How can credit fund managers secure regulatory access to European credit markets?
For credit fund managers that target European-wide loan origination, an alternative investment fund organized under the laws of an EU Member State (EU AIF) and managed by an EU Authorized Alternative Investment Manager (EU AIFM) is typically a “must have”. Such a setup generally provides (easy) access to prospective corporate borrowers in several EU Member States. Credit fund managers that do not avail of an in-house EU AIFM can contract with an EU “host” AIFM. A EU Host AIM is a third-party fund management service provider.
Obtaining access to credit markets is typically not the only driver for having the fund managed by an EU (host) AIFM. The EU (host) AIFM also secures that the fund manager has a (pre-)marketing passport, which secures an EU wide and efficient distribution of the fund. Hence, an EU (host) AIFM and an EU AIF are two key building blocks for an effective credit fund that targets European-wide loan origination. Luxembourg offers both; it provides for fund entities that answer the needs of an international investor base and it embraces the EU host AIFM model.
What is the typical design of the investor facing entity of a Luxembourg credit fund?
The EU AIF is typically organized as a Luxembourg special limited partnership (SCSp AIF). An AIF SCSp can conduct credit strategies including direct lending. Furthermore, an AIF SCSp can essentially accommodate all features and governance aspects that can be accommodated by Anglo Saxon limited partnerships. Hence, US or UK managers familiar with Cayman or Delaware limited partnerships require little guidance to become familiar with the fund governance and fund terms of an AIF SCSp.
Any need to adopt a specific fund regime at the level of the Luxembourg investor facing entity to accommodate a credit strategy?
An SCSp AIF with an EU (host) AIFM is subject to indirect regulatory oversight. The relevant EU regulator has oversight over the EU (host) AIFM and the EU (host) AIFM oversees whether the SCSp AIF complies with the standards of the Alternative Investment Fund Managers Directive (AIFMD).
The SCSp AIF can opt-in to apply the reserved alterative investment fund regime (RAIF) if it, for instance, wishes to accommodate umbrella structures with segregated compartments in an unregulated environment. Alternatively, the AIF SCSp can opt-in for a layer of regulation directly applicable at fund level under the specialized investment fund (SIF) regime or the specialized investment company in risk capital (SICAR) regime (jointly, Product Laws). The choice for the RAIF, SIF or SICAR regime is the exception nowadays, especially for credit strategies. If an SCSp AIF opts-in for RAIF status or a Product Law it is typically driven by the needs of specific investors or a preference for umbrella structures.
Any Luxembourg tax leakage at the level of the investor-facing SCSp AIF?
The investor-facing SCSp AIF is in principle tax neutral, subject to the possible application of the reverse hybrid rules in so far it regards the ‘main’ Luxembourg corporate income tax. Tax neutrality is further subject to the absence of an actual business or a deemed business in so far it regards Luxembourg municipal business tax (6.75% rate in Luxembourg City). The reverse hybrid rules and the absence of a deemed business are discussed below. An SCSp that qualifies an AIF is deemed not to conduct an actual business and is therefore not subject to municipal business tax. An SCSp that does not qualify as an AIF, for example certain types of separate managed accounts, co-investment vehicles, aggregators, carried collectors and structuring vehicles, should carefully monitor that it remains sufficiently passive. For that purpose, such SCSps should carefully consider their object clause, investment strategy and their functions in general.
If an investor-facing SCSp AIF opts-in for the RAIF regime or a Product Law, it will be subject to 1 basis point per annum of subscription tax on its assets under management.
A Luxembourg credit fund, caught by regulation beyond AIFMD and the Product Laws?
An SCSp AIF, which is not subject to entity-specific regulation, may nevertheless face regulation pursuant to the Luxembourg banking law if it engages in direct lending. The banking law regulates professionals that perform lending operations aimed at the public. The Luxembourg regulator has clarified that a lending activity is not aimed at the public if the principal amount of the originated loans amounts to at least EUR 3 million and the loans are granted exclusively to professionals. The concept of professionals is very broad and de facto encompasses all borrowers except retail type of borrowers. SCSp AIFs engaged in direct lending activities typically have no difficulty to comply with the criteria and thus remain out of the scope of the banking law.
