Absolute Credit Series: Beyond Borders: Structuring Rated Funds and CFOs for Non-U.S. Investors

LINDSAY TRAPP (00:03)
Good morning and welcome to another episode of Absolute Credit. I’m Lindsay Trapp, a partner in Kirkland’s New York office and very excited to be coming to you today from the podcast studio in our New York office joined by my partners, Kate Luarasi and Meredith Levy. Welcome.

MEREDITH LEVY (00:19)
Thank you. It’s great to be here.

LT (00:20)
Excellent. We are very excited today because we have definitely been seeing a bit of a trend coming through in the rated fund and CFO space that involves non-U.S. investors, which is fantastic. And we’ve certainly had non-U.S. investors in these structures for a while. Obviously, there’s a lot of insurance regimes that kind of run around the world and some of those differ. Some provide a look-through structure similar to the EU. Others do structures more like the U.S. in relation to their equivalent of risk-based capital. So there’s a lot of interest from folks in coming into this, but there’s also a lot of interest in the residual tranches in these structures from non-insurers who are also based outside of the United States. I’m sure, Kate, you’ve been seeing very similar things with folks kind of trying to, let’s say, mix and match where we used to just stick that structure onto the offshore fund now.

KATE LUARASI (01:21):
Yeah, 100%. I will say there’s definitely some jurisdictions, as the three of us know very well, that are still very hard to pair up with rated notes and CFOs just by virtue of all of the other regulatory regimes, reporting, structuring requirements that they require. But certainly with non-U.S. jurisdictions, there is kind of a sweet spot and we do see that a lot. Meredith, would love to get your thoughts on what you’re seeing as well, maybe in or outside of our deals.

ML (01:52):
Yeah. So as you have both noted, we have been having a lot of conversations with non-U.S. investors who are interested in these structures. And the thing that I’m here to talk about today is how those investors’ tax profiles might affect how we think about bringing them into these structures. So for U.S. investors or U.S. people, we’re subject to U.S. tax on everything, all of our income, no matter where it’s earned. And so no matter what type of investment we make as a U.S. person, we pay tax. A non-U.S. investor does not subject themselves to U.S. tax in all situations. A non-U.S. investor is subject to U.S. tax generally in two situations. The first is if they’re engaged or treated as engaged in a U.S. trade or business. And then the second is they can be subject to some withholding taxes with respect to some types of U.S. source income like U.S. source dividends and sometimes interest. And so non-U.S. investors who come into these structures will need to think about how those investment, whether their investment might be reduced then by some tax leakage and how we might be able to make these structures that are very heavily structured for the insurance and regulatory regimes that they’re intended to address work for the non-U.S. investors tax profiles and from an after-tax return perspective.

LT (03:30):
So I think rated funds are funds. So we probably should just go back to the basics and talk a little bit about how do we get to the questions around particularly ECI in the context of credit funds, which are probably the most common asset class for rated funds, but certainly not the only ones – but what is ECI?

ML (03:52):
So the first category of tax that non-U.S. investors might have to pay is what I described as being engaged in a U.S. trader business. So for starters, that could be if a non-U.S. investor came here and opened up shop and started to conduct a business here, meaning in the U.S., they would be subject to tax. But as a non-U.S. investor, you could also be treated as engaged in a trader business if you are a partner in a fund and that fund is engaged in a trader business. And so what constitutes a trader business is the subject of lots of discussions with us and with tax lawyers and also a lot of legal authority. But one category of activity that may be a trader business is the business of loan origination. And so that is where this comes up in credit funds. And so if a non-U.S. investor was a partner in a partnership that was going out and making senior loans, negotiating those loans, if the non-U.S. investor were to be a partner in a partnership that was engaged in loan origination, negotiating loans, soliciting borrowers to make loans, that is generally a U.S. trader business and might cause the non-U.S. investor or would cause the non-U.S. investor to be treated as engaged in a U.S. trader business and therefore subject to tax on the income from that investment.

