Considerations for Forming Private Credit Funds

Formation of a private credit fund originating loans in the US leads US fund sponsors to design a fund that can accommodate investors’ tax and regulatory requirements. The authors have found that private credit funds that make use of income tax treaties often strike the best balance for private credit funds designed to serve global institutional clients from a tax and regulatory requirements perspective.

That being said, fund formation options abound, and private credit fund managers, from time to time, use many of the tools described below.

Why Private Credit & Why Now?

Private credit funds are an essential source of capital, and in the US now represent a $1 trillion market, making newly originated private credit finance roughly comparable in the US marketplace to high yield bonds or leveraged loans. Equally, as private credit funds have become of critical economic importance they are equally of interest to the Federal Reserve, the SEC and to EU regulators. While regulators have taken steps to minimize the liquidity and leverage risks inherent is the deployment of private credit in open-end funds, regulators have tread only lightly on closed-end private credit funds, even acknowledging that closed-end funds are well designed for private credit. From a tax perspective, the Internal Revenue Service also has private credit top of mind.

Challenges for Private Credit Funds

There are common themes across all $1 trillion in private credit funds, with a diverse set of solutions. First, from the perspective of US fund sponsors, private credit funds will mean selecting one or more tax strategies suitable for their target investor-bases. Second, a high level of regulation of fund sponsors and fund-level substantive regulation follows, both under US law and the national private placement laws of the countries where private credit funds are marketed.

Tax Factors

Because tax strategies can affect returns dramatically, we start with tax factors when designing a private credit fund.

Investors. Private credit funds that are in the business of “loan origination” are deemed to be engaged in a trade or business within the United States. This determination impacts several classes of investors:

US Resident Taxable Investors & “Super” Tax-Exempt Investors. US resident taxable investors, such as US resident individuals, or US “super” tax exempt entities (such as state sponsored pension plans) need a tax solution that where the fund itself generally does not bear material taxation, and income flows-through the fund entity.
US Tax-Exempt Investors. US residents that generally are tax-exempt face the peril of becoming subject to corporate level income tax on their “unrelated business taxable income” (“UBTI”) from a private credit fund that engages in borrowing in order to achieve leverage.
- UBTI sensitive investors would be subject to taxation at the rates applicable to corporations or trusts, depending on the organization’s legal characteristics, and potentially state level income tax.
- If we assume a private credit fund strategy that will utilize leverage (in the form of a bank asset-based loan facility, for example) a UBTI solution is needed.

Non-US Resident Investors. For non-US resident investors, any income from US loan origination income will be treated as income which is effectively connected with the conduct of a trade or business within the United States (“ECI”).
- A non-US person that realizes ECI must pay US federal income tax on such ECI (including US federal income tax withholding), file US tax returns and may also be subject to the US “branch profits” tax on such ECI.
- ECI sensitive investors require a US tax solution to avoid bearing such taxes.

Hedge Fund Structures Are Not Good Enough. US tax-exempt investors (e.g., ERISA plans) are well used to blocking UBTI by investing in an offshore fund that checks the box closed to be treated as a corporation for US tax purposes. However, as demonstrated by the recent YA Global case, absent meticulous planning, ECI attaches to US loan origination, subjecting the offshore fund to tax at US corporate income tax rates. Therefore, if US tax-exempt investors use an offshore fund (e.g., Cayman) to address UBTI, as they might in the context of hedge funds trading over-the-counter bonds with “CUSIPs”, the investor steps into the shoes of an ECI sensitive investor, and like our potential non-resident investors, will need an ECI solution.

Tax Challenges & Solutions By Leveraged Private Fund Type

Investor Type	Solution	Typically needs an ECI Solution or UBTI Solution	Typically uses a US limited partnership	Typically uses an offshore “closed” entity (such as Cayman, Ireland or Lux)
US Persons
US Taxable	Needs a fund not subject to entity level taxation	不	Yes, for qualified purchasers; not for “retail”	不
US Super Tax Exempt	Needs a fund not subject to entity level taxation	不	是	不
US Tax Exempt (ERISA plan or IRA)	Needs a fund that blocks UBTI	是	不	Yes, but also can make use of a Form 1099 issuer, such as a business development company (BDC)
Non-US Persons
Qualified Under a Treaty	Needs either to be able to rely on its own tax treaty or needs Form 1099 issuer	是	不	是
Not Qualified Under a Treaty	Needs to rely on the fund’s tax treaty compliance or to invest in a Form 1099 issuer	是	不	是

Entity Structure. The US manager’s structural tool kit leads fund sponsors to select from tax solutions each of which has its own pros/cons.

Delaware limited partnerships are the most straightforward. They can also work by themselves where the investor base is entirely in the United States, or as a feeder fund into something else.
- Sold in the US? Yes, to US taxable and super-tax-exempt investors. Not suitable for US tax-exempt investors as they would be subject to taxation on UBTI.
- Sold outside the US? No. Delaware LPs are not suitable for offshore investors, as they would be subject to taxation on ECI, and potentially the branch profits tax.

