Absolute Credit Series: Regulatory Relief & Tax Alpha: Why Insurance-Dedicated Funds Are Gaining Ground

LT (00:00)
Good afternoon and welcome to the Kirkland & Ellis Absolute Credit vlog. I’m Lindsay Trapp. I’m a partner based in our New York office, and today I’m very excited to be joined by my partners Bruce Gelman and Kate Luarasi to discuss another tool in the toolbox, insurance-dedicated funds. Hi, Bruce and Kate.

KL (00:24)
Hey, Lindsay, thanks so much for having us. We’re excited to be on here and to discuss one more avenue by which we can incentivize insurance company investors to invest more into structures. These are a growing vertical within a lot of our sponsor platforms and Bruce and I do a lot. Bruce is actually the OG around these parts. Will let Bruce talk a little bit more, but it’s always great to be working alongside Bruce and to be able to deploy one more means of regulatory capital efficiency for our clients.

BG (01:04)
I know you mentioned insurance companies being interested in these products, but we can certainly talk about that. I hope we do. We will. But there are lots of other types of investors, including high-net-worth investors, foundations, endowments that can use the product very efficiently, and lots of reasons to do that.

LT (01:24)
Well, with that, why don’t we just give a little bit of background of what is an insurance-dedicated fund?

BG (01:31)
Sure, I’ll start. All an insurance-dedicated fund is, is an investment fund that invests in … it could be credit investments, private equity, hedge fund, real estate, really anything. It’s structured to be owned by insurance companies’ separate account. And all that means is the only investors, direct investors in the insurance-dedicated fund are insurance companies. The question is, how do you get access to them? It’s not as if any one of us can make an investment directly in an insurance-dedicated fund. You have to buy, if you’re an individual, you have to buy, get investments, get access through a private placement life insurance or a private placement variable annuity contract. And if you’re an insurance company, you typically get access through a private placement variable annuity contract.

LT (02:18)
So, what’s the purpose of them, ultimately? These are not like the products that Kate and I do on the other side, which is structured credit, where you’re looking to get long-term bond treatment. So how does an IDF help?

BG (02:33)
Yeah, so the question is, why do you set these up? And we can talk initially about what you and Kate brought up, which is the insurance companies making the investments. And that’s typically for regulatory capital benefits. If an insurance company makes an investment in one of our sponsors’ private equity fund, they like to do that, except there’s a capital charge for doing that. So it’s very expensive from a regulatory standpoint. But if they make the investment through an insurance-dedicated fund, there typically is no capital charge for those investors coming into the fund. Lots of our other clients, lots of our other sponsored clients set these up for other reasons though, not only to attract insurance company capital, but also to attract high-net-worth capital, family offices capital, private foundations or endowments. And the reason is as follows. When we invest in credit, for example, as an individual, it’s obviously a very good return, but it’s, depending on what state you’re in, could be 40 to 50% tax rates. When you go through an insurance-dedicated fund and structure through, whether it’s an annuity contract or a life insurance contract, there’s no taxation. So there’s a lot of tax alpha generated from going through these products. In fact, if you think about 40 to 50% tax rates, if you’re thinking about a 10% net return from a credit fund, you’re left with $5 or $6 after tax in a taxable credit fund. But if you go through an insurance-dedicated fund, that 10% return, there’s a little bit of leakage from the insurance company costs, but you’re typically looking at 9.5% effective return. If you extrapolate that over a lifetime, 40 years, it’s a much different return profile over that period versus paying tax year-in and year-out in a credit fund.

LT (04:18)
So there’s really a big tax angle to it.

BG (04:21)
Yeah, and I mentioned the foundations and endowments and pensions. Those investors we see coming into these products, because a lot of our sponsors generate what’s called UBTI to those investors or tax for those tax-exempt investors. Using these products, a sponsor can do whatever it wants, and it doesn’t generate UBTI to the investors. What the investors are receiving in those cases are just annuity income free from UBTI or free from tax, as long as they don’t borrow to make the investment in the underlying annuity contract.