(05:27):
That non-U.S. investor also would be required to file a U.S. tax return to pay the tax on the income that it receives and it would be subject to withholding tax from the funds. So that is when somebody says, “I’m sensitive to ECI and I want to invest in a credit fund,” that is the concern that they are trying to address.

KL (05:48):
And Meredith, we’re seeing a lot of expansion in this space. So it feels like every day we’re taking calls about newer, more niche, more esoteric type assets in the credit space or what we like to call as a credit adjacent. So this would pick up, I don’t know, certain ABF or royalty assets, you can be pharma at various stages, some very different real estate assets or even carbon credit. Really the world is our oyster in this space. How did you think about applying the ECI analysis that you just ran through for us? How do you apply that to these other credit or credit adjacent, but definitely more niche, more esoteric assets?

ML (06:35):
So a great example of that is real estate. The tax rules also provide that if you are a non-U.S. investor and you invest in certain U.S. real estate assets, that is also treated as ECI. So the gain from the sale of those assets would create the same tax considerations that we talked about a moment ago. And as you move into some of these other types of asset classes, the ECI analysis can become considerably more bespoke. So this is not just an issue to think about if you’re forming credit funds, it’s an issue that, or a consideration, I should really say, that needs to be taken into account when you are doing any of these types of funds that we’re seeing trying to become rated funds and CFO structures.

LT (07:31):
Awesome. So I guess at its base people are probably like, well, why is this a problem then? If we have things that fix this for credit funds, what happens with rated funds, which obviously debt and equity are treated differently for tax purposes in certain circumstances. So I guess let’s start with that as a base. How is it different if you are an investor that’s solely coming into the debt in the structure and how is it if you’re coming into the equity or I guess specifically that there may be certain rated tranches that are also treated as equity as well?

ML (08:06):
Right. So often these structures have different tranches from the most senior to the most junior or equity-like issuance. And although the name of the instrument that is being issued as a note versus as an equity interest is one factor in the determination of how we would treat these instruments from a tax perspective, that’s not the only factor. And so when we do these structures, we will look at all of the tranches and determine whether the features of that tranche may get treated as debt from a tax perspective or as equity from a tax perspective. And the way that we treat the instrument from a tax perspective will affect how investors, but specifically non-U.S. investors are treated for tax purposes as a result of an investment in that class of notes or equity. The notes, if they’re treated as notes that are issued by a U.S. issuer, those non-U.S. investors will often seek to confirm whether those notes will require them to be subject to withholding tax on the interest payments, and they may have their own trade or business concerns with entering into a note purchase agreement or other instrument that allows them to purchase the notes under the fund documents.

The equity tranche or any tranche that’s called notes but that we intend to treat as equity from a tax perspective is just like investing in the equity of any fund that makes the types of investments that we were talking about earlier. So if you acquire the equity tranche of a rated feeder or a CFO, you are treated as an investor basically indirectly in the underlying fund assets. And so if those fund assets are assets that generate ECI, you need to be concerned as an investor in the equity tranche with the treatment of that ECI to you. If the investments that are held by the underlying funds are investments that the income from which is subject to U.S. withholding, that will also indirectly flow up to the non-U.S. investors. So the calculus for a non-U.S. investor who’s coming into one of these structures is what types of assets is the underlying fund, or funds sometimes, investing in and what is the tax treatment of that?

And then what is the tax treatment of the type of instrument that I am acquiring? Am I treated as owning those assets indirectly but recognizing the income from that from a tax perspective or am I really treated as a lender for tax purposes to the entity that holds those assets, in which case the tax consequences would be different?