What is typical for credit fund terms in LPAs compared to private equity strategies?
When comparing credit strategies with private equity strategies, the three key differences are that credit funds invest at a higher pace, are more liquid and are generally less risky. They are more liquid since typical loans generate a recurring yield and have a term of approximately 5 years, while liquidity events in private equity structures typically take some 8-10 years. Credit funds invest at a higher pace as deals require less ramp-up time compared to buyout strategies for example. Credit is by nature less risky than private equity because of its senior ranking, its inflation-resilient features (interest rates often have a floating element) and increased liquidity. All these features impact the fund terms. The high investment pace impacts the investment period of the fund, which is typically shorter than what is usual in private equity. The same goes for the fund’s life span. Another consequence of the investment pace is that the basis for management fees leans more towards invested capital than committed capital. As credit funds anticipate continuous and early liquidity events, it would not be fair to require an immediate distribution of proceeds upon an exit; the manager needs a fair chance to generate returns in order to meet the hurdle and therefore requires the right to put the released cash back to work. The relevant recycling provisions have the special attention of investors as they may cause dry tax events: investors typically recognize the income collected by the tax transparent fund, but the fund retains the cash to put it to work again, as opposed to distributing it and enabling the investors to pay their tax bill. The remuneration model of credit funds varies widely, but it can generally be held that the riskier the strategy, the higher the workload to manage the loans, the higher the management fees and carried payable by the fund. Managements fees for senior secured strategies are typically around 1-1.25% and for distressed strategies more around 1.75% - 2%. Less risky senior secured credit strategies typically have a lower hurdle (around 6% as opposed to the typical 8%) and a lower carried (around 15% rather than the typical 20%).
Any need for a Luxembourg GP and what about its Luxembourg footprint and functions?
A fund in the form of an SCSp requires a Luxembourg general partner entity with footprint in Luxembourg. The general partner is the governing body of the SCSp. If the general partner has no relevant Luxembourg footprint in relation to its governance the limited partnership may no longer be recognized under Luxembourg company law. This would push the fund into unexplored territory in terms of applicable legal framework and enforceability of the limited partnership agreement. If the fund would have a non-Luxembourg GP or a Luxembourg GP with insufficient Luxembourg footprint, there is also an increased risk that the jurisdiction where the fund manager has presence claims tax presence of the fund and the GP. This may ultimately mean that the Luxembourg fund pays tax in that other jurisdiction, which adversely impacts the fund’s performance and is detrimental for the manager’s reputation. The latter is typically a concern if the fund manager is based in the EU or the UK and is less of a concern if the manager is based in the US. It can be concluded that the Luxembourg footprint of the GP is predominantly determined by Luxembourg company law and foreign tax considerations.
The GP acts as the manager of the fund and will appoint an EU (host) AIFM for the investment management functions and other service providers (e.g., a depositary and a central administration agent) for the functions that can (practically) not be conducted by the GP. The GP retains the more administrative tasks, such as capital calls, cash distributions and investor onboarding and in some cases also the fund marketing function.
What is the typical design of the loan originating entity?
It is generally not the investor-facing SCSp AIF that originates the loans. Rather, the SCSp usually grants the loans through a tax opaque Luxembourg entity. Such entity should have access to tax treaties and thus potentially to reduced rates of interest withholding tax. This is however subject to a substance and beneficial ownership test. Source country requirements should be closely monitored in that respect. Source taxation is often not the driving force for the use of the tax opaque Luxembourg investment-facing entity. The Luxembourg entity is often used to push any applicable tax filing requirements imposed by source countries away from the investors and down to the Luxembourg entity. Finally, a Luxembourg entity is also often used to accommodate third-party leverage and the accompanying security package.
