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Episode 1: Learning About Debt Funds

Alex Kensgaard and Chris McCrory, in-house private debt experts at GPFS, discuss some of the nuances around tax, complex loan products, and more when it comes to private debt funds.

This is our first podcast here for, for GP Fun Solutions, subsidiary of GP Fund Solutions. So, looking forward to talking a little bit about debt today. So today we got, myself, Alex Kensgaard, a Director here at GP Fund Solutions, and we also have Chris McCrory, an Associate Director at GPFS.

So a little bit about myself, I've been in the finance industry for 13 years now.

I moved to Minneapolis from Wisconsin for a career in fund administration. I started with a smaller company and made some moves around the industry until I finally found my home at GPFS. I focus primarily in the the debt side of the the world. I've been in that side for quite some time and that's where I started out as, and it's just been a fun journey from there. So, Chris, how about you? What's your experience in the industry?

Yeah. I'm Chris McCrory. I have been in the industry for about 11 years. I actually started on the hedge side to begin with, and then I ended up moving to private equity. And I've been focused on debt primarily since 2016.

And I've been with GPFS now since April of 2021.

It's awesome. Alright. Well, how we're gonna structure this format today is we have a a couple of questions we got from some GPFS employees. They're looking to learn a little bit more about debt. We're looking to talk about debt. So, how about we just jump right into some of these questions? And then we can take it away from there.

Yeah. Sounds good.

Alright. So, the first question I got, is just a really straightforward one. What are the main differences between debt fund accounting and equity fund accounting. So how about I hand that one off to you? And I'll jump right in afterwards.

Yeah. The the main difference is in terms of when they, the fund sees income or if they see realized gains in debt funds, they have a constant stream of interest income. And they tend to see cash flows on a regular basis monthly, quarterly, within the fund, which can give them some added flexibility.

Equity funds tend to have much large chunkier gains when they realize their, their equity investments years after they start them.

Yeah. That makes perfect sense. And it's all about the types of investments that they're buying in within the fund. So within the structure of the fund, you can have all sorts of different structures that are unique each individual client, but definitely it's all about what types of investments and and what types of debt they have out there too. And I'm sure we'll jump into the types of debt later in this podcast too.

Yeah. I definitely think and the investors definitely gravitate sometimes towards both wanting a little bit of both of those. You could have funds that have both debt and equity components depending on the fund. So it can get pretty interesting.

Yeah. Definitely.

The next question we got from Carlos is a really good follow-up on that one, and it is thinking about it for more of the, investor perspective. So rather outside of the fund, whether it's debt or equity from an investor standpoint, what are the benefits of investing in a debt fund versus an equity fund?

Yeah. I think a lot of it can come down to cash flows as well, debt funds because they get interest cash in on a regular basis in most cases.

Those funds tend to do quarterly distributions back to their investors as well, either in a net distribution form where they are actually sending cash or even if they are calling capital at same time, it's gonna lower the cash burden of the capital call. So from the investor's perspective, that is one way it could be beneficial as the cash flow perspective.

It also can be impacted by the risk levels in the overarching market on whether or not debt instruments are better or worse than an equity instrument, very similar to in the the public market, do you want publicly traded equities, or do you want to get into the bond market? It's kind of the same decision making lines.

Yeah. That makes a ton of sense too. And, you know, from from a debt investors standpoint, you get that little bit more of a known quantity with, with those debt investments. You still have some risk there on potential defaults and making sure the the borrower can can pay those interest payments and and any principal you know, payments along with it, but you do get that known cash flow. You get some some interest rates that are are relatively ,you know, I don't wanna stay stable in this environment, but a little bit more of a unknown quantity at that point in time. So and, you know, you still get the overall value of those those debts as well too. There is there's different aspects of the the secondary market where you can use the debt funds and the debt investments as a opportunity to get some more gains, but that's more of a a distressed market, which is a whole another podcast topic.

But still, like, we do see, you know, clients who who have that reliable income strategy, but they're like you said before, you can mix and match it with some some equity investments and try to get you know, boosted absolute returns as well.

Yeah. In my experience, I've seen a kind of across Chris entire spectrum. There'll be funds that are purely third party purchases of pieces of large loans all the way down to more simple mezzanine style funds that our deal base where I like to use the term that's on Shark Tank. I don't know if we can put that in here, but, it's it tends to be a negotiated debt and equity component to the deal. So it's not just debt or equity. A lot of times it is both.