LT (11:08):
If we have this and let’s say we have someone who has delightedly decided to come into the equity, if they were a non-U.S. person or as very commonly happens, you have perhaps a non-U.S. affiliate of a U.S. insurer and they would like to have both entities within the same vehicle. Are there things that we can do to help this? I think Kate and I have looked at what would happen if we tried to block below. So obviously if we have a non-U.S. fund and all non-U.S. investors, that’s a very easy stack, but putting some of those different levers that we can pull or different structures that we can use between the feeder and the master fund can have an impact on the rating, can have an impact on the cash flows and create other things that are not particularly wonderful with administering that theater. So what else can we do to try to help this?

ML (12:10):
Well, I think what you’re observing is that there are structures that certain non-U.S. investors outside of the rated fund context like to invest in. And those are structures where sometimes the tax that I described that needed to be paid by the non-U.S. investor can be paid by a fund entity or an entity that is set up by the sponsor for investors in the funds and that becomes part of the stack of entities. But that means that if you think about the stack as the notes and the equity being issued from the top, the cash that that entity that pays the interest on the notes and then makes the residual payments on the equity is going to be reduced by the taxes that are paid in the stack of entities on behalf, effectively, of these non-U.S. investors. So for tax purposes, we think of entities as either transparent like partnerships or corporate corporations that themselves pay tax.

So if you were to compare two fund structures, one that was a stack of all tax transparent flow-through entities where the tax consequences of investing in that strategy flowed up or to all investors, then the cash that’s received by the top entity to pay the payments on the notes and the payments on the equity is gross of any taxes. If you stick an entity that pays the tax on behalf of some of these investors or really all of the investors that are upstairs in between and then issue notes and equity from an issuer that holds an interest in the taxpaying entity, you will have, depending on the tax rate and the income that’s earned by that entity, you will have not a hundred cents on the dollar with which to satisfy your obligations under the notes and the equity. And so sometimes that can work though as you noted, I guess it can have some knock on effects for the ratings, but sometimes that’s different than the return expectation that investors in a fund may have.

KL (14:35):
We are seeing an increasing amount of baskets at the top of the waterfall, especially in horizontal structures where the equity investors want to be able to receive some cash upfront so that they can essentially pay their own taxes. Obviously it’s always a friction point, one with the rating agencies and two with the other investors more significantly the debt investors tend to be very focused on every single penny that’s kind of going out the door ahead of them. But yeah, we are seeing a lot more of that. We’ve done this a few times where sometimes it’s actually easier to not put in a dollar basket, but rather to back into it and just refer to the types of calculations that will be made. Do you find that when we’re negotiating those types of provisions, there’s a set preference either way?

ML (15:36):
Well, from the tax lawyer’s perspective, my set preference would be to make sure that the equity owners, to the extent that this is important to them, are able to get enough cash out to pay their taxes. Because as we talked about earlier, if everything is tax transparent, anybody who owns equity, if they are subject to tax on the type of income that is being generated by the underlying funds, they are going to have to pay tax currently on that income whether or not they get a distribution. That’s just the way partnership tax works. And so if you are somebody who’s very focused on making sure that the equity owners are protected, then I think it is often hard to estimate what that basket should be with any sort of specificity and certainty. And so using words that describe how you would make those calculations, but allowing the calculations to be made based on the facts in existence at the time that the calculation is made will provide more certainty that the equity owners will be able to get enough cash out of the system in order to pay their taxes.

Of course, on the other side, that means the debt holders don’t necessarily know the exact dollar amount of cash that is going out the door in order to pay the equity. This tension is not unique to rated feeders and CFOs. I mean, when you negotiate large credit agreements for businesses or funds, the use of cash to be able to pay your taxes as compared to the use of cash to pay back the interest that you might own on the loan is always a discussion point. And here I think it’s just heightened because it’s not the borrower entity that has to fund its tax, it’s the upstairs investors that really need cash, a distribution of cash, in order to satisfy liability that they have to the government.

LT (17:40):
So if we don’t really have too many options below for the varying reasons we’ve discussed, and then we’re also looking at, okay, well, are we going to have enough money to even pay the taxes? There are options if we put some stuff above the structures, right?