KL (04:50)
So I think one of the things that’s like maybe the most interesting and probably foundational aspect of this is Lindsay and I are immediately seizing on the fact that this is great for risk-based capital purposes. But as Bruce just highlighted, this is actually something that came out of the code. This is ultimately a tax structure that happens to have attendant benefits for insurance company investors, but it’s actually set up for all kinds of investors and can really be a thoughtful and compelling way to increase AUM for our clients. Bruce just highlighted it’s investment strategy neutral. So you don’t need to … like some of our rated products will require a certain part of a certain portion of the portfolio composition downstairs to be credit or income-generating products. The beauty of IDFs is that they don’t have that requirement. So long as you meet investor control doctrine and diversification and other requirements, which we’ll go through in a bit, it’s actually investment strategy neutral. So you do not have the rating requirements and you do not have the credit strategy requirements downstairs.

BG (06:06)
That’s right, Kate, you know, the benefits to the fund manager. Why would a fund manager be interested in this? And you really highlighted that, like it’s a way to get regulatory capital, insurance company capital into a product that … into investment strategy that they might otherwise not do or might otherwise not make as big an investment. But it’s also, you know, that capital then, whether it’s individuals like high-net-worth families or whether it’s insurance companies, it’s very sticky capital. You know, whether the sponsor has a closed-end fund, where you have a 10-year fund, you’re constantly raising capital for the next fund or an open-end fund. This capital tends to be much stickier in the sense that people, whether your insurance companies that are investing or individuals, they’re thinking very long-term. And it is just another strategy, another arrow for the quiver for fund managers to use to provide another option to get capital indirectly into their flagship fund or something else.

LT (07:07)
So that leads me to the next question from my side, which is: How do these structures ultimately fit within the wider fund structure? Are they the feeder, of sorts, or is this going to be a standalone structure?

BG (07:21)
There’s lots of different ways. Many of the ones we see are just … effectively, we’ve got sponsors that have lots of different funds, a flagship fund and lots of other funds. These can be standalone in that they can invest on a side-by-side basis with the flagship fund and some of their other products, or they can be like a fund-to-funds model where this, that this insurance-dedicated fund is going into the flagship fund and also lots of other products by the sponsor. As Kate mentioned, and we can get to this later, there are diversification requirements which need to be met, not a big issue for most of our sponsors.

LT (08:03)
So, generally, I’m guessing this is also a Delaware partnership structure, or is there corporation or trust type structure more like a ‘40 Act fund?

BG (08:16)
Typically, we see these as ... they can really be anything, they tend to be Delaware partnerships or LLCs, and the reason for that is the ultimate owners of these assets, whether it’s the insurance company owner at the top or the individuals, they’re effectively buying policies from an underlying life insurance company. And the underlying life insurance company as the sole effective owner of the policy effectively doesn’t pay any tax in the sense that all of the income, whether it’s credit or private equity or anything else, flows through to the insurance company investor. But the insurance company investor gets a credit, gets a reserve deduction for everything it ultimately has to pay out to the … whether it’s an individual or the policy owner that’s a life insurance company. And so what you want effectively is something that’s otherwise not taxable in the structure. So a partnership or LLC is typically what we expect.

LT (09:10)
So we’ve talked a lot about how these are not necessarily new products. Certainly I know I’ve heard about IDFs for quite a long time, but it doesn’t seem as though they are something that every single manager out there just has one, the same way that they’re setting up some of their regular fund strategies. So do these tend to start small, get big? Particularly as it seems that often they’re single investor type of structures, as well with the kind of one insurance LP, are they often smaller on size? What’s the typical range, I guess, and how big have these gotten in the market?

KL (09:53)
That’s a great question. So here at Kirkland, we’ve done a lot of these and continue to do them. There is a pretty wide spectrum in size. So, you know, some of them can be as low as $25, $50 million. On the other end of the spectrum, you know, there’s IDFs in the market with $5+ billion. I would say the bulk of concentration, especially for managers, you know, launching their first IDF would probably be closer to the $100 million, $200 million size. We do see a lot of concentration there for first time IDFs. Certainly, you know, and happily for our clients, we also see increased size in subsequent and successor IDFs. So if the first one’s $100 million, you know, the second one is pretty often like $200 million plus. It really honestly comes down to you know, if there is an anchor investor and to the extent that that anchor is an insurance company, a lot of them are actually just single investor vehicles or they end up being single investor vehicles. So I think one important point that we should probably highlight is the cost efficiencies. For the first one, there is a lot of learning. It’s a curve for sure. And to the extent that there is a very small ticket on the line, maybe the cost efficiencies aren’t there. A lot of our clients make the decision that if they’re starting with a $25 million ticket for their first IDF, it’s really more of an investment and efficiencies of scale can be reached on multiple successor IDFs. But really, if we’re looking to hit that cost efficiency mark on the first one, we’d probably advise that, you know, be looking at an anchor investor with around $100 million in that ticket size for your first IDF.

