Structuring Considerations for Direct Lending Funds

Kramer Levin’s Alternative Investment Management practice recently hosted “Structuring Considerations for Direct Lending Funds,” a seminar designed to assist those fund managers who form investment vehicles to lend to small and medium-size businesses.

Partners Barry Herzog, Kevin P. Scanlan and George M. Silfen led a discussion of related issues, including private fund structures, registered fund structures, U.S. tax considerations and foreign investor considerations. The event received extensive coverage in the Hedge Fund Law Report, which subsequently published a two-part series exploring the various approaches managers can take to structure a direct lending fund in order to minimize tax inefficiencies (subscription required).

While market activity and investor demand have combined to create both significant demand and opportunity for direct lending funds, several considerations must also be taken into account when considering establishing such a fund, including tax-related costs for foreign and U.S. tax-exempt investors in such activities. Such costs can be mitigated, provided a fund is structured appropriately.

Generally, non-U.S. investors investing in U.S. securities are not taxed on interest income due to the “portfolio interest” exemption or on gains from sales. However, loan originations may be treated as a trade or business, and, therefore, both the interest and any gains on the disposition of a loan may be taxed at U.S. rates for a foreign investor. As a result, direct lending funds can become a less attractive option to foreign investors than traditional securities-based hedge funds, for example. Similarly, a U.S. tax-exempt entity that invests in the direct lending vehicle is also vulnerable to U.S. tax liabilities if the fund utilizes leverage.

Structuring a direct lending fund for U.S. taxable investors is relatively straightforward. But, if a fund manager is seeking investments from foreign or U.S. tax-exempt investors, the vehicle must be more carefully structured in order to minimize the tax leakage and make it a more attractive option for a larger number of investors. For example, a manager could establish a parallel Cayman-based fund that owns and invests in i) a U.S. corporation that originates loans in the U.S. and ii) a Cayman corporation that may acquire a portion of such loans from the U.S. entity. Although this “season and sell” strategy is not risk-free, if properly structured it could avoid U.S. tax on a significant portion of the income from the portfolio.

Managers can also utilize a U.S. corporation blocker, owned by the Cayman fund, through which the non-U.S. and tax-exempt investors invest. The U.S. blocker can be capitalized in part with debt and in part with equity. The U.S. blocker subsequently invests into the loan origination fund. While the income of the U.S. blocker (i.e., its prorated share of the origination fund’s income) could be subject to U.S. tax, the interest expense of the U.S. blocker could offset a portion of such income. So long as no investor into the U.S. blocker owns a 10% or greater interest in the U.S. blocker, the interest income on the internal leverage should be exempt portfolio interest. Treaty structures may also be available to minimize tax costs of loan origination funds.

Alternatively, managers may structure a closed-end registered investment company (“RICs” - taxed under Subchapter M of the Internal Revenue Code), which removes the need for any additional feeder funds or blockers. The structure does not generate ECI and blocks UBTI for tax-exempt investors. It also generates dividends (sourced from interest on debt holdings) that are exempt from withholding. However, RICs require registration with the Securities and Exchange Commission and compliance with regulatory obligations of the Investment Company Act of 1940.

Each of the above structures presents fund managers with a unique set of benefits and potential drawbacks. Kramer Levin’s Investment Management, Corporate and Tax attorneys work with fund managers to ensure their direct lending funds are structured in the most advantageous manner for them and their investors.