The widespread economic disruption precipitated by the coronavirus (COVID-19) global pandemic and oil price volatility has caused debt portfolios to come under scrutiny and fund sponsors and investors to consider opportunities in the marketplace. Many asset managers are forming funds focused on liquid credit opportunities, secondary portfolio purchases and, as with the expansion of nonbank lending after the 2008 global financial crisis, providing customized solutions to distressed and other borrowers that are either unable or unwilling to borrow from traditional banks. In addition, certain existing funds are extending their offering periods and modifying their investment strategies to capture the opportunity.
The investment opportunities being pursued by these funds are driven by multiple factors, including the ability to acquire loans at significant discounts due to the overall economic disruption, ratings downgrades, forced selling behavior by certain participants in the market (e.g., as a result of certain existing portfolios with high levels of leverage), and borrowers that will require additional capital infusions.
These special opportunities and dislocation funds typically have broad mandates that contemplate investments in debt and other securities, as well as both increased economic instability and stability, depending on whether the market further declines or recovers. These products are being launched rapidly and, in some cases, represent a pivot away from a more traditional acquisition fund platform.
Investors are also looking to increase their exposure to credit, driven by a belief that the market will rebound in a manner comparable to that after the 2008 financial crisis and the desire to increase their returns in light of significant recent losses.
The terms of these opportunistic funds vary, but many managers are raising and deploying capital on an expedited basis and in an increasingly competitive environment to take advantage of opportunities that may present themselves on a temporary or limited basis.
Accordingly, closed-end opportunistic/dislocation funds may have reduced fundraising timelines (e.g., between two and 12 months), investment periods (e.g., between one and three years), and terms (e.g., between five and eight years, subject to extensions) and may have expansive recycling capabilities (e.g., permitting reinvestments at any time for any purpose for which capital could otherwise be drawn). Many managers of recent closed-end opportunity funds are charging management fees as a percentage of invested capital throughout the fund term (as opposed to capital commitments during the investment period and invested capital thereafter), and if the funds are levered, invested capital could include the amount of the leverage deployed in investments.
Managers of hedge funds and other open-ended private funds focused on market dislocation opportunities are also forming funds that may differ from their typical structures to address the illiquidity of the underlying investments. Given this illiquidity and potential valuation difficulties, these funds may have longer lock-up periods (e.g., from three to four years), may side pocket certain assets, and may charge fees based on invested capital (rather than on a mark-to-market basis).
As a result of expedited fundraising and the concentrated investment strategy, many managers are forming opportunistic funds through various structures, including through traditional commingled fund structures, “annex,” or co-investment funds alongside existing flagship products, funds-of-one or separate accounts, and hybrid fund structures.
Sponsors considering raising an opportunity or dislocation fund should consider the following matters:
1) Sponsors should ensure that disclosures are fulsome, including with respect to unique risks and conflicts associated with the structure (including with respect to concentration, volatility, risk of default, investment allocations, valuation issues, side pockets, and recycling).
2) Sponsors raising these funds on an opportunistic basis, while simultaneously managing other funds with overlapping investment strategies or that may otherwise participate in such opportunities on a more limited basis, should consider how investments will be allocated among the various products and whether their allocation policies and disclosures need to be updated (including to reflect whether any such fund will or will not have any priority to such deals).
3) Sponsors raising a “co-investment” fund should review the relevant disclosures in the offering documents for the main fund and any applicable side letters to determine any limitations or obligations under the flagship fund’s co-investment policy.
4) Managers should fully consider valuation issues, including with respect to any discretion to adjust equalization payments required in connection with subsequent closings, and, if managing a hedge fund or similar structure, whether to include more robust disclosure on the likelihood that investments may be side pocketed or redemptions otherwise suspended.
5) Sponsors considering pivoting the focus of an existing investment fund to more opportunistic investments, or otherwise repurposing or relaunching an existing investment fund, should determine whether any investor or advisory committee consents or approvals are required and whether additional disclosure is required in the offering documents, including with respect to existing investments. In addition, such sponsors should be prepared to address questions regarding mission creep from existing investors.
6) Depending on the structure and investment strategy of the fund, managers should be mindful that lender licensing issues under state law may also be relevant.
7) Given the pace in which these funds are currently being launched, many managers may want to leverage the documents for existing funds for purposes of these new offerings. Nevertheless, managers should thoroughly and carefully review their governing documents to ensure that the offering terms, conflicts of interests and risks are appropriately considered.
8) If the strategy will include loan originations (including DIP loans or restructured existing loans) and the use of leverage, the sponsor will need to consider the tax implications for tax exempt and non-US investors in structuring the fund. A sponsor will need to consider including structural features that will be attractive to, and expected by, these investor groups.
Investors considering an investment either in a new product or examining an existing investment in a fund that is considering making opportunistic investments should consider taking the following actions:
1) Investors should communicate with the sponsor regarding any concerns with mission creep and capability and unique features of the fund, such as the sponsor’s expectations regarding the use of leverage.
2) Investors should request and review the manager’s valuation policy and investment allocation policy for these funds. Sponsors with more than one fund product may have obligations to exclusively allocate investment opportunities to one or more other funds that implement that same or similar investment strategy.
3) Investors should confirm whether the management fee calculations are appropriate and whether any discounts may be applicable based on being an early investor and/or their aggregate investments across all of the funds managed by a sponsor.
4) Investors should review and consider any other fees that the sponsor and its affiliates may receive in connection with the fund’s investment activity and the extent to which any such fees may or may not be shared with the fund or offset management fees. Such fees could include, for example, agency fees, arrangement fees, origination fees, structuring fees, commitment fees, consent fees, amendment fees, consulting fees, directors’ fees, investment banking fees, advisory fees, investment management fees, breakup fees, closing fees, transaction fees, financing fees, monitoring fees, and syndication fees.
5) Investors should confirm the basis upon which subsequent closing investors will participate in existing investments and confirm whether the sponsor’s discretion to adjust equalization payments due to material changes in the value of existing investments is acceptable.
6) Investors should make sure that they are comfortable with any requirements to fund additional capital contributions that may be required due to the excuse, exclusion, or default of another investor.
7) Investors should review and consider whether any expanded use of recycling is acceptable and evaluate the applicable limits to recycling in the governing documents.
8) Given that many of these funds may have shorter capital call notice periods, investors should consider whether the drawdown procedures are acceptable.
9) Investors should review the tax structure of the fund, available entry points, and the impact of structural features and mitigation strategies on the expected after-tax yield of the investment.
10) The market for dislocation and opportunistic funds is developing rapidly as COVID-19 economic disruption continues. Given the compacted timeframes for drafting and reviewing fund documentation and subscription agreements, careful consideration should be given to ensure that investment terms are clear.
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We are assisting our clients with a wide range of such funds. If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Ethan W. Johnson
Peter M. Phleger
Jarrod A. Huffman
Carrie J. Rief
Ayman A. Khaleq