Is a Credit Fund right for You?

If you take private equity and a bank and mash them together, you have your credit funds. These funds offer debt instruments (similar to a bank) but target higher returns (similar to private equity).  Think of them as an extremely useful Frankenstein.  If the bank has said no, and you don’t want to dilute your ownership (ie you don’t want an equity partner), then these funds can potentially offer the solution.  But as always, there are positives and negatives.

WHERE DO CREDIT FUNDS GET THEIR MONEY?

Credit Funds are usually funded by a series of high net worth individuals, superannuation funds or sovereign wealth funds.   These funds are established to only provide debt instruments to companies, this gives investors the perception that they are lower risk.  

ARE CREDIT FUNDS ALL THE SAME?

No, individual fund mandates can vary:

• Distressed funds: Designed to invest in companies with existing distressed debt, usually via the purchase of those debt instruments at a discount to face value. However, they can also inject new debt into a company that is in distress.
• Mezzanine funds: Target a higher return by taking a lower position in the capital structure, with any security over the company and its assets ranking behind the claims of senior secured lenders (i.e. the bank retains its first ranking security).  Useful for property developers who want to borrow more funds against the value of a property than a bank alone is prepared to lend, and thus get the LVR from ~75% (bank) to ~90% (bank + mezzanine fund).
• Niche funders, includes invoice financing (secured against receivables) and asset leasing
• Securitisation funds: When portfolios of small loans are divided into safer and riskier portfolio components, these investors can look at the various pieces to access different risk and return profiles.  This is useful for financial service companies looking to fund loan books.

WHAT ARE THE BENEFITS OF RAISING DEBT FROM A CREDIT FUND?

You stay in control.  You retain your equity. Interest is tax deductible and can often have flexible arrangements such as PIK (Payment in Kind) which means that interest is capitalised and is only repaid at maturity.  This means you have more cash available to grow or turnaround your business. 

WHAT ARE THE COSTS ASSOCIATED WITH RAISING CAPITAL FROM A CREDIT FUND?

Credit Funds provide debt and more debt means more risk. Similar to banks, these funds will insist on security, financial and operational covenants etc, so if your business performs poorly and you breach a term of the agreement then you are at risk of losing the lot.  Some of these funds have earned the reputation as being “vulture funds” as they look for companies with good asset value versus the value of the loan, and aren’t afraid of enforcing their documented rights to recover the value of the loan.  Opinions vary on this as many people feel the banks also behave like this and credit funds are at least able to engage in a commercially sensible negotiation around a range of restructuring options.  For example they can convert debt into equity whereas a Big 4 bank really struggles with this concept and are more inclined to opt for a receivership sale.

WHAT CAN’T CREDIT FUNDS DO?

Issue Performance bonds: People know who CBA are but they don’t know who “Cayman Island Trust II” is. Therefore, they cannot provide these types of facilities. This can complicate security arrangements as the bank providing those facilities will likely want to retain security or receive cash backing.

Provide Working capital facilities / Overdrafts / Cash Management: Credit funds have a limited pool of money. By committing that money to a facility that could remain undrawn means that money isn’t bringing them any interest or return, making it very ‘expensive’ until there is a future drawdown.

Similarly, they do not have the operations staff to handle multiple drawdowns and repayments. They generally prefer that funds are fully drawn once the commitment is established.
Hedging: Interest rate swaps, foreign exchange contracts etc cannot be done by a credit fund and will need to continue with a bank. Similar to the performance bond this can create issues with security and the bank will likely insist on a cash reserve.

So if you want to stay in control, pay a little more interest than you would to a bank and happy to increase your risk a little bit, a Credit Fund could be a good source of capital.

To learn more please visit Neu.Capital or contact us at [email protected]