Some managers, especially the ones that need to accommodate different pools of investors (for example related to currency preferences or US check-the-box elections) use master/feeder fund structures. The feeders are marketed to certain pools of investors and invest the capital drawn down from those investors in the master fund. The master fund conducts the loan origination activities. In such a structure the feeders are typically organized as SCSps while the master is typically organized as a Luxembourg opaque entity (usually a partnership limited by shares or SCA) that qualifies as a regular Luxembourg taxpayer.
UK based credit fund managers often explore whether the Luxembourg investment facing entity can be replaced by a UK entity. The UK qualifying asset holding regime is technically a valid alternative, especially if the lender will also hold an equity kicker as the UK regime provides for a capital gains tax exemption applicable to such instrument. Lawyers produce matrixes to compare the Luxembourg and UK regime, which typically results in something close to a draw or a marginal win for Luxembourg or the UK. The fact is that Luxembourg investor-facing vehicles are tried and tested, appreciated and understood by investors. In addition, asset managers and investors alike consider Luxembourg a reliable and stable partner. For those “soft” reasons, but also because it hosts the investor-facing fund, Luxembourg is often the preferred jurisdiction for the investment-facing vehicle.
How is the Luxembourg investment-facing entity financed?
The loan portfolio held by the investment facing entity is typically funded with a proportion of equity injected by the investor facing SCSp shareholder and for the remainder with one or more loans granted by that same SCSp. The loans carry a fixed or floating yield that mirrors the yield derived from the originated loans, reduced by an arm’s length margin, and they mirror the currency of the originated loans. It is key that the yield under that debt is tax deductible and thus sets off the taxable income derived from the originated loans. As a matter of principle, arm’s length interest paid to the SCSp should be tax deductible, subject to earning stripping and anti-hybrid rules.
Earning stripping rules are typically of little concern when it comes to direct lending strategies as these rules only apply if an entity earns non-interest like income. Direct lending strategies do typically generate, apart from the usual interest income, other income such as origination fees, guarantee fees, commitment fees and original issue discount. Such type of income should normally qualify as interest like income in the sense of the earning stripping rules. However, extra care should be taken if the fund targets discounted or distressed credit assets in the secondary market. In view of rising interest rates, secondary credit deals typically trade at a discount and more distressed debt is expected to become available soon. If debt is bought at a discount and is redeemed or sold above its purchase price, it is likely that the gain realized will not qualify as interest-like income. If such gain exceeds EUR 3 million per annum (and it typically easily does as discounts are currently in the high single and low double digits), the earning stripping rule is effective. This means that only the higher of EUR 3 million and 30% of the non-interest-like income is annually allowed for deduction to offset the gain. Importantly, if the investor-facing entity qualifies as an AIF, the earning stripping rules are switched off. In the typically master feeder structure, the investor-facing Luxembourg entity qualifies as an AIF and thus the earning stripping rules should not be a concern.
The deduction of interest due under the loans granted by the SCSp to its Luxembourg investment-facing tax opaque subsidiary can also be denied pursuant to anti-hybrid rules. The question whether those rules apply depends on the ultimate investor base, which is obviously hard to anticipate but should be carefully monitored. In general, the rules are mainly triggered by taxable investors that consider the SCSp AIF as tax opaque or consider the master/investment facing entity as tax transparent and that hold a stake of at least 10% in the SCSp AIF. Investors holding a less than 10% stake are protected by a specific presumption that only applies if they invest in an AIF. Investors that hold a stake of at least 10%, consider the SCSp AIF as tax opaque and hold together an aggregate stake of at least 50% in the SCSp AIF render the investor-facing SCSp a taxable entity (18.19% Luxembourg corporate income tax due on the income allocable to such investors).
Experience has shown that the anti-hybrid rules and the reverse hybrid rules usually do not pose a problem for the Luxembourg asset management industry. Especially credit funds typically have a diversified investor base (with none of the investors holding a state of at least 10%) and are therefore generally protected by the 10% rule. However, if the credit fund manager offers co-investments and separated managed account type of SCSp structures alongside the main fund, the risk of those rules applying increases as the investor base in such vehicles is often much less or not at all diversified. The 10% presumption would also not apply in such cases, as it is subject to the requirement of being an AIF. Recently, the Luxembourg government proposed modifications to the reverse hybrid rules to avoid that the rules lead to “overkill” with respect to exempt investors by providing that tax exempt investors such as pension funds and sovereign wealth funds do not cause taxation under the reverse hybrid rules.