Leveraged Blockers use a feeder fund treated as a partnership for US federal income tax purposes and a blocker corporation that pays US corporate income tax. The blocker corporation then borrows money from the feeder fund. If structured properly, the interest expense on the loans from the feeder fund will offset the corporate income tax of the blocker corporation.
- Sold in the US? No. These structures are typically tax inefficient for US investors.
- Outside the US? Yes, typically on a national private placement basis, although EU alternative investment managers directive (“AIFMD”) compatible structures are possible.

Season and Sell uses two fund structures, an onshore vehicle treated as a partnership for US federal tax purposes and an offshore vehicle, typically Cayman, treated as a corporation for US federal tax purposes designed for US tax-exempt and non-US resident investors.
- The onshore fund doubles as a loan origination vehicle for the investors that are compatible with investing in a Delaware partnership and also as a potential seasoning vehicle to sell on loans (typically in part) to an offshore fund that will take the view that the offshore fund did not originate the loan, and that it is therefore not engaged in a US trade or business that would result in ECI.
- In a season and sell vehicle, independence of the offshore fund from the onshore seasoning fund is paramount. Accordingly, care is needed to eliminate any indicia that the two funds are operating in parallel with one another.
  - Sold in the US? Yes, to UBTI sensitive investors only.
  - Sold outside the US? Yes, typically sold on a national private placement basis.

Treaty Funds solve for ECI by looking to either the income tax treaty of a host country with the United States at the level of the fund, if “undertakings for collective investment” or similar vehicles meet the requirements for benefits under the double tax treaty of the fund’s domicile and tax residency, or to the tax treaty of a qualified investor’s country of residence with the United States, who is said to “bring its own tax treaty.”
- Funds whose tax treaties solve for ECI can also accept (and typically need) US investors, and so typically offer a feeder fund that blocks UBTI (for US tax-exempt investors) and a feeder fund that is a flow-through entity (for US taxable investors).
- Sold in the US: Yes, to US taxable investors, US super-tax-exempt investors, and US UBTI sensitive investors.
- Sold outside the US: Yes. Treaty funds typically are designed to be compatible with AIFMD marketing passports and are sold both to investors that can rely on their own tax treaties, and with a bit of structuring, those that need to rely on the fund’s tax treaty, typically offering both solutions simultaneously.

Business Development Companies (BDCs) solve for ECI and UBTI because their dividends generally are not treated as ECI or UBTI, and, if sufficient income is paid out, the BDC will not itself be subject to US federal income taxation.
- Sold in the US. Yes, to US taxable, super-tax exempt and tax-exempt investors.
- Sold outside the US. Yes, on a national private placement basis.

Key Tax Tools

	Delaware LP	Leveraged Blocker	Season & Sell	Treaty Fund	BDC
Can Escape ECI	不	是	是	是	是
Can Escape UBTI	不	是	是	是	是
Can be a Parallel Fund	是	是	不	是	No. Requires routine exemptive order from SEC, subject to conditions
Legal Authority for tax position	Partnership for US federal tax purposes by default	Tax opinion	Guidelines from tax advisors	Tax Treaty	Subchapter M of Internal Revenue Code
Complexity	Low	Medium	Low	High	Highest
Tax Challenges	No non-US investors; no UBTI sensitive investors	Cannot have a 10% investor at any closing	Following tax guidelines; IRS active scrutiny underway	Meeting independent agency of US manager	Compliance with distribution rules

US Securities Law Regulation of Private Credit Funds & Their Sponsors

The SEC position is quite clear that loans fund “investment companies” and are within scope of the Investment Company Act of 1940, as amended (the “1940 Act”). Briefly, “investment companies” are issuers that either hold themselves out as investment companies or whose assets are comprised more than 40% of “investment securities,” a term that starts with the defined term “securities”, while excluding government securities and cash items. While “loans” are not called out in the enumeration of investments that comprise securities, “notes” are, and a careful parsing of the 1940 Act by the SEC and the courts makes plain that all manner of commercial finance are “securities” and therefore “investment securities” under the 1940 Act.

Since nearly all forms of commercial finance are securities under the Investment Company Act, it follows that they must also be securities under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), since the 1940 Act and the Advisers Act were adopted simultaneously in a single bill. That private credit funds are “investment companies” and their sponsors are “investment advisers” arises even though loans are not securities for other purposes that may be important to the operation of private credit funds. Indeed, as recounted meticulously by Professor Franco all manner of commercial finance that are securities under the 1940 Act are equally unlikely to be securities under the Securities Act of 1933, as amended, (the “Securities Act”) and the Securities Exchange Act of 1934, as amended (the “Exchange Act”).

Accordingly, sponsors of credit funds are sponsoring investment companies that either (i) register under the 1940 Act, (ii) elect to be regulated as business development companies (“BDCs”), or (iii) comport themselves so as to meet the private fund exemptions found in 1940 Act Sections 3(c)(1)(fewer than 100 beneficial owner accredited investors investing through a private placement) or 3(c)(7)(only qualified purchasers investing through a private placement, collectively “Private Funds”). In the meanwhile, except for US-based private fund managers with less than $150 million in assets under management exclusively in Private Funds, registration of the US based fund sponsor under the Advisers Act is inevitable.