And then furthermore, if something does go bad with usually what you see is it restructures into some sort of equity component in the underlying company as well. So it can from an accounting standpoint or a tax standpoint, it can get a tricky, but it does make it pretty interesting when you see it in real time over the, you know, three to five year life of the, the of the loan itself.

Yeah. Absolutely. And, you know, with a lot of the private equity funds that do have expertise in these industries too, that's where that can come into play too. So when you're lending money out or possibly originating these deals to to a borrower or a company, you know, you want that company to succeed and you want them to to have their best foot forward and and have that knowledge that the the private equity firms may have. So it's not even just a matter of, hey, thank you for that 10 percent. Interest rate return, it's, you know, let's make sure your business is up and running and succeed in as the best it can out there.

Yeah. So let's flip the coin then. Why do you think a fund manager would choose to launch a debt fund as opposed to an equity fund?

Oh, that's a great question. So I think there's a lot of different aspects of that too. So when you're launching a fund, you have a lot of decision making that goes into that start too and what kind of fund you want.

You know, for a different type of debt fund. You can think about it as, you know, the direct lending or the origination type of funds where want to have more direct involvement with the companies. You want to have those conversations.

And that negotiation aspect too of stake would you want to potentially get from that company? So from a, you know, a fund manager perspective, you have a lot of decisions to make there. So there's also then the secondary market opportunities.

If you're looking to buy, you know, just pieces of big deals. You don't want to be leading those negotiations. You don't want to be taking that lead aspect of it, but you still see those good opportunities with the investment types. So it's a lot of flexibility there, I think, from from a fund, what your expertise is and where you want to live in that market.

Yeah. I think that's exactly right. I think it really does depend on the scope of what the manager wants to get into.

I've also seen when it comes to tax laws, a conversation at the manager level about whether they are a loan originator, so are they helping to create that loan product, or are they purchasing a third party and the tax scope behind that can change depending on whether they're actually originating. So it's been pretty interesting, especially with the rising rate market that we've been seeing lately.

Yeah. The market and the macro scale too, I think, comes into play. We've seen, you know, when we first started looking at the the debt investments it was right after the financial crash of, you know, 2008/2009, around there. So the market was very different than it is today. And that's, you know, and that's kind of the secondary market option. If you're looking for some distressed products where you're hoping that those companies can make it through some tough times. There's a lot of potential pick up there for some of those absolute returns and not just the the reliable income, aspect there.

Yeah. Another item that can happen with distressed products is there are funds that are specifically loan funds and if that does restructure your own equity, it kind of becomes out of scope and they have to actually try and do something with that product. So that kind of fuels that other side of the market as well when you get to the third party aspect.

Yeah. Lots of lots of flexibility there in the loan and debt marketplace.

Yeah. Absolutely. Oh, one more thing for the manager side too that I think Alex, you and I have talked about is, the operations of the fund itself in real time can change pretty drastically if they have constant cash flows coming in.

I've seen a lot of situations where once the portfolio in the fund is pretty robust, they've got quite a bit of cash coming in on a monthly basis to the point where they don't have to call capital quite as frequently, because operationally they always have cash in their bank account to pay expenses and then when they decide to do a capital event, they kind of clear the ledger on both sides of that and call and distribute simultaneously.

So it can add a quite a bit of flexibility if you do have debt in your portfolio.

Whereas, on the equity side, if they wanna do anything, they, in most cases, will have to either draw on the line of credit or call capital.

Yeah and and with the the rate environment too, there's a lot of impacts to that line of credit now. There's a lot more scrutiny on some of the interest expense that could potentially happen out there if you're drawing on the line of credit more often.

And the rate environment works both ways, I guess. So for new originated loans, if you're looking at some of the rates that are a little bit higher, there's a benefit for some of those cash flows coming in. But on the the other side of the coin, you're also paying a little bit more for for that cash line of credit side.

Yeah. That's exactly right. When you have a fixed income fund that has fixed rates on its loan products, if those loans started three years ago during COVID period, when rates were super low, those do not look nearly as good as ones that are starting now when rates are quite, you know, historic highs, at least in my lifetime.

So, it is very interesting to see how it has moved in the last three to five years and to see where, try and predict what's going happen in the next three to five years because it's been so volatile.

Yeah. And it's not even the the changes. It's the the pacing of it too. There's been a lot of Yeah. A lot of movement very quickly.

