As insurance companies look for opportunities to invest in a diversified portfolio of funds, and funds look for ways to access additional capital, there is increasing demand for innovative rated note structures. Such investments are typically structured as one or two tranches of rated debt supported by limited partnership interests in the underlying funds that comprise the investment portfolio and a tranche of equity commitments, which, as the first-loss tranche, is important for the ratings analysis. The past year has seen an increase in the use of such note structures, and we expect their popularity to continue to increase so long as market performance is strong and insurance regulators do not change the investment classification of the notes issued, or the loans incurred by, these structures.
This article reviews how these investments are typically structured, some important parameters that need to be determined in their structuring, the current regulatory environment and recent trends.
- Basic Structure: Structured notes obligations generally involve two entities: an issuer, which is a special purpose vehicle that issues debt and equity, and an asset holdco, which is a special purpose vehicle that is a direct subsidiary of the issuer and is the entity that holds the investment portfolio. The issuer then pledges its ownership interest in the asset holdco for the benefit of the noteholders.
- Debt-Like Characteristics: Insurance companies rely on the debt characterization of the structured notes obligations for their risk-based capital ("RBC") analysis. To support this analysis, the return on the debt is generally structured as regular interest payments and repayment of principal, subject to a priority of payments waterfall. The equity in the issuer gets the benefit of the upside once the scheduled debt payments have been made pursuant to the priority of payments.
- Priority of Payments Waterfall: Structured notes structures typically have long tenors (for example, 10 - 15 years). Because of this, a structured notes obligation that relies on market performance and is supported by alternative investments which are inherently illiquid assets requires some protection from economic downturns. Common terms used to provide that protection include:
- Payment of interest is generally required only to the extent cash is available; otherwise, the interest is deferred until cash is next available in the priority of payments.
- The amortization schedule is usually a target amortization schedule that requires amortization payments only to the extent cash is available in the priority of payments (with cumulative catch-up payments in subsequent periods).
- Full repayment of the debt can be targeted within a relatively short period of time (e.g, four-five years) based on modeled cash flows, but legal final maturity will often be set at 10-15 years to provide flexibility, in particular in case of an economic downturn.
- Distributions are made to equity only once interest and target amortization have been paid in accordance with the target schedule. Distributions to equity are also generally subject to pro forma satisfaction of a loan-to-value ratio and, sometimes, a liquidity ratio.
- Funding Capital Calls: There are certain structural holes that the investors need to be prepared to either address in the documentation or, more commonly, accept as deal risk:
- The debt and equity committed to the issuer is generally (but not always) equal to the LP commitments made to the underlying funds. If the underlying funds can call capital to pay fees and expenses in addition to the LP capital commitment, in the absence of adequate reserve, there is a possibility that there will not be sufficient cash available to fund a capital call to pay fees or expenses.
- Many funds permit recycling of commitments. However, if the issuer has received a cash distribution from the underlying funds, and that cash is run through the waterfall, it is no longer available for recycling. The portfolio needs to provide sufficient cash into the structure to be able to cover these additional calls on capital.
In these cases, the issuer would become a defaulting LP if the investment portfolio does not generate sufficient cash to service these capital calls, thereby impairing the debtholders’ collateral. It is therefore important to control when and how much cash leaves the structure.
- Investment-Grade Rating: Insurance companies rely on the investment grade or quasi- investment grade rating of the debt for their RBC analysis. If the debt is downgraded, the debtholders might request an Event of Default or a draw stop on unfunded commitments until the investment grade rating is restored.
Critical Structuring Parameters
When structuring these investments, issuers must determine certain key parameters. We list three of them here, and discuss each in turn.
- Whether the investment portfolio will be set as of the closing date;
- Whether the commitments to the issuer will be funded in full on the closing date; and
- Whether the issuer will be consolidated with its parent’s balance sheet and whether that parent has other obligations that subject the parent and its subsidiaries to covenants with which the structured notes obligations might conflict.
