To counter the global decline in spreads and potential market corrections, Australian and European investors have turned to the US for private debt in search of higher absolute returns. While the lure of investing in US private debt is clear – higher base rates, longer manager track records and diversification, the structures used by US managers can create substantial hidden costs and undisclosed leakage for international investors.
With this in mind, choosing an investment structure to minimise tax leakage is imperative. As US managers attempt to diversify their investor base, a multitude of structure options now exist for overseas investors. These include treaty structures, onshore corporations, tax blocker structures, Cayman structures and more.
Here we discuss three structures and explore the aspects of each model that may erode Australian investors’ actual returns.
Structure 1: Season and sell
The “season and sell” structure has historically been the most popular model for offshore investors accessing US private debt. This involves an onshore entity holding a loan for 30-90 days before passing a portion of the loan to an offshore vehicle to avoid effectively connected income tax. Beyond bypassing the withholding tax on returns, economics of origination can be shared among onshore and offshore funds if original issue discount structures are used. Finally, additional fees tend to be lower than those incurred with other structures despite offshore investors paying more than their onshore counterparts.
However, the time delay inherent in the structure when the investment is “seasoning” results in a loss in returns for offshore investors. In addition, offshore investors lose out on origination fees as these are retained by the onshore fund. This means that, while the “season and sell” approach is popular, it is not necessarily always the best approach for every investor.
Structure 2: Business development corporation (BDC)
Recent years have seen a surge in business development corporation launches, with the vast majority of these being private or non-traded rather than public. Business development corporations lend equity collected from investors to small- to mid-sized companies in return for “interest-related dividends”. As a result, investors are not subject to withholding tax and offshore investors can participate on the same terms as their onshore counterparts.
The model is constrained, however, by the requirement of selling a stake in the business development corporation to another investor instead of simply withdrawing funds. In addition, managers of business development corporations can seek an IPO without investor support and dividends are dependent on asset valuations remaining positive. Finally, investors face higher fee levels as part of this high-risk, high-return investment approach.
Structure 3: Irish collective asset management vehicle (ICAV)
The ICAV first became available in 2015 to address some of the potential difficulties of the season and sell and business development corporation approaches outlined previously.
While this structure allows offshore investors to participate on the same terms as onshore investors and avoids conflicts of interest and withholding taxes, it is not without its drawbacks. Fees associated with the structure tend to be higher than the season and sell structure and, in order to remain tax exempt, a careful balance of onshore to offshore investors must be maintained. This sometimes means that investors are limited in what they can invest to maintain this balance.
Assessing potential value for money
The last two years have seen significant developments in the structures that offshore investors can use to access US private debt without incurring an unfeasible tax burden. While season and sell has become significantly less popular, ICAVs, BDCs, partnership structures and tax blockers have gained interest. These developments have major implications for investors’ costs and “leakage”, as well as the underlying risks of investment.
Careful examination and effective negotiation throughout the manager selection process are vital to managing risks effectively and maximising net performance outcomes in this increasingly complex asset class.
Niels Bodenheim, senior director, private markets, bfinance