Assessment and mitigation of stability and systemic risks posed by shadow banking entities and activities – the FSB is focused on the fact that shadow banking entities and activities are various in form and are constantly evolving. The policy in this area is therefore aimed at creating a framework to detect and assess shadow banking on an on-going basis.

These five policy areas show a considered and thorough approach to the proposed regulation. It is wide reaching and has the potential to impact a range of legislative measures and regulatory bodies.

Development and implementation of the policies is at various stages. Recommendations made by FSB are not legally binding and need to be adopted in domestic legislation by the relevant national or supra-national regulator. Elements of the reforms can be seen at an EU-level in measures such as the progress of the Capital Requirements Directive and the Alternative Investment Fund Managers Directive.

HarmonisationThere has been a great deal of discussion in the last year about the potential mismatch in requirements as different jurisdictions come to pass enabling legislation. By way of example, in response to the mismatch in securitisation retention requirements, the European Banking Authority has acknowledged the need for harmonisation and has signalled that there may be some flexibility in this regard. However, it remains unclear how this and other conflicts may be resolved.

Inconsistent implementation may be justified as addressing issues particular to a jurisdiction or on national policy lines, but it will continue to create an even more complex environment for those funds who are within the ambit of shadow banking regulation.

One thing is certain, the situation is very fluid. For example, we should not expect that the reforms to give effect to the policies developed by the FSB will be enacted in a single coherent piece of legislation. As such, it is crucial that debt funds continue to monitor legislative developments and the range of EU and domestic laws still in consultation.

“ It is crucial that debt funds continue to monitor legislative developments and the range of EU and domestic laws”

14Private Equity Debt Funds

Q&A with Robin Doumar, Managing Partner, Park Square Capital Are investors still pouring money into debt fund products and strategies?There remains tremendous interest in credit and fixed income strategies. The FT published an interesting statistic noting inflows since 2009 to fixed income have outstripped those to equity funds during the 1990s tech bubble, both in absolute and relative terms. In our view that has created enormous distortions in bond markets globally, which we believe are in bubble territory.

What is your view of the evolution of European sponsors to be one-stop shops for multiple investment strategies?

‘One-stop’ shopping is a great way for a fund manager to maximise assets under management, bolster fee income and generate stable earnings for managers that want to go public or have recently done so. However, it creates inherent conflicts of interest and these managers’ core expertise is not credit. We are sceptical that the first point of call for a sponsor will be the credit arm of one of their competitors. As a result we think that Park Square’s position as an independent credit provider will continue to be an important differentiator to sponsors.

Which regions are debt funds looking at with particular interest at the moment?

The frothiness in bond markets and tightening spreads triggered by the global liquidity glut from quantitative easing has driven investors to peripheral markets and into increasingly riskier capital structures. We have resisted this trend and remain focused on our core markets. For the meagre yield pick-up on offer, we think markets outside the European core offer poor risk-adjusted returns in the context of tapering and a rising interest rate environment.

Where do you see yields going in the near future?

As tapering continues apace we believe yields will remain stable in the immediate future, and begin increasing over the intermediate term. The key question will be whether the transition proceeds smoothly or more quickly through a sudden correction, which could be down to exogenous factors or shocks that are impossible to predict. The general trend has to be upwards, however, as we are at the zero bound on key benchmarks with nowhere lower to go. The rising cost of bank balance sheet capital triggered by tightening regulatory standards and widening spreads on AAA financing costs for CLOs makes further tightening unlikely.

Is investor attitude to debt investments over equities changing, especially in light of the recent surge in IPOs around the world?

Sophisticated investors have always had an allocation for both equities and credit strategies in their portfolios. The dramatic run-up in equity values and new peak levels reached across equity indices, however, makes credit appealing on a risk-adjusted basis. The challenge for Limited Partners is that credit outperformance will depend disproportionately on manager selection. Stable, consistent returns are predicated on avoiding credit losses, which for fixed income investors is a paramount concern given our capped upside.

15Q&A

Q&A with Dagmar Kent Kershaw, Head of Credit Fund Management, ICG What are the current levels of interest from in debt fund products and strategies?

There is a strong appetite from investors. It is coming from three key areas, all of which highlight the general search for value and yield. First, fixed income investors who are being turned off government bonds continue to look for yield, and are increasingly finding it in debt fund products. Second, investors are coming out of equity as they look to de-risk without losing yield, and so are turning to debt fund products as a low-beta alternative to equity. Third, investors are turning away from emerging markets and finding a new home in debt funds.

The European debt market is evolving, with bank debt being replaced by bridge financing and later, high-yield financing to take out the bridge. Do you think this trend will continue, and what are the drivers?

Banks, as we know, need to shrink their balance sheets. When it comes to leveraged lending, that means not re-upping to the same degree as they have in the past. Not pulling out entirely, but decreasing their hold sizes.

There has certainly been a meaningful trend of replacing bank loans with high yield bonds. This has been driven by an increased availability of capital in the bond universe, and high yield gives borrowers access to a larger audience of buyers. It is an easier asset class to access, and borrowers are attracted to locking in low interest rates for five years. The growth of senior secured bonds, which sit pari-passu to loans, has been meaningful in bringing more investors into high yield.

Over the past 18 months we have seen the return of covenant-lite deals and PIKs, and the emergence of new structures such as uni-tranche financings. What do you see as the catalyst for this trend?

The market has obviously had to be more inventive in recent years, particularly in the mid-market which is where we are really seeing bank retrenchment which is being replaced by new entrants moving into direct lending. This is where most of the real innovation is happening, including uni-tranche financings.

What is the biggest headache for debt funds at the moment?

Asset sourcing is certainly the biggest challenge. It is a popular area of the market and everyone is looking for the best assets. Bond issuances are frequently over-subscribed, which is a trend we expect to continue to see.

“ The market has obviously had to be more inventive in recent years, particularly in the mid-market”

British Private Equity & Venture Capital Association bvca@bvca.co.uk www.bvca.co.uk

About the SponsorDebevoise & Plimpton LLP

Debevoise & Plimpton LLP is a leading international law firm, with eight offices around the world. The firm has been a pioneer in private equity for over 25 years and is a recognised leader in both fund formation and private equity transactional work. With over 200 lawyers serving private equity in the US, Europe and Asia, Debevoise is among a handful of firms with a truly global private equity practice.