In the past year, many private lenders have inquired about pursuing a non-performing debt fund strategy. However, they have many misconceptions that these funds can look and perform exactly like a performing open-ended debt fund. Nothing could be further from the truth. There are several factors that differ: (1) Closed-End structures are highly preferred; (2) Distribution plans are remarkably different; and (3) Enhanced risk factors must be considered.
Closed-End Funds are Preferred
In distressed debt funds, there are two primary types of strategies: (1) acquire defaulted loans at a discount to foreclose and (2) acquire defaulted loans at a discount to reperform or refinance the loans. With both strategies, we tend to prefer closed-ended funds as opposed to open-ended funds. The reasons are identical to when we work on real estate or private equity funds.
The first reason is the assets in the portfolio are not uniform in time frame to produce income for the fund. In other words, unlike a performing debt fund that produces income consistently, distressed debt funds take variable amounts of time after acquisition of the loans when it comes to reperform, refinance, foreclose, acquire the real estate, reposition the real estate and/or liquidate it. This makes it more challenging to operate if you are open-ended because of an ongoing redemption plan.
The second reason is the accounting, particularly the impact of net asset value or NAV. Distressed debt funds don’t have the simplicity in calculating NAV as performing debt funds. To put it simply, NAV will usually increase significantly over time. This doesn’t conform well to an open-ended fund structure because investors admitted later in the life cycle will get a significantly reduced gain in their investment as compared to early stage investors. Further, redemptions are very challenging to satisfy if the distressed debt fund is open ended because of liquidity challenges and the increased potential for losses. It is possible that an investor could redeem before a loss is incurred, which leads to imbalanced application of losses to the capital accounts.
Distribution Plans are Remarkably Different
Open-ended debt funds for performing loans typically have a simple distribution plan for the interest and fee income. They are more analogous to a fixed income type investment as opposed to a growth investment. Distressed debt funds are more akin to a growth investment because we are pursuing a large IRR based on the discounted purchase price leading to sale of the real estate or loan after a lengthy asset management process. To this end, the economics typically mimic that of a real estate fund with multiple hurdles, GP catchups, returns of capital, and so on.
Enhanced Risk Factors Must be Considered
Distressed debt funds are inherently an opportunistic and higher risk investment. There is a higher likelihood of higher expenses caused by legal and administrative expenses associated with processing foreclosures, managing title claims, borrower disputes, and so on. Further, servicing becomes exceedingly more complex. For these reasons, distressed debt funds warrant significantly enhanced risk factors and disclosures to the investors.
If a private lender is considering creating a debt fund that concentrates in distressed debt as an investment, it is important to consult with experts to properly design them for operational success, profitability, and long-term viability. Failure to consider these can result in accounting stress, investor relations issues, and potential litigation. If you’re interested in learning more about opportunistic or distressed debt fund strategies, please contact the Corporate and Securities team at Geraci LLP.
