Seven Things to Know About Credit Secondaries Investing 

Purchase Price Calculations Can Be Tricky

When transferring an asset into a continuation vehicle in a GP-led transaction, the governing documents will set a reference date to determine the valuation basis for the purchase price calculation. However, they will include a price adjustment mechanism to increase the price to reflect any capital contributions that take place between the reference date and closing date, and to decrease the price to reflect any distributions that take place during that period.

When negotiating a GP-led credit deal, it is important to ensure that all of the different types of inflows and outflows relevant to credit investments are captured by the adjustment provision. Inflows, for example, could include drawdowns on revolvers, while outflows could include not only repayments on principal, but also interest payments and fees that get paid by borrowers to lenders. In particular, it is important to ensure that payment-in-kind (PIK) interest and accrued interest is either accounted for in the purchase price adjustment or otherwise delivered at closing. 

Leverage Gets Complex 

Private credit typically has a lower return profile than private equity, and as a result some continuation vehicles may seek to incorporate leverage to boost returns. Putting leverage on a continuation vehicle, however, may add unexpected complexity to deal execution by introducing the risk that the debt could crowd out equity. Credit secondaries participants should consider whether any contemplated continuation vehicle leverage leaves enough room for investors in the selling funds to be able elect to roll their interest in the underlying investments to the continuation vehicle, while still providing the anchor secondary investors with sufficient deal size to justify the work required to lead the transaction. 

Consent to Conflicts May Take a Different Form 

GP-led secondaries are inherently conflicted transactions, and traditional private equity GP-leds typically require the approval of a selling fund’s limited partner advisory committee (LPAC). Some private credit funds, however, particularly those sponsored by firms with well-established hedge funds or other liquid strategies, may as a result of that lineage have a built-in conflict approval mechanism in the form of independent directors who can review and approve conflicts. If the documentation of a selling fund includes this mechanism, it should be carefully reviewed to determine whether approval of GP-led secondary transactions is within the scope of independent director duties. Even if it is, the general partner of a selling fund should consider whether that kind of approval is appropriate, or if it should instead seek approval from the LPAC or a majority in interest of limited partners as a matter of best practice. Credit secondaries investors may also wish to confirm the approach the sellers will be taking to consent. 

Cross Capital Structure Investments Can Complicate Exits and Follow-Ons  

Private credit sponsors are more likely than their private equity counterparts to invest multiple funds and accounts across the capital structure of a particular issuer. Both the sponsor and potential investors in a GP-led credit deal should consider what other related interests the selling funds and the other funds and accounts managed by that sponsor hold with respect to the assets being transferred.

Consideration should also be given to work outs and foreclosures, particularly where the selling funds hold other interests in the capital structure and/or the potential investors in the GP-led credit deal have U.S. tax sensitivities. Parties to the transaction should determine and document at the outset how the sponsor of the continuation vehicle will handle exits and follow-ons with respect to the vehicle’s assets in light of any other debt or equity holdings its other funds may have in the relevant issuer. Will the sponsor allocate those opportunities pro rata among the continuation vehicle and any other funds with an interest? Will dispositions need to occur at the same time? 

Representations May Be Limited 

Early deals in the nascent GP-led credit secondaries space have raised questions over the level of representations that continuation vehicles should receive and whether any post-closing remedies should exist for breach of those representations. Credit secondaries investors may be less likely to receive the benefit of asset-level representations, but may still push for the sellers to provide fundamental representations and other representations that cover the current state of the underlying credit contracts and assets.

Investors will also want these representations to be supported by indemnity and/or representations and warranties insurance (RWI). The sponsor, however, may take the view that such representations are not appropriate for the continuation vehicle’s portfolio and may seek to have any representations terminate at closing. In many instances, the right mix of representations and post-closing remedies will depend on the particular assets being transferred to the continuation vehicle and their respective risk profiles. 

Transfer Red Tape May Add to Closing and Post-Closing Steps 

The process for transferring credit is different than the process for transferring equity. To transfer credit investments, often an agent will need to be notified and approve the transfer, which could delay the closing of the transaction. To address this potential timing issue, it may be desirable for parties to a credit secondaries transaction to enter into a participation agreement, whereby economic ownership is passed to the continuation vehicle on the closing date while the title technically remains with the sellers. Once approvals have been obtained post-closing, the title can be transferred to the continuation vehicle pursuant to an elevation provision in the participation agreement. Preparation of a purchase and elevation agreement requires the involvement of experienced credit counsel and will be an additional expense incurred by the transaction parties.  

Tax Structuring 

Similar to potential sensitivity around acquiring “flow-through” assets in more traditional private equity secondaries, a key area of focus for credit secondaries is around structuring, both in terms of the nature of the acquired assets (i.e., whether the asset portfolio includes loan-related fees, delayed draw term loans, revolvers, distressed assets and the likelihood of having REO on foreclosure, each of which may require additional structuring) and also in terms of the mechanism for recycling, if relevant. Non-U.S. investors typically have concerns around investing in activities treated as the conduct of a U.S. trade or business on a flow-through basis, so if these investors are part of the investor base, it would be relevant to understand how the sponsor intends to deploy recycled proceeds and what structuring, if any, is required to insulate sensitive investors from direct U.S. tax payments and filing obligations in respect of the asset portfolio. 

Seasoned secondaries and credit investors alike are showing increased interest in credit secondaries investing. But private credit continuation vehicles are not an exact replica of their private equity counterparts. These GP-led deals present unique issues that will need be addressed in the transaction process and documentation to ensure a smooth closing with results that meet the parties’ respective expectations.