Allens insights

Debt funds open a new asset class

By Tom Highnam (view CV)

The dominance of the banks in the Australian corporate debt market is an anomaly.

Banks' share of the primary loan market in Australia is about 95 per cent, in Europe it's 54 per cent, the United States, just 16 per cent.

Globally, debt funds are a growing source of financing and the time appears ripe for Australia to follow the trend.

To facilitate debt fund involvement, loan documentation in Australia needs a rethink on behalf of all participants to remove barriers to entry.

First, debt funds are frequently closed-end with limited access to capital. If the debt fund acts through a trustee it will always include a limitation of liability clause into documentation it signs.

In both cases (and rightly or wrongly), the indemnity provided by that debt fund may be viewed by agents as less attractive than that provided by a bank.

There are mitigating factors. First, the agents are indemnified by the borrower, so first recourse will be to that creditor. Second, the Agent's expenses come out of the proceeds of any recovery before amounts owing to the lenders. Third, the documentation will usually provide that no agent is obliged to act unless it is indemnified to its satisfaction from lenders.

This issue is being discussed by the Asia Pacific Loan Market Association committee. It is also considering super-priority of payments to lenders who do so indemnify Agents.

Secondly, the assignment clause included in syndicated debt facilities needs to be carefully drafted to ensure that it does not inadvertently prevent the participation of genuine debt funds. It is common for borrowers to include a restriction in respect of the transfer of loans to 'distressed debt funds'. Without a clear definition of this concept some genuine yield debt funds can be prohibited from participating.

Thirdly, debt funds are unlikely to fund themselves through matching deposits in the interbank market. Therefore, a break cost formulation applying on prepayments referable to matching deposits (common in older syndicated loan facilities) will not benefit a debt fund.

Fourthly, the practice of syndicated loan agreements satisfying the public offer exemptions in the Income Tax Assessment Act 1936 are important for debt funds and lending syndicates as a whole. Lenders will generally be asked to represent that they are providing finance in the course of operating in the financial markets. Superannuation funds will need to be especially mindful of this provision.

Finally, there are particular risks under the public offer exemptions in the Tax Act for debt funds which have a large number of affiliates who may also be equity investors. Some of the larger, global private equity groups would fall within this group. If the debt fund is an offshore affiliate of the sponsor of the borrower. the 'offshore associate' prohibition within the s128F exemption under the Tax Act may be triggered. This will jeopardise all lenders, not just the specific debt fund.

In short, none of these barriers to entry for new, debt fund lenders are insurmountable. However, they need to be considered by existing bank financiers to facilitate the growth of an alternative credit provider market.

An edited version of this article was published in the Australian Financial Reivew on 30 October 2013.

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