November Private Credit Highlights: Sustainable Loans, Diverse Debt Strategy and More

Originally published Nov. 26 on Dechert.com's THE CRED

Diverse Debt Instruments: PE Firms' Strategic Use of ABS and Private Credit

By Markus Bolsinger , Sabina Comis , Chris Field , David Miles , Eng-Lye Ong , Phil Butler , Eliot Relles & William C Robertson

This is an excerpt from Dechert's 2025 Global Private Equity Outlook. To read the full report, click here.

PE firms are continuing to avail themselves of a broad range of debt instruments. Junior debt, senior debt, NAV facilities and asset-backed securities (ABS) are all commonly held by respondents – though there are some nuances by region.

For example, firms based in Asia-Pacific are more likely to say they use ABS and other structured products than their counterparts in the EMEA region and in North America, respectively. They are also more likely than their international counterparts to hold first lien or senior debt. Firms based in the EMEA region are the most likely to be using NAV facilities.

Looking ahead, many PE firms are clearly expecting to continue to work closely with providers – and to do so across a variety of debt products. In particular, 58% of PE firms taking part in this research say they will use junior debt facilities more frequently over the next 12 months; 47% expect to make more use of the ABS market. Again, Asia-Pacific-based firms are particularly likely to explore this latter solution.

“These statistics show the continued growth (outside of the portfolio level) in the range for which private credit is used, with both fund and GP level financing becoming more of a feature.” — David Miles, co-head, global leveraged finance, corporate and securities

Elsewhere, it is notable that 49% of EMEA-based PE firms are expecting to increase their use of NAV facilities. Among North American firms, meanwhile, 40% anticipate increased use of first lien and senior debt loans. All of which suggests that the wide range of solutions that private credit providers can offer will continue to appeal to their peers in the PE industry. Further regulatory scrutiny of private credit might skew this picture over time – as might a decline in availability if interest rates continue to fall – but significant numbers of firms believe private credit offers value in current market conditions.

“Private credit has shown that it is able to lend at scale across sectors, with multiple product ranges providing flexibility of solutions to particular transactions and very often with single counterparty execution risk,” says David Miles, co-head of global leveraged finance, corporate and securities. “Those features, in a market where, at times, other financing solutions have not been as available due to broader macroeconomic conditions or other broader restrictions, has enabled private credit to continue to grow its share of the lending market space in many geographies.”

ESG and Sustainability-Linked Loans – Private Credit

By David Miles & Jonathan Groves

Environmental, social and governance (“ESG”) issues have become a more prominent factor in the Private Credit market in recent years as some investors seek to ensure their commitments are deployed in such a way so as to encourage ESG policies.

From a leveraged loan documentation perspective, the sustainability-linked loan (“SLL”) has evolved with the LMA, LSTA and APLMA jointly publishing the Sustainability-Linked Loan Principles (the “SLLPs”) in March 2019. The SLLPs provide guidance on the minimum standards for a loan to gain an SLL label. There are a range of issues for private credit lenders to consider, including:

1. KPIs – the SLLPs include the requirement for the selection of KPIs and the setting of related sustainability performance targets (SPTs). The SLLPs also include a requirement for an independent external reviewer to verify the borrower’s performance against each KPI and SPT. The SLLPs encourage formulating a clear definition for the KPIs that should include scope, parameters, calculation methodology, a definition of a baseline and how it can be benchmarked against an industry standard. The SLLPs require that SPTs should be ambitious, represent a material improvement in the respective KPIs and be beyond a ‘business as usual’ trajectory and “regulatory required targets”.
2. Reporting – How often should the KPIs be monitored and reported against? This typically aligns with the financial information reporting with a separate ESG compliance certificate being delivered annually (the SLLPs recommend that borrowers should report on their KPIs at least once per annum). The annual reporting requirement includes a “sustainability confirmation statement with verification report attached,” setting out the performance against SPTs and related impact on the Margin. The SLLPs specify that the independent external verification of performance should continue for the duration of the term of the loan (and that this verification must be conducted by a qualified external reviewer).
3. Reward (and discipline) – The “reward” of a Margin reduction for achieving ESG targets is now well established, and so is the “discipline” of a Margin increase for each KPI not achieved (or failure to deliver the ESG compliance certificate). The SLLPs recognize that Margin is likely to go down if targets are met, but also up if they are not. It remains less common for underperformance with respect to ESG KPIs to constitute an Event of Default.
4. Use of the benefit – Requiring the Borrower to use some or all of the savings that become available by virtue of the Margin reduction to reinvest in ESG initiatives can be a way of further improving the ESG credentials of the transaction for all parties (for example, 50% of the economic value received as a result of the reduction in the Margin to be used for sustainability-linked initiatives and/or charitable purposes over the course of the following Financial Year).