ML (18:03):
Right.

LT (18:05):
We can do some of the fund things that we do up above the equity in particular, but technically you could do it over some of the notes that are treated as equity for tax, my favorite tranches. So is that something that we have seen or you have seen?

ML (18:20):
The question I think always becomes how does that affect the return? So what you’re describing is instead of having a fund structure where somewhere in that stack there is an entity that pays tax, that upstairs maybe there’s between the rated feeder and the investor, there might be an entity that pays tax and that is entirely a question of what that does to the investor’s return. It might work and in some cases that might just not be how they’re thinking about modeling it. There’s also, I think depending on what the fund is investing in, whether that is almost too blunt of a solution is something to think about because we talked about earlier all the types of things that can create ECI, but there are other investments that funds make that are not trader business generating assets. There is a statutory rule that if you trade in stocks and securities, that is not ECI.

And so if part of what your fund holds are those types of assets and part of what your fund holds are ECI generating assets, putting just an entity on top of the structure to absorb and pay tax on all of that might affect the returns more than is expected.

KL (19:51):
Class C or D are always the ones on the table. I think it’s interesting. Obviously Meredith and her team are key, tax is key, reg folks are key. There’s no bright-line test other than those sub-IG notes and the equity notes are always kind of a friction point, but it’s always something to figure out. A lot of the investors in those notes frequently want some kind of determination that that class C, for example, is going to be deemed to be debt and that they won’t be subject to the same highest level of transfer restrictions or withholding provisions as the subordinated notes are. And there’s a little bit of wiggle room, but you can’t really give away the house on those just because it’s to the point earlier, it’s always a balancing act and it’s always a measurement of consequences and materiality.

And if you give something away on, for example, withholding treatment or transfer restrictions, et cetera, what are the chances that that uncertainty has now shifted the burden and all of the risk back to the fund, which ultimately everybody’s... It’s not necessarily a zero-sum game. You and I talk about this all the time, it’s not necessarily if we give this other tranche loses it or it’s a sponsor versus the investors, it almost never is. There is actually a lot of inherent alignment in making sure that that risk is somewhat evenly parceled out. And so the fund can’t always take on the risk for a particular investor that tends to be skittish or more sensitive to certain items. And a lot of that is because in working with Meredith and her team and our other tax folks, it’s not a simple clear-cut answer. So it really does tend to be a risk shifting mechanism and more than anything and on alignment, if all of that risk is shifted back to the fund, that is something that impacts not just the lower tranches, but ultimately class A, class B up and down the capital stack, everybody faces that risk just by virtue of having invested in the fund in one form of capital or another.

LT (22:33):
For sure.

KL (22:33):
It’s unfortunately not a bright-line test or easy gives either way.

LT (22:39):
From an insurance regulatory capital as well, if you seek somehow to mitigate the tax burdens through some sort of fund-ish type structure up above, depending on the jurisdiction and obviously people would have to go to their local regulators and kind of sort that through. But if for instance, you took that through a fund or another equity type of structure, blocker structure, that ultimately could mean that you are not for regulatory purposes holding a note anymore, in which case you may not be getting any equivalent of risk-based capital solvency capital treatment for those particular instruments. And so then it becomes a question from an economic standpoint, is that what you were hoping for? Is that what you were trying to do? So there’s just a lot that goes into it, but hopefully I think everybody’s now gotten at least the flavor of the things that we get to see and talk about and chat about.

This is the lovely nerding couch where we like to think through these things and do every strange permutation that we can come up with. So, this has been awesome, ladies. Thank you so much for coming in, and thank you to all of you for watching and we hope that this has been helpful or useful for you. You can now catch Absolute Credit on both Spotify and Apple Podcasts as well, which we’re very excited about and thank you so much to our amazing team for making that happen. And we look forward to seeing you guys in the next episode.