BG (11:52)
And that’s especially true with the ICOLI investors where they’re coming in as a single investor. They know what they’re putting in. It’s typically $100 million or so. Those tend to be closed-end funds. They’re coming in for 15 years, 20 years or something. And that’s it. A number of ones in the market that we see are commingled funds with lots of different kinds of investors, taxable investors who are using PPLI products or variable annuity structures for the institutions. And those tend to be ... they can be closed in as well, but they typically open end in the sense that they go on forever. And so the money comes in like a hedge fund, no distributions like a hedge fund. And when you’re ready to redeem 20, 30, 40 years from now, you redeem. And those tend to be not the single investor ICOLI products, but the commingled products for other investors, the taxable investors and the foundations endowment type investors.

LT (12:46)
So can be a very good long-term investment for a manager to not only, you know, for the immediate fund that they’re looking at, but to build a platform that can ultimately grow in size over time and cover seemingly any strategy that they can think up, which is also fantastic. So, let’s say a manager decides that they would like to pull the trigger on doing one of these structures. About how long would you expect it to take to set one up? Is it similar to setting up a fund? Or is this something that takes a little bit longer because you’re dealing with the IRS or is it, just kind of, you set it up to meet the code?

KL (13:30)
They can actually be pretty quick. I guess the two most dispositive factors of consideration in answering the question are going to be, has the manager done one before? Are they familiar with it? And two, are they using an administrator? If they’re using an administrator, there’s two very prominent ones in this space. And they cut some of the guesswork and some of the admin headache. There are really two main documents. Now, they’re fundamentally important, but there’s two main documents. One of them is the advisory agreement. That tends to be fairly simple. Obviously, you’re going to have regulatory components. You’re going to have critical tax components and you’re going to have the manager weighing in on what can work for them operationally. The other piece is essentially a supplement, and that is going to govern the terms of the IDF. And it’s also going to have something that kind of looks like a PPM in the back. So it’s going to describe the manager and the strategy. Depending on how many fund products and strategies that IDF invests in on the platform or with third-party managers, the disclosures can be 50 to 500+ pages. So the number of documents is not large, but it does require critical thinking at very specific inflection points. Again, if you have a manager that’s done them before and is familiar with the process, and if you have an administrator that’s coming in and taking on some of that noise and admin headache, it can actually be a very, very quick process, and there’s no, you know, there’s no filings, et cetera. You just activate it and the investors sign on and you can go.

BG (15:25)
There are two ways to go. One is, which Kate and I have done, which is where the manager goes in alone. They want to create their own IDF. And that typically takes a little longer because the manager typically hasn’t done this before. But it looks very much like their traditional fund. You go through the whole fund process. We have to add our tax mumbo jumbo and insurance company language into the documentation. It ends up being a little longer compared to the administrators in the space. And as Kate said, there are two administrators in the space, and we work with both of them. They’re both very good. From beginning to end, if you go through the administrator process, it probably can be done in 90 days or maybe a little quicker if that’s what needs to happen. It also depends on: what kind of capital are you raising? With raising insurance company capital, those tend to be single investor products, single investor IDFs where the insurance company wants to allocate to you $100 million to the manager. That realistically can be done in 60 or 90 days if we hustle and everyone desires to do that. If you’re raising taxable money or foundation money for the tax benefits, that typically takes longer, not for the lawyers, because documentation can be quick, but it’s really to go out and get a new insurance policy from an insurance company, the individuals have to get it underwritten and that typically takes time. So the legal documentation is quick. It’s really just the process of going to get a life insurance policy, there’s medical underwriting, everything else. I would say that’s three to five months typically. For institutions where you don’t need a life insurance policy, you can rely on an annuity, those can be quick. And then you’re back to the 60 to 90 days from beginning to ready to close.