Private Credit's Evolution Through Innovation with Grishma Parekh

The private credit industry has grown substantially over the past several decades - nearly a $2 trillion market in 2024 - but what key factors are driving its evolution? In this edition of THE CRED Convos, Grishma Parekh , co-head of North American core senior lending at HPS Investment Partners, highlights what makes private credit increasingly appealing to investors and lenders.

Watch here

Focusing on the Management Fee Base

By Gerald Brown & Matthew Duxbury

When it comes to fund management fees, the focus for managers and investors is often on the headline fee rate. However, the manner in which the management fee base is determined can also have a material impact on the fees ultimately charged. This article compares the most common models for private credit funds and explores different approaches to charging management fees on the fund’s borrowings.

Management Fee Base Models

Broadly speaking, there are three management fee base models adopted by private credit fund managers, although there are many available variations to these, and more bespoke arrangements may also be entered into with individual LPs.

1. Invested Capital

This is increasingly the most common approach for private credit funds. Under this method, management fees are charged on invested capital throughout the fund’s term. Invested capital is calculated by reference to initial investment cost (as opposed to NAV), and it is usually reduced as investments are realized / principal is returned.

Typically, there will be no fee on unfunded commitments, although if a fee is charged on unfunded commitments, this will typically only be applied during the investment period and may be at a lower rate compared to invested capital to incentivize quicker deployment.

There are several approaches to defining the scope of “invested capital”, including the treatment of borrowings (see below), costs and expenses and committed but not deployed amounts. The different approaches can become quite nuanced, and getting the invested capital definition correct is key to ensuring that this captures all components of the intended management fee base.

2. Committed Capital during the Investment Period and Invested Capital after the Investment Period

Although not as common as for private equity and venture capital funds, many private credit funds continue to adopt the model of taking fees on committed capital during the investment period and on invested capital post-investment period. This model can be more common for credit strategies that lend themselves to slower rates of deployment.

Like most private equity funds, private credit funds using this model are less likely to include borrowings in the management fee base. The post-investment period management fee may also be subject to a lower fee rate for credit strategies where there is less active management required post-investment period.

3. NAV

Particularly for managers who also focus on (or historically were focused on) public assets, using the net asset value (NAV) for the management fee base is also common. Using NAV places increased importance on valuations (and therefore will not be suitable for certain hard-to-value strategies) and subjects the manager to any volatility with the NAV (the risk of this will be strategy dependent). For evergreen private credit funds, NAV is often used.

Borrowings

1. Subscription Line Credit Facilities

The use of subscription line credit facilities (‘sub-lines’) has become a common feature for private credit funds, although their use raises interesting questions as to whether amounts drawn down under a sub-line should form part of the management fee base. For funds adopting the invested capital model, this provides the manager with quicker access to management fees. Including sub-line drawdowns can be justified as this capital is being managed, and therefore the manager should be compensated for doing so, but investors will often negotiate for the preferred return to accrue on these amounts.

2. Investment Leverage

For private credit funds deploying leverage for investment purposes, there is a split in approach among managers as to whether management fees are charged on leverage, although we have seen a number of private credit fund managers including leverage as part of the management fee base. In particular, where a private credit fund manager offers levered and unlevered parallel funds for the same strategy, it is common for management fees to be charged on leverage for the levered parallel fund. Where there is a high borrowing cap on the leverage that can be utilized by a fund, investors may look to negotiate a cap on the amount of leverage that counts towards the management fee base.

