The Growth of Senior Debt Funds

The Australian debt landscape

In Australia, the banks’ share of the primary loan market is estimated to be around 95%, versus 16% in the United States and 54% in Europe. This statistic is accentuated when considering the lack of alternative sources of funding for Australian corporates beyond the primary lender market.

The global trends point towards the growth of funds as a source of financing. With a large and sophisticated superannuation market yet to tap the corporate loan market, it is expected that the Australian market will rapidly follow the global trends.

Reasons for change

Some reasons that could lead to a change in Australia include:

• the Basel III accord imposes more onerous capital requirements on banks and increased risk weighting across certain asset classes. Thus, riskier loans and longer-term loans become more expensive to hold; and
• the saturation point for domestic banks has been reached. With the retreat of the European banks, coupled with a small institutional and retail bond market, stress has been put on the domestic banks to find other solutions.

Signs of change

Cash Funds have tended not to take on construction risk by lending to green field projects. The reasons for this include:

• insufficient expertise in assessing and structuring around construction risk; and
• construction projects generally requiring extra active management in terms of reviewing progress that may not suit a fund’s more passive investment appetite.

But, the signs of a change are visible. QIC Global Infrastructure has been active in direct senior debt investment in significant projects for a number of years. Moreover, Metrics Credit Partners launched the Diversified Australian Senior Loan Fund in 2012. Finally, Intermediate Capital Group is establishing a senior debt fund looking to invest up to a $1 billion over the next five years.

Type of funds

Funds investing in debt split into five categories:

• superannuation funds investing through an investment manager (such as QIC);
• superannuation funds investing directly;
• private debt funds;
• hedge funds; and
• managed Collateralised loan obligations.

Legal issues for funds in syndicated debt transactions

There are a number of issues for incoming funds, existing banks, lender agents, security trustees and borrowers to consider when introducing a fund into a lender syndicate. These include:

• an issue is frequently raised for funds acting as lenders where the fund is a closed-end fund that may have limited access to free capital;
• if the fund acts through a trustee or responsible entity who requires a limitation of liability clause. There is little that can be done to avoid this issue, because professional trustees/responsible entities are unlikely to accept personal liability. (It should be noted that a Facility Agent’s and Security Trustee’s risk can be mitigated through several ways, including: the loan documents providing that the Facility Agent and Security Trustee are indemnified by the borrower and guarantor group, and they also providing for a waterfall of payments from the proceeds of recovery against a borrower or guarantor – the fees, costs, liabilities and expenses of the Facility Agent and Security Trustee will generally come out of the proceeds of any recovery before amounts owing to the lenders).
• lender funds fund themselves differently to banks. Thus, it is important to closely examine the break costs and break gain concepts to ensure they adequately cater for lender funds. Some lenders may say that break costs should only be compensating for actual losses and cost, not compensating for loss of profit (hence margin is often excluded from these provisions). But, a lender may not be making its modelled return, which may have impacts on a fund’s return on investment and may be a significant focus on a lender fund. Further, by having a borrower pay additional amounts to some lenders, the general principle in syndicated lending of treating all lenders equally is broken. However, despite this argument, a lender fund will only have to recover certain amounts by way of break costs.
• the customary representations and warranties that a borrower requests a lender to make in confirmation of a valid offer for the purposes of s128F of the Income Tax Assessment Act 1936 (“the Tax Act”) may cause issues for lender funds. Funds regulated by the Superannuation Industry Supervision Act 1993 (“the SIS Act”), also called Super Funds, will need to be especially mindful of this provision. This could raise issues regarding:
• section 62 of the SIS Act which requires the trustee to maintain the Super Fund solely for the provision of superannuation benefits; and
• the Registrable Superannuation Entity or other licences applicable to the relevant trustee.

Should you be contemplating establishing a senior debt fund, One Investment Group’s independent wholesale trustee services team can assist in the establishment of a wholesale trust and the ongoing compliance and governance responsibilities of the trust.