What about the Luxembourg footprint needed at the level of the investment facing entity, also in the context of ATAD 3?
Luxembourg tax law does not impose any tax driven local footprint requirements on the GP, SCSp or the investment-facing Luxembourg entity. Tax lawyers generally refer to local footprint as substance and it mainly evolves around the number of empowered local board members, the number of annual board meetings, the place where accounts are kept, where active bank accounts are held and whether the entity has office premises and employees. That fact that Luxembourg tax law does not impose substance requirements does not mean that substance is irrelevant. A sufficient level of substance is especially key at the level of the investment-facing entity if the entity intends to claim tax treaty benefits e.g. reduced withholding tax rates on interest. The level of substance is ultimately driven by source country requirements and requires a case-by-case approach focused on the aforementioned criteria.
In the context of a pending EU directive regarding shell entities (referred to as ATAD 3), credit fund managers should anticipate increased focus on the substance of the investment-facing entity that originates the loans. The pending ATAD 3 directive and especially the “substance indicators” set forth therein are nowadays seen as the point of reference for substance and fund managers therefore target, to a certain extent, alignment with those indicators. That being said, rumor has it that the draft ATAD 3 directive is not endorsed by all EU Member States in its current form and it is therefore reasonable to anticipate at least some relaxation in the applicable substance criteria.
It can generally be held that AIF status at the level of the investment facing entity adds to the substance analysis, especially since AIFs are considered out of scope based on the draft ATAD 3 directive. This does not mean, however, that the entity should solely rely on its AIF status for substance purposes. Actual Luxembourg substance should not be ignored since source jurisdictions may go beyond the ATAD 3 standards. As mentioned above, the Luxembourg investment-facing tax opaque entity is often organized as a partnership limited by shares (SCA). A Luxembourg SCA is a taxable entity but is governed through the classic LP/GP model. Its GP is typically the same entity as the GP of the feeder SCSp(s). As the governing body of an entity is the key source of substance, the substance of an SCA should effectively be identified at the level of its GP. Hence, the need for substance at SCA level cascades up to its GP. In such a case the GP’s substance thus goes beyond the typical substance of a GP that is discussed above.
What about the management fee flow?
Luxembourg transfer pricing rules require that the functions conducted by the GP are renumerated in line with what a third party, conducting the same functions, would generate. Tax lawyers refer to it as the arm’s length principle. As GP functions are typically limited, the tax leakage at GP level is seldom material and should typically not exceed EUR 20K p.a. GPs that conduct, for example, a key function such as fund marketing or central administration of the fund should factor in additional tax leakage. The remuneration of the GP can be generated in basically three different set ups: (i) the SCSp pays a separate remuneration to the GP and the management fee paid to the fund manager is reduced with that amount, (ii) the SCSp pays the management fee to the GP and the GP on pays the management fee to the fund manager, but retaining an arm’s length mark-up, or (iii) the SCSp pays the fund manager also for the GP services and the manager pays in return an arm’s length fee to the GP. The first model requires a specific clause in the LPA and an and imputation on the management fee to ensure that investors do not face a double fee. Commercially, that model is generally not seen as preferrable, because it tends to raise investors’ eyebrows due to (unjustified) concerns that they somehow pay double. In addition, the GP remuneration clauses are generally perceived as “ugly” when it comes to the usual LPA aesthetics. The second model is dominant. In the second model it is key that the outgoing fee can shelter the incoming management fee from Luxembourg taxation. However, the deduction is not always clear-cut due to the above discussed anti-hybrid rules, especially when the GP is disregarded from a US tax perspective. The third model has gained traction due to the anti-hybrid rules, but sometimes also because fund managers do not want to run an important part of their earnings model (the management fee) though an entity that has unlimitedly liability for debts for the fund.