This is a good segue to our next question from, from one of the GPFS employees here is you know, as interest rates might fall in the upcoming years, you know, are we expecting to slow down of raising new debt funds in the industry?

And, you know, for my opinion on that one, it's, you know, the debt funds themselves are quite dynamic and you can structure and you can build you know, for what you're looking for out there, you know, the terms are the main negotiation piece of that. And, you know, as the market changes in the rate market, some of those terms and potential aspects of how you're building these loans themselves in the origination front, those terms themselves will change to kind of reflect it. And that's, you know, what those terms are can be variable rates versus fixed rates, adding more floors or ceilings potentially for some of these rates to really just narrow that window, and we haven't even gotten into, you know, cash rates versus Payment-in-Kind (PIK) rates as well, which are a lot of levers that you can pull out there and when you're building up these funds.

So, you know, I don't think there's a slowdown, you know, in the near future here of the raising capital. I think if anything, there's opportunities there for for increased, debt funds with certain types that the firms are comfortable with.

Yeah. I would agree with that. I know two, three years ago when rates were really low, everybody wanted to borrow money because it was very cheap to do so and to have that operational cash gives you a lot of flexibility, whereas now the borrowers are being a little bit more choosy about whether they need to or not because that cost of the borrowing is much higher.

From the funds perspective, if you have a variable rate loan right now, it looks a lot better because those rates are changing in real time with the market. Whereas, if you have more fixed rate products, those don't look as good right now unless you're starting and you're basically starting your portfolio right now. So it really has varied and obviously there is the secondary market as well. So if the fund has it in scope, they can always go out and get loans through that third party rather than trying to originate as well. To get, you know, the rate scope that they're looking for.

Yeah. And I think that the main point I want to bring up here on, you know, raising new debt funds is there's so many ways to structure and build these out. You know, if the risk of of lending out this cash to a company, you know, because these rates are a little bit higher, we don't really want them to pay off early. We want to have that stable, reliable income, and we want to be able to see those interest cash payments come in. So we've seen a lot of different ways that you can build that you know, build the interest rate stability within that loan product itself. And one of the ways we've seen that is, you know, make whole amounts; there's exit fee; prepayment penalties.

Just to encourage the borrower to stay committed to at least the majority of the term, of that investment.

Yeah. That's right. The prepayment fees, especially can be pretty daunting when you read those agreements in the first couple of years if they pay it off, they are not in substantial amounts. And the fund is at least going to get compensated in that regard if it pays off early, and it's more of a protective measure than to be what would seem predatory on the surface almost.

Yeah. And it's the rate environment too. It's, you know, four years ago. We were talking about how five percent's pretty high. Five percent would be great right about now. Yeah.

I would take that if I was a borrower for sure.

You could also jump into just talking a little about what that make whole calculation really is. What's that mean? I mean, I think we're in the weeds, we're in the industry. Do you want to explain a little bit what that make whole amount really means for people in real life?

Yeah. Sure. So make whole, usually in the loan agreements, there will be a date in the future. After the loan is started, at which point, regardless of when that loan pays off, it is going to pay interest through that date.

So let's say it's two years after the loan start date, the loan will have to pay interest when it pays off regardless of when it pays off. So if the loan, you know, the borrower is just paying their interest on a regular basis for two and a half, three years, that make hold date is no longer applicable because they've been paying interest. Where it becomes applicable is if the fund gets into this deal and a year later it pays off.

Well, a lot of them, if they're afraid of that happening, or they're trying to guarantee some aspect of the income within that instrument, they will institute a make hold date that says you're going to pay us interest through a specific date regardless.

And it does just kind of protect against all of the work that goes into it. These are real common in origination deals from what I've seen because of all the legal aspects, you have to do all the background checking to even get that loan off the ground and then, you know, lend that money out, it's pretty expensive to do it. So if it pays off in a year and you don't have that three to five year runway of income that you're expecting, you know, it hurts the fund a little bit in that regard.

Yeah. I think oftentimes when we're in the weeds and looking through these loan agreements that can be quite substantial and pretty daunting to read through. Those are real people that create those loan documentation. They're compensated for their time as well. So there's a lot of work that goes into these deals to make them real, make them happen.

That's right. Yeah. It's not it's definitely not a snap of the fingers.

Right. Let's switch gears a little bit. So, you know, next section here is talking about some of the types of loans that exist out there. So, would you be able to explain what a delayed draw term loan is and what are some of the advantages or disadvantages of of using both types of loans from a regular term loan or a delayed draw term loan from a borrower's perspective?