LT (17:11)
So, certainly something to factor in if you’re in the middle of the wider fundraise, let’s say, and this is going to be one pocket of that.

Switching gears a little bit: There is a term that you guys use when we were chatting about this last week, and I was wondering if you could give a little bit more information on what an ICOLI is.

BG (17:33)
So, many of the IDFs we’ve seen in the last couple of years have been ICOLI investors. And in fact, probably done a dozen or so IDFs in the last two years, many of them, not all, but many of them have been ICOLI investors. Those are really just insurance company investors that, as we said before, can invest in these products, can invest with the managers. But if they invest directly with those managers, there’s a capital charge, a regulatory capital charge to them. So the structure of the insurance-dedicated fund structure is really just that. It’s just in its structure to solve the regulatory capital charge issue that those investors have. So if they go through an insurance-dedicated fund, they’re typically, as we said before, no capital charge to them. So what ICOLI is, is really just an insurance company-owned life insurance policy, series of life insurance policies that invest in these products. They do get a tax benefit too, but it’s primarily for the regulatory capital charge benefit.

KL (18:34)
Bruce, as a corollary, some of our clients, especially those that set up and understand these structures, are eager to participate and set them up for, let’s say, knowledgeable employees or other employee participation. Where is that line drawn for purposes of investor control doctrine if the participating employee is also in charge of, let’s say, the directional investment strategy of the IDF? Is it possible for them to participate as an investor to the extent that the insurance policy is set up with a different beneficiary, for example, a spouse or a child or someone along those lines?

BG (19:20)
Look, we like to say that anything is possible. So what happens typically in these structures is when we talk about the opportunity to fund managers, not only for ICOLI and other insurance company investors, but for individuals, the tax benefits really drive these alternatives. And so when the managers hear that their investors can come into credit with no taxation over 40 years, or if you invest on behalf of your children over 80 years, depending on their life, that really draws a lot of attention. One of the easiest ways to raise capital, of course, is from insiders. The reason that we pause on those types of structures and why we have to look at those very closely is that one of the reasons these structures work is that the underlying insurance company investor that’s making the investment into the IDF is the tax owner of the assets, not the policy owner. So, Kate, if you buy a policy from an insurance company and you invest in an IDF through, you know, ABC Insurance Company, it’s the ABC Insurance Company that’s the investor and the tax owner of the assets, not you. In order for the insurance company to be treated as a tax owner and not you, you can’t be seen as controlling the investment. You can decide to invest and ask ABC Insurance Company to invest in the underlying IDFs, but you can’t make investment decisions. So if you’re a fund manager, you can certainly buy private placement life insurance and go out and make investments in unrelated funds, no problem. But when you talk about making investments in your underlying funds, the question is, are you making those investment decisions? If you’re a fund manager, portfolio manager or fund, it’s gonna be very difficult to make those, make a private placement life insurance investment in your IDF where you’re managing the investments. If you’re a retired partner, we’ve had some sponsors, you know, retired partners who really have no control over the investments. They don’t have full transparency on the investments. Those are types of people that are what I would call former insiders that can make investments in these products. Everything else is a slippery slope, and there’s no bright line. It’s just shades of gray, and we have to get as comfortable as we can depending on the facts.

LT (21:24)
In summation, maybe on these structures, certainly flexible. We always like to be able to offer insurance and other products that can have many diverse underlying assets. But certainly it seems like obviously there’s a restriction on the types of investors that can come in directly or that do come in directly. And then dealing with these kinds of control and diversification tests are certainly something to manage. Definitely interesting as well that from an investor’s side, they will have this indirect relationship. So it’s something for them to kind of think through and perhaps understand a little bit more when they’re going out to purchase these policies about how that ultimately is going to work for them and how much do they actually want or need sort of that oversight position. So very interesting stuff.

Thank you guys so much for joining. For all of those of you out there watching us certainly get in touch if you are thinking about an IDF or want to discuss it more because you haven’t heard much about it before, we would absolutely be happy to discuss this as another option for raising capital into your funds and particularly for the insurance capital market. Thank you very much and we’ll see you in the next episode.