Setting the Investment Portfolio
The issuer needs to determine whether the asset holdco will have set the investment portfolio as of the closing date, or whether the asset holdco will build or adjust the portfolio after the closing date based on agreed investment guidelines. If the investment portfolio may change after the closing date, it is important to ensure the investment portfolio will be sufficiently diversified to support an appropriate rating. In addition, the issuer needs to be prohibited from committing more than the aggregate principal amount of debt and equity that has been committed to the issuer. Alternatively, noteholders will have to be comfortable that expected distributions on the underlying funds will be sufficient to fund capital calls for which no matching source of funding is identified at closing.
Funded or Unfunded Commitments
Another important parameter is whether the debt and equity commitments will be fully drawn on the closing date, or if there will be a delayed drawing schedule. Having some or all of the commitments unfunded as of the closing date presents additional considerations. There needs to be a comfort level regarding the credit worthiness of the debt holders and equity holders. Protections may be necessary to ensure the issuer receives the full draw amount needed, including defaulting noteholder provisions and GP or other parent support from the issuer or the underlying funds. Finally, the investment may need to come with drawing conditions, such as a ratings downgrade or an LTV breach, in the event the condition of the structured notes obligation has changed since the closing date. However, the matter of drawing conditions should be approached cautiously, as a draw stop may cause the issuer to become a defaulting limited partner with respect to some or all of the underling funds, thereby exacerbating the problem.
Balance Sheet Considerations
While the issuer of a structured notes obligation is a special purpose vehicle, the parent of the issuer may be a company that itself has debt obligations. If the parent is required to consolidate the issuer in its balance sheet, the covenants in the parent’s debt agreements may extend to the parent’s subsidiaries and must be considered to ensure that the debt issuance by the issuer does not conflict with those covenants.
Many structured notes structures include liquidity support, in the form of a revolving facility provided by a third-party lender, that can be used to bridge a funding shortfall. These liquidity facilities are generally available to fund fees and expenses, interest on the debt tranches and, sometimes, capital calls from the underlying funds. While these liquidity facilities are rarely used, including a liquidity facility in the structure provides stability to the structured notes obligation by supporting the ratings analysis and reducing the possibility that the structure will fail.
The structure of structured notes obligations is based on the current RBC treatment of the notes’ debt investments as debt investments. However, the National Association of Insurance Commissioners ("NAIC"), the standard-setting and regulatory support organization created and governed by state insurance regulators, has for a number of years been exploring changes to statutory accounting principles and securities valuation office ("SVO") procedures that could affect the reporting and capital treatment of structured notes obligations rated note feeder vehicles and similar structures. Currently, the NAIC is working on a principles-based approach to structured notes with the goal of settling on final rules by May 2023 with a January 1, 2024 effective date. We generally see the insurance company debtholders assume the risk of a change in law or of the structured notes obligation not achieving the desired capital or reporting treatment.
- Decoupling of debt and equity commitments: While investors in some structured notes obligations are purchasing a vertical slice of the structure that includes both debt and equity, we are increasingly seeing structures that decouple the two. This strategy works well for insurance companies that wish to invest in rated debt instruments but not the equity. The equity is then purchased by investors such as a balance sheet fund of the firm forming the structured notes obligation, family offices and other third-party investors attracted to the combination of levered exposure to multiple funds and the potential for high returns. While equity holders may be required to make an initial funding, often no further funding is required (subject to certain downside events such as a loss of rating for a period of time) until the debt has been funded in full. If the portfolio produces sufficient cash flows to service future capital calls, it is possible that the equity is never drawn again but still gets the benefit of excess cash distributions out of the system.
- Equity Credit Support: To the extent that equity commitments are not funded in full on the closing date, equity holders may be required to have an eligible rating or provide adequate credit support from a person with an eligible rating. This credit support frequently takes the form of a parent guaranty, a letter of credit or a cash collateralization, in each case for the full amount of the equity commitment. This credit support not only supports the ratings analysis, but also provides comfort to the debtholders that the equity holders will fund when required to do so under the terms of the transaction documents.
In the current market environment, we expect to see more private equity firms and insurance companies develop and invest in these structures to maximize their access to liquidity and as a new investment opportunity. We also expect further innovations as market participants react to regulatory and other developments.