Sure. I'll kind of equate these to real life loans that most people are aware of.

The most common loan is, I would say it's a term loan. It has a fixed amount that you're borrowing with a, you know, a rate that is either fixed or variable through a specific maturity date in the future. And then you would make payments throughout that period. So the funding for that as the borrower, I'm going to get all of that money right now. I'm going to pay that off over time, or in the case of a car loan, you're getting an asset, something like that.

So that is the most standard description of a loan, I would say. A delayed draw is more similar to a credit card. With the exception of you can't borrow, it's more strict on how and when you can borrow, and it has a cap on the total amount over the life of that delayed draw.

So I would think of that as an unfunded loan with the opportunity to borrow in the future as needed. So, the reason why a lot, a lot of times what we see in our deals, in our funds, is they'll have a term loan with a delayed drop component attached to it. Which gives them, you know, the upfront funding that they need along with a mechanism for potential funding in the future. And then that will also have its own maturity date.

So eventually, they can't use that delayed draw anymore.

It's usually much more short term compared to the the original full loan.

Yeah. Absolutely. And the one remaining aspect of that too is when we get one step further for full flexibility, there is the revolving type of loan. You know, in the delayed draw, once you borrow it, even if you pay it back, you can't borrow again on that same amount. Whereas a revolver, it's going up, it's going down. You have a credit limit, and you can pay, repay, and borrow as often as you need.

That's right. Those are the most interesting ones I would say overall are the loans that include revolvers because you never know what's going to happen. The terms on term loan and a delayed draw are pretty concrete and fixed where you can model them ahead of time. A revolver, you just don't know until they decide they're going draw.

Great.

I know we touched on Payment-in-Kind a little bit earlier.

But what if we dig a little bit deeper into that. So could you explain that concept for us? And then we can talk a little bit about some of the advantages of that for both, the borrower and the lender.

Sure. Yeah. Payment-in-Kind is pretty common right now, I would say with newer deals because interest rates are so high. When interest rates are higher, the cash burden of the borrower to make their payments is also higher on a regular basis. So a lot of times we'll see a cash rate along with what's called a PIK rate or a Payment-in-Kind rate.

The cash rate, pretty obvious, you're paying cash on a regular basis. The PIK rate, it actually will capitalize into the principal balance.

The PIK rate is usually lower than the cash rate and then when you combine them together, we call that the all in rate.

So, it's basically a portion of a higher interest rate is being paid cash, and the rest of it is going to capitalize into the balance of the loan, and in most cases will be used to generate interest going forward. So I think that'll probably segue into your next thought here, Alex.

So, yeah, one of the advantages of that, you know, what I was just thinking about is you get that cash flow liquidity for it. So with cash interest, that's real cash, you need to put that out, you need to make your payments. With with the PIK side, you're basically delaying it.

And it can potentially even compound depending on the terms of the loan too. So, these PIK amounts where, let's say, you're getting charged eight percent for PIK, that eight percent compounds monthly, quarterly, whatever the terms are. At the end of the life of that loan, it can be a pretty substantial amount that you're getting paid out at the end.

Yeah. That's right. I I think the concept of an exit fee or the concept of PIK, it's usually either or in a fund agreement in terms of a payment fee at the end.

PIK tends to be kind of hidden, I would say. A lot of people, if you were looking at a calculation without seeing the full Excel calculation, over the life of that loan, you wouldn't realize how much that compounds and creates additional interest down the road. It's not insignificant when you look at the full life of the loan.

And often I go back to my distressed debt days where if the company is not doing as well and they can't make those cash payments, restructuring reorganizations, you know, the renegotiation of that term, it often moves into a PIK type of category which can then be even higher interest rates because there's more risk and you want to get that premium for that risk that exists out there.

Yeah. I think that's right. It's the great unknown when it comes to capitalized interest because just like the principal balance, until they pay it back, you don't really know if they're going to pay it back. Whereas cash interest you're getting on a regular basis, and you can feel pretty good about locking in that income.

Alright.

You know, we're we're really cruising through our time here. So how about we just hit a couple more questions?

Sure. Let's do it.

Alright.

So one of the the items that we're seeing in the marketplace, is you know, companies such as Blackstone are choosing to to rely more on CLOs.

Do you think this is gonna have an impact to the private credit industry as a whole, or what do you think the impacts are of some of these more structured, loan pools such as, CLOs or collateralized loan obligations?

