The term “private debt” is typically applied to debt investments that are not financed by banks and are not issued or traded in an open market. Since the 2008-2009 global financial crisis (GFC), private debt has found its way to portfolios of institutional investors. Regulatory changes have required that banks deleverage their balance sheets, and non-bank lenders and private debt funds have emerged as the alternative to the debt that was previously available through banks.
The economic impact of the global COVID-19 pandemic has a resemblance to the GFC. Impact on businesses due to social distancing measures, short term business closures and reduced consumer demand will also lead to an increase in bankruptcy claims, workout plans on existing debt and forbearance and other debt modifications. Companies in retail, travel, energy and real estate have been impacted the most. Companies are finding it harder to service their existing debt, which puts them in a distressed situation.
A recent Preqin report estimated that North America focused private debt funds raised in excess of $500 Billion as of 2019. Investments in distressed debt outperformed other private debt strategies during GFC. Recent news about private debt managers coming to market with new distressed debt offerings and raising significant capital in a very short duration indicates that investors are also positively biased to this asset class and expect it to outperform during the COVID-19 economic turmoil.
As investors increase allocation to the distressed debt asset class, private debt managers will need to invest in their business infrastructure that supports this asset class. To ensure efficient operation at the required new scale, a close review of the infrastructure for fund raising, middle office, back office and administration, and taxes will be required.
Managers are raising new vehicles that were not planned before the crisis in the form of focused funds and or co-investment structure to pursue emerging opportunities. Increased scrutiny during the investment and operational due diligence processes is expected as investors consider these opportunities. Each investor discussion will need to be managed meticulously. As the volume of investor interest and engagement is also expected to increase, investing in a scalable solution to manage the increased volume of investor communication during the fund raising process will be important. Some key trends would be:
- Increased expectation from investors for transparency, communication and data security
- Increased volume of investor queries, and with many firms required to implement a virtual process for ODD during fund raising, increases the risk of exposure of sensitive IP
- More frequent and ongoing communication with investors on fund performance
Managing the capital raising process and capitalizing on immediate investor allocation opportunities efficiently will be an important differentiator.
Increased investments will lead to increased volume of activity for the middle-office teams. Loan administration, loan closing, administrative agency and compliance teams will see a spike in their normal operational volumes. Life cycle events for existing facilities will see increased volumes in drawdowns and loan term modifications. Managers who currently don’t outsource these functions will need to compare the cost and benefit of building internal teams to support the volume spike vs. outsourcing them to a top-tier fund administrator. Existing middle-office systems will also need reconfiguration to manage volumes and newer terms and loan types that will come to market as managers capitalize on this opportunity. Managers will also face technology decisions around upgrading existing infrastructure or outsourcing to leverage a service provider’s technology.
Back office and Fund Administration
Administrators and fund valuation committees will need to work together to define processes surrounding valuation of the distressed assets. Managers will be required to utilize side pockets in existing portfolios to account for positions that may be less liquid or distressed and need to be accounted for separately. Reliance on the fund administrators’ valuation and accounting expertise will be important, as will collaboration with expert teams with prior relevant experience and learnings from the GFC. The accounting teams will also need to work with the tax teams to ensure foreclosure transactions as well as discounts on distressed assets are accounted for appropriately.
In response to the COVID-19 pandemic, Congress has enacted legislation (CARES Act) to help keep businesses open and operating, as well as assist lenders and borrowers with their outstanding loans. The creation of the Paycheck Protection Program is an example of the relief included in the legislation. There could be limited forgiveness of debt issued under the program if the borrower meets the requirements of the program. Generally, debt forbearance, forgiveness and modification can have tax issues, such as inclusion of income for modified debt as well as debt forgiveness.
The following issues with distressed debt investments could arise. Recognition of cancellation of debt (COD) income may occur when there are material changes to the terms of the debt such as principal balance being reduced or interest terms. These modifications may lead to “phantom income” being reported to the borrower. Phantom income is when a taxpayer receives a greater allocation of taxable income without a corresponding inflow of cash to offset a tax liability.
There could also be issues surrounding the tax implications arising from debt restructuring for UBTI sensitive investors. UBTI-sensitive and foreign investors might find themselves suddenly with unrelated business taxable income (UBTI) or effectively connected income as a result of restructuring or debt modification. These modifications may cause foreign investors to be subject to U.S. tax and withholding as a result. The investment intent is a vital part of determining whether the modification is now ordinary income under dealer property rules or capital gains on the resale of notes. You must understand whether or not you are in the “trade or business” for tax purposes with regards to significant debt modifications.
In addition, distressed market debt investors need to be aware of the market discount rules. If an investor purchases debt at a market discount, the tax rules state that the market discount accrues over the term of the debt and is recognized into taxable income as ordinary income.
Distressed debt can also cause unexpected cash flow issues as a result of phantom income upon foreclosure. The mortgagee (lender) may purchase the mortgaged property at a foreclosure sale. The lender is treated as exchanging the note for the property. In a foreclosure sale, a lender would trigger taxable gain to the extent the fair market value (FMV) of the property surrendered to the lender is greater than the value of the debt. In addition, if there is unpaid interest that has not been previously reported as income, the lender will realize interest income to the excess of the property’s FMV over the basis of the debt. Cash realization may occur later when the property is sold. This could lead to phantom taxable income in the year of the foreclosure.
To learn more about SS&C’s solutions for distressed debt and how we can support your operational needs and provide scale, contact us or sign up for our upcoming webinar Distressed Credit- Operational Agility in Volatile Markets.
Alternative Investments, Commercial Lending, Real Estate & Property Management