The popularity of funds in private lending has surged significantly in recent years. Geraci LLP, known for its expertise in this realm, has been instrumental in crafting and tailoring debt funds for private lenders nationwide, catering to a spectrum of sizes and requirements. Over time, we have accumulated profound insights into the intricacies of designing debt funds, addressing pivotal considerations along the way. In this article, we identify what to avoid when establishing debt funds.
1. The Kitchen Sink
This is the number one thing we recommend avoiding in your debt fund in private lending. Many sponsors, in the interest of maximizing their business, seek for their fund to be able to invest in practically anything. As an extreme example, a lender once asked to create a fund that could make all of the loans we typically see in private lending, but also develop commercial real estate, invest in marketable securities including stocks and bonds, make loans overseas, buy real estate overseas, and invest in cryptocurrency.
The primary legal issue this type of fund presents is that the economics, fees, disclosures, and compliance need to conform to this mandate. This leads to a host of considerations including fee modeling, distribution modeling, additional complex disclosures, and compliance with the Investment Adviser and Investment Company Act (see Section 5 below).
But the legal issues are manageable if one truly wishes to pursue such a flexible strategy. However, the bigger issue is a practical one. When a fund has such a broad mandate, it tends to create confusion with investors. That’s the last thing you want to do.
Finally, what can exacerbate this strategy is if the fund does not account for these variable strategies in its economics. This can result in failure to deliver on expectations, resulting in potential investor disputes and litigation.
2. Too Many LP Classes
This is a common strategy we see many clients pursue with their funds. They create several LP classes for investors to come in. They typically segregate the investors based on investment amount and will extend different economics or liquidity rights to each class, with the larger investors getting more favorable economics or rights.
This is a great idea in theory. However, it needs to be executed and structured in a way that is meaningful and impactful. Many times, the structures do not present a meaningful difference between the classes where after taxes, there is less than a 50 basis point difference to the investor.
3. Excessive Fund Manager Compensation
Generally, it’s widely understood to avoid excessive management fees. However, one area has created a point of contention with certain investors, namely Registered Investment Advisers’ (RIAs) thoughts about Origination Fees. Many RIAs challenge fund managers that take all the origination fees. While this was considered standard practice for several years, in the past three to five years, many RIAs have challenged this allocation of fee income as a conflict of interest. Their logic is that it incentivizes the fund manager/originator to only originate new loans as opposed to managing the assets well. It’s not a position we necessarily agree with, but it is a point of contention that is commonly put forward. Fund managers should know that if they do plan to raise money through RIAs, that this may be an objection they face and they should ensure that this is addressed when setting up their funds.
These are three of the most common issues we see when designing and structuring funds. There are many more. If you’d like to evaluate your fund or discuss fund formation, please do not hesitate to contact the Corporate and Securities team at Geraci LLP for a consultation.