Yeah. I don't have a ton of experience in this, so I will eventually pass this one back to you, Alex because I know you have more extensive, at least fund specific, experience.

I don't think overarching that it's going have a huge impact because underneath those CLOs has to be a debt instrument. It's not just being made up out of thin air. And I would equate it to how a mortgage backed security works, where it's based off of mortgage loans underneath it.

I do think that that will change the type of loan that is possibly coming out depending on what types of CLOs are being purchased or being utilized, I would say, in this case.

But yeah, I'll pass that back to you because I think you have a little bit better expertise than I do.

Yeah. Absolutely. So let let me just do a quick high level of what a collateralized loan application is. So, essentially, the way I think about it is you're going to have some assets on one side and liabilities on the other. So with the asset side, that's your loan pool. You collect, you build up your portfolio of all of your loans that exist out there, and those are gonna have the standard loan terms and cash flows that you would expect. So every single every single month, every single quarter, you're getting cash flows in from this loan pool.

And that's essentially going to be all of these cash proceeds that you can use to buy more investments, you can increase the pool size, etcetera as you're kind of building this up. And at a certain point in time, you're going to get to a critical mass, and you're going to be able to securitize this loan pool.

And then you're going to create more of the liability side of this. So with that liability side, you're going to give out some guaranteed interest rate payments out the door. So, you know, you're going to structure this in terms of seniority too. So, maybe the most senior, you know, tranche of this CLO is going to pay out eight percent interest.

Then the next the next level down is going to be a little bit riskier. Maybe that will pay out a little bit higher rate.

Build up all these tranches and securitize all these levels of cash flows out based on your loan pool size until you eventually have, you know, the final trench of the equity trench. So, whatever's left over of your, you know, mandatory obligated payments out the door, you're going to be able to have some of those assets still remaining there. And this is kind of where the structuring comes into play of if you have a lot of expertise and you're building up these loan pools yourself, and you can market these out in you know, out in the marketplace, there's going to be people who want those stable returns, that highest seniority in those guaranteed payments out the door. So there's benefits for all types of individuals when you're creating these debt instruments out there of what you're looking for in terms of risk and return.

Is the issuing party when they're doing this, are they looking at some sort of break even point when they're kind of determining how to group these things?

Oh, I'm sure there's so much analysis that goes into creating, you know, that actual securitization. That's where the firm's expertise comes into play. So, the people who are creating these CLOs are really in the weeds and really in-depth and have that innate knowledge of what their, you know, what makes up these loan pools, what they're packaging, and what they're eventually trying to securitize and get out the door. So it's an exciting industry. I think going back to the original question, though, is there's also a place for that in the marketplace and, you know, the private credit industry itself is based a lot on real individual companies that have these cash flow needs. And I think that's that's the role of private equity industry itself fills, in the marketplace.

Yeah. I do agree. I think this is more like Blackstone relying on CLOs as opposed to trying to find borrowers is more tangential. I think both can exist simultaneously.

Especially with where rates are currently. I think it's definitely doable.

Alright. Maybe we'll end with one one question of what's your favorite thing about debt, Chris?

My favorite thing is that it never feels stagnant. There's always something going on, on a monthly, quarterly, yearly cycle.

And you never really know exactly what that deal is going to look like until you get into the deal docs.

One loan compared to another or even the deal, if it includes equity, they look completely different in a lot of cases.

So it can be really, really interesting as someone who's been in industry for a while is I'll see a new deal every year that's got a component that I've never seen.

And then the other side of it is, they can amend these things on the fly too. So, it can just change and then you're working with both the fund and possibly the deal teams to make sure we're handling it correctly from an accounting standpoint and sometimes from a tax standpoint. So I always feel like I'm on my toes. I never feel like I'm being too repetitive in what I'm doing because of that.

No. I think that's it. You've nailed it right there, Chris. I love the the excitement that debt has. You know, as an accountant, we live for excitement.

So, I really do agree with you there.

Yeah, I like the the diversity in what we do because we have loan products in our funds. Alright.

I think we'll cap it there, Chris. So, you know, thanks for the time today. I think it was really fantastic to be able to talk about our debt products and what we really enjoy about them out in the marketplace. So, hopefully, you know, people were able to to learn some more, about the debt instruments and, you know, we'll go from there.

Yeah. It was fun.

Awesome. Well, thank you.

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