Electing BDCs, Registered 1940 Act Funds & Private Funds Compared

Fund sponsors who are looking for broad adoption of their credit funds in the US will face limited choices. US mutual funds that offer daily redemptions (and are required to manage the fund under a monthly liquidity risk management program subject to a strict limit on illiquid investments) will prove effectively eliminated by the SEC’s mandate that these daily redemption funds maintain sufficient liquidity. (The European Union has similarly constrained open-end loan origination investment funds so that the fund’s liquidity management policy aligns with its investors’ redemption rights.) As such, portfolios of private loans could not operate as daily-redemption style “mutual funds”. In the context of funds aimed at institutional investors, private credit funds can and do operate as SEC regulated closed-end BDCs, as registered closed end funds or potentially as “interval funds” or even more frequently as Private Funds, that can double as “alternative investment funds” for EU regulatory and marketing purposes. Selection of these closed end fund (i.e., not daily redemption fund) types takes into consideration the following factors:

Private Credit	私人基金	BDC	Closed-End	Interval Fund
Regulatory Burden	Lowest, but can be medium if AIFMD passports are sought	High: SEC regulated, exemptive order needed; annual review of adviser profitability by independent board	High: SEC registered; annual review of adviser profitability by independent board	High: SEC registered; annual review of adviser profitability by independent board
Used for Retail	不	是	是	是
Used for Institutional	是	是	是	不
Tax Status	Varies	Regulated Investment Company IRC Sub-Chapter M (Form 1099)	Regulated Investment Company IRC Sub-Chapter M (Form 1099)	Regulated Investment Company IRC Sub-Chapter M (Form 1099)
Leverage	Unlimited, except in the EU under AIFMD 2 (300% for closed-ended funds; 175% for open-end funds)	2x (150% asset coverage)	0.33x (300% asset coverage)	0.33x (300% asset coverage)
20% “carry” permitted	Yes, but must be sold to “qualified clients” i.e., those (i) with a net worth in excess of $2.2 million or (ii) who has at least $1.1 million under management.	是	No: fulcrum fee only	No: fulcrum fee only
Prohibited from annual performance fees	不	不	是	是
1933 Act Registered	No; Private Placement	Sometimes	是	Yes (in practice)
1934 Act Registered	不	Yes – always	Not unless exchange traded	不
1940 Act Registered	No: exempted under 3(c)(1) or 3(c)(7)	No – but regulated by the 1940 Act	是	是
Can be marketing in the US by Private Placement to accredited investors	是	是	是	是
Can Be Marketed In the EU via an AIMFD Passport to professional investors	是	No – National Private Placement Only	No – National Private Placement Only	No – National Private Placement Only
Issues Redeemable Securities	Sometimes, but not typically.	No – typically is either listed or can conduct periodic tender offers	No – typically is either listed or can conduct periodic tender offers	No, but must offer redemption for at least 5% no less frequently than quarterly
Traded CUSIPs	不	Yes, but not for private BDCs	Yes, for listed closed end funds	不
Substantial Material Assistance	NA	Required as to 70%	NA	NA
Invests in private placements; private credit	是	Yes, at least as to 70%	是	Optional, subject to liquidity needs
Lends to “eligible portfolio companies” that have not issued any marginable securities	NA	Yes as to 70% (although not the only prong defining eligible portfolio companies)	Optional	Optional, subject to liquidity needs
Can invest in negotiated loans with other funds and accounts	是	Only after receipt of SEC exemptive order	Only after receipt of SEC exemptive order	Only after receipt of SEC exemptive order
Majority of directors are not interested	NA	Mandatory by statue: Tends to be 75% – but not due to statute	No, in theory. Tends to be 75% – but not due to statute	No, in theory. Tends to be 75% – but not due to statute
Subject to ERISA 25% Plan Assets Test	是	是	不	不

Marketing Private Credit Outside the US

Marketing private credit funds outside of the US can be accomplished by means of national private placements in each host country that permits private placements to their category of institutional investors. A country-by-country application process is required, with approvals generally at the discretion of and on the timetable of the regulator, or in some cases, with notice filings and essentially self-executing exemptions based on investor categories.

In certain instances, the appointment of a locally authorized distributor may be mandatory. The EU offers by means of the AIFMD the prospect of a single qualification process for a passport that would permit marketing by the EU authorized fund manager (or a licensed MiFID firm) throughout the 27 member states, without the need for country-specific applications. EU passporting, while compelling, is only currently available to funds that are (i) formed in an EU member-state and (ii) have appointed an EU member-state authorized management company (i.e., an “AIFM” for a private credit fund marketed to professional investors). For many US fund sponsors, accessing EU institutional markets can tip the balance in favor of a master private fund formed in an EU member state, with feeder funds designed to accommodate the disparate needs of investors globally.