For Luxembourg VAT purposes, fund management services are deemed to take place in Luxembourg as the fund qualifies as a VAT taxable person. However, those services do not attract Luxembourg VAT as an exemption applies. Other services, such as marketing, fund administration and investment advisory can also benefit from an VAT exemption. Specific attention should be given to (dead) deal costs and legal fees to avoid unnecessary VAT burden at the level of the fund. Credit funds that target borrowers outside the EU are generally in a VAT neutral position.
How should the carried be structured?
If the carried is held by the Luxembourg GP and that GP is organized as a limited liability company, the carried revenues would, as a matter of principle, be taxed at GP level at an effective rate of 24.95%. In addition, there is a potential risk that the carried may taint the fund as a municipal business taxpayer (6.75% on the fund’s profits). A Luxembourg GP that holds an interest of at least 5% in a SCSp taints the SCSp as a municipal business taxpayer. Although the general view of practitioners is that a carried interest is not an interest in the sense of the 5% rule, it is better to avoid the debate all together. Practically speaking, when LPs are onboarded, they inquire about the 5% rule and they are not easily convinced that a carried held by a Luxembourg GP does not give rise to municipal business tax concerns. The 5% rule is a particular concern when the fund performs over the hurdle rate and becomes entitled to 100% of the distributions during catch-up and to the typical 20% of the distributions after catch-up. Some funds use an SCSp as a general partner entity, but this would generally trigger the same risk; a GP SCSp that conducts a business (and that is what a GP typically does) can also trigger the 5% rule and taint the fund as a municipal business taxpayer.
Some reflections on a the AIFMD 2 proposal
In November 2021 the European Commission published a proposal to amend the alternative investment fund managers directive (AIFMD 2). The proposed changes target amongst other AIFMs that manage funds that conduct a direct lending or secondary credit strategy. Implementation by EU Member States is not foreseen before 2025. It can generally be held that the proposal was welcomed and that it should not have material adverse impact on the typical credit fund structures currently used in Luxembourg. The draft will likely be subject to some technical changes, but little change is expected to the main principles. The AIFMD 2 proposal clarifies, although there was already very little doubt, that EU AIFMs can conduct direct lending strategies. It requires EU (host) AIFMs to implement policies, procedures and processes for granting credit, assessing credit risk, and administering and monitoring the credit portfolio. The proposal further prescribes several risk mitigation tools when it comes to lending strategies. In order to limit concentration risk, EU AIFMs should ensure that a loan originated to a financial institution or a collective investment scheme does not exceed 20% (subject to ramp-up and ramp-down) of the AIF’s capital. It remains to be seen how this rule will be applied in the context of the above-described feeder master structure whereby the feeder originates a loan to the master for substantial all the feeder’s AIF’s capital. A risk retention obligation (economic interest of 5%) is used to combat “originate and sell” structures to avoid that the lender may be more incentivized by the origination fees rather than the future performance of the originated loans. The proposal requires loan origination funds to be closed-ended if the notional value of the originated loans exceed 60% of its NAV. This requirement aims to limit liquidity mismatch risk (illiquid loan portfolio facing redemption request) but gives little consideration to the liquidity in the originated portfolio which can for example encompass short term and thus more liquid loans. AIFMD 2 does not lift the restrictions imposed by certain EU Member States to get access to certain pools of borrowers.
Summary
Private lending is a booming business. European credit strategies are typically conducted through Luxembourg fund structures, which are often organized in a two-tier structure. The investor-facing entity is usually a Luxembourg partnership managed by an authorized EU (host) AIFM. The investment-facing entity is typically a Luxembourg corporate taxpayer that is organized as lending vehicle or as a master AIF. The substance in the structure, the flow of fees and the structuring of the carried is driven by a combination of commercial, tax and regulatory considerations. Credit funds have specific fund terms driven by the investment pace and the relatively liquid character and risk profile of the asset class. The pending AIFMD 2 directive is not expected to have a material adverse impact on the direct lending industry.
