Overview
In the news
In recent weeks several well known retail-oriented “evergreen” private credit funds have received redemption requests from their investors, which exceed their share repurchase limits, leading to several concerning newsworthy developments.
These events are one of many areas of attention the $3 trillion private credit market is currently receiving.
Redemption woes being perhaps a “canary” in the private credit fund coal mine, the financial press is focusing on the quality and liquidity of private credit fund assets, bank lending exposure to private credit fund borrowers, collateral quality, the impact of AI on underlying SaaS borrowers, mark downs in the values of some loans, and the anxiety of retail investors, among other things.
In Depth
Systemic signals?
Are we seeing the early signs of systemic failure in the financial system resembling the Global Financial Crisis (GFC)? Hopefully not. Many of the headlines are about risk management in action and putting the risks in perspective, for example:
- The small percentage of private credit fund loan exposure banks have as compared to all commercial lending by banks.
- The small percentage of retail investors in private credit.
- Numerous private credit funds and other buyers have stepped up to provide financial support to private credit funds that are in the news.
- Fundraising in private credit continues, albeit at a slow and sporadic pace at the moment.
The big lesson from the GFC
In the GFC, private investment funds were not at the center of the systemic failures of poor mortgage loan quality and excess leverage. But hedge funds became a source of liquidity for investors, and many hedge funds experienced extreme requests for liquidity.
Private credit funds, per se, did not yet exist, and private credit (“fixed income”) strategies were found mainly in hedge funds. At the time, hedge funds overwhelmingly promised, after an initial lockup period, 100% liquidity to all investors at any quarter end.
When credit markets froze from late 2008 into 2009, credit hedge funds could not liquidate assets to raise cash and failed to fulfill their investors’ redemption expectations. Instead, credit hedge funds had to suspend or cut back redemptions (known as “putting up a gate”) or move their less liquid investments into side pockets (if they had them) to be resolved over time. Hedge funds with too many problems would go into liquidation.
The big lesson from the GFC for the private fund industry was that an asset to fund liquidity mismatch could be fatal for a fund and possibly the fund manager’s business.
Aligning expectations with liquidity
From this difficult period private credit funds emerged, and they were designed to avoid a mismatch between fund investor liquidity expectations and portfolio liquidity. At first this was addressed by housing only liquid investments in hedge funds, which adopted 25% per investor quarterly redemption limits. (These 25% quarterly investor level restrictions were welcomed by fund managers and investors alike as neither group wanted to experience dramatic changes in a fund’s capital base.) Less liquid assets (like middle market loans) would be housed in closed-end fund structures resembling private equity funds (a/k/a “private equity-lite”), which had a five-to-six-year life and economic terms tailored to the private credit asset class. Side pockets, which investors disliked because their size and use could be unpredictable, were banished from the market (they would wisely resurface for other strategies later in the 2010s).
Evergreen funds
The growth of private credit from $100 billion to $3 trillion in the years after the GFC through today is not just a story of the growth of middle market lending by investment funds. The expansion includes at least a dozen types of credit strategies, reflecting the creativity of financiers and the appetite of investors for differentiated fixed income returns. For example, our clients use Evergreen Funds to offer asset-based finance (ABF), real estate lending, airplane finance, FinTech lending, and of course middle market direct lending.
As I have explained here, credit fund managers have been eager to move away from the constraints, costs, and on and off fundraising of managing serial closed-end funds. At the same time, investors are open-minded for credit funds with liquidity terms that are calibrated to the term and liquidity of the particular opportunities. Hence the shift over the last seven to eight years to Evergreen Fund structures.
But not all Evergreen Funds are the same. The driver is the type of investor targeted. Retail investors require an Interval Fund or Business Development Company, which are regulated under the Investment Company Act of 1940 and subject to certain liquidity provisions. High-net-worth investors can invest in registered funds and also private Evergreen Funds, as can institutional investors. Private Evergreen Funds have more flexibility with respect to liquidity terms.
One key attribute for these Interval Funds and certain Business Development Companies is a recurring liquidity offer of 5% to 25% of fund NAV per quarter. (In practice this has most often been 5%, with some of these funds increasing payouts by up to 2% and using liquid assets to raise cash.)
In contrast, non-retail Evergreen Funds can use the “Slow Pay” Evergreen structure, where redeeming investors are placed in an internal liquidating account and are paid out their share of asset proceeds as assets are repaid, refinanced, or sold.
Evergreen fund types and terms
| Evergreen Fund Type | 1940 Act Registered? | Eligible Investors | Tax Reporting | Current Income Distributions | Investor Liquidity | Comments |
|---|---|---|---|---|---|---|
| Interval Fund | Yes | Retail HNW and Institutional |
1099 | Yes | Quarterly 5% to 25% fund wide cap | Some funds facing substantially higher redemption demand have increased the cap by up to 2%. |
| Non-traded BDC | Yes | Retail HNW and Institutional |
1099 | Yes | Quarterly 5% fund wide cap | (Same as Interval Fund) |
| Hedge Fund | No | HNW and Institutional |
K-1 | Yes | Quarterly 25% per investor limit | Good for a mix of liquid and less liquid credit assets |
| Slow Pay Fund | No | HNW and Institutional |
K-1 | Yes | Each redeeming investor gets an internal liquidating account, and redemptions are paid as assets are liquidated in the ordinary course (when repaid, refinanced, sold). No caps apply. | Good for a high percentage of less liquid assets. Some Slow Pay funds also offer other liquidity options, such as buybacks and clean-up calls, to assure full redemptions in a reasonable timeframe. |
The differences have turned out to be important in recent times of economic stress.
Interval Funds and Non-Traded BDCs facing high redemption demand recently had to take the newsworthy and disappointing step of pro rating redemption payouts because a cap had been reached.
In a hedge fund, investors agree in advance to a quarterly cap on the amount of their investment that they can redeem. In a “slow pay” fund, they agree to receive their share of each asset as it liquidates via repayment, refinancing, or sale naturally over time; there is never a need for a cutback.
Conclusions
Fund structures for private credit are diverse. We will see how much investors in retail products will tolerate delayed redemptions. Meanwhile, private credit will continue to have many options to align a desired investor base with fund liquidity and asset liquidity.
*For more than 20 years McDermott Will & Schulte’s fully integrated private capital team has been at the forefront of developing private credit funds and private evergreen fund structures.
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