ESG Integrated Disclosure Project Update with Jeff Cohen from Oak Hill Advisors

What do alternative credit investors need to know about the ESG Integrated Disclosure Project (IDP)? In this insightful edition of THE CRED Convos, Dechert partner Mikhaelle Schiappacasse sits down with Jeff Cohen, CAIA , Head of ESG and Sustainability at Oak Hill Advisors and the Acting Vice Chair of the ESG IDP to discuss the project's development, frameworks and standards informing IDP, the value it brings to the market, how others can support the initiative and much more.

Watch here

Reforms to the Tax Treatment of Carried Interest – Key Takeaways for Private Credit

By Mark Stapleton, Daniel Hawthorne , Nicolas Kokkinos & Jennifer Hutchings

On 30 October 2024, the new Chancellor Rachel Reeves announced a two-step reform to the tax treatment of carried interest in the UK. In summary, the key takeaways are as follows:

Two-Step Reform

• From 6 April 2025: The tax rate on carried interest qualifying for capital gains treatment will increase to 32 percent. Apart from this, all other rules will stay the same while the government continues to consult on further changes to take effect in April 2026.
• From 6 April 2026: All carried interest will be taxed as deemed trading income with no grandfathering for existing carried interest arrangements. However, “qualifying carried interest” will be taxed at an effective rate of approximately 34 percent, while non-qualifying carried interest will be taxed at up to 47 percent (including NICs). Draft legislation is expected in 2025. For reasons set out below, the proposed changes may ultimately lower the effective rate of tax on carried interest arising from credit strategies.

What is “Qualifying Carried Interest”?

• Carried Interest will be qualifying where it meets a modified version of the existing income-based carried interest (IBCI) rules.
• One significant change is that the IBCI rules will be amended to remove the employment-related security (ERS) exclusion from the 40-month average holding period test. Accordingly, the IBCI rules will apply on an equal basis to self-employed investment managers (i.e., members of LLPs) and employed investment managers. While this could adversely impact credit fund managers holding carried interest as an employee, the government will consult with industry bodies to make it easier for credit funds to meet the 40-month test to enable credit funds to continue to enjoy more favourable rates of tax on carried interest returns.
• Two new conditions to the IBCI rules are under current consultation:

1. A minimum co-investment commitment requirement?similar to France and Italy is being contemplated. The government has indicated that any co-investment condition would likely be assessed on a collective basis on the management team as a whole rather than at an individual level to mitigate the impact on junior managers.

2. A minimum holding period requirement between the award of carried interest to an individual and the receipt of the carried interest. The consultation indicates that this could be a period of 5-7 years, but this was in the context of private equity investment strategies and it is unclear at this stage whether different holding periods for different fund strategies will be introduced.

• Stakeholder comments on these two new conditions need to be submitted to HMRC by 31 January 2025.

Simplification of Tax Regime

• The new trading income tax charge applicable to carried interest will be an exclusive tax charge, which will eliminate the need to assess the underlying nature of carried interest when received (capital gain, dividend, interest). Provided the new IBCI rules can be satisfied, this change could simplify downstream fund structuring, and could reduce the effective tax rate for carried interest largely comprised of interest income to 34 percent as opposed to up to 45 percent in the case of interest income under the current regime.

For further discussion on how these changes may affect you or your existing arrangements, please contact a member of Dechert's Global Tax team.

More From Dechert

2025 Global Private Equity Outlook: Explores growth opportunities and emerging trends as we head into 2025

2024 U.S. Election: Implications on Private Equity & Private Credit

The Making of Strange Bedfellows in Private Credit: Big banks teaming with arch-rival private capital groups?

Join the Dechert Team at Upcoming Conferences

Members of the Dechert team will be available to meet and discuss market opportunities with you at:

Women in Private Markets Summit — December 4-5 — London, UK

Fund Finance Forum | Navigating 2025 — January 23 — London, UK

THE CRED Editorial Board

Claire Bentley , Matt Carter , Angelina Liang , David Miles , Nathalie Sadler & Jonathan Gaynor

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