As a practitioner of impact investing, I have seen a multitude of fund proposals with debt investments as core focus – more commonly called “debt funds”. What do they have in common and what do you need to get right when assessing them?
The rationale behind debt funds: While some of them might also conduct a limited number of equity investments, their main investment strategy consists in providing (private) debt to businesses and financial institutions in emerging and low-income countries. The value proposition of such funds varies across markets and sectors, but fund managers usually highlight: 1) diversification into lower risk investment products, 2) the need for debt to high growth companies not only thirsty for leverage but eager to build a lending track record. For Limited Partners like development banks, it offers a great impact opportunity to reach clients that are too small and/or to aggregate small opportunities into large investments that fit both policy objectives and transaction costs. To make it a bit clearer: as an impact investor, if I want to gain large exposure to financial institutions active in climate business, it is probably more efficient to do it on a fund level, since bilateral opportunities are often too small to be worth the effort. Actually, many debt funds are more driven by the needs of the investors – who are struggling to find sufficiently large opportunities – than the ones of the market. Whatever your reason to invest or structure one, below I list a few things that I believe are essential to look at when assessing one:
1)The expected return: is of course probably less than equity funds, as the underlying investment is supposed to be of lower risk. The tricky part, however, is that you are in fact taking a capital share in a fund but getting debt-like returns. It is equity-like risk in some sense, because i) you have no recourse on the fund ii) you rarely get a fixed repayment schedule and iii) you have no guaranteed income. On the other hand, you get a debt-like return that is subject to a few cuts, that go to cover the operational costs and the compensation of the fund managers. The risk-return picture is therefore rarely favorable to the investor (Limited Partner) on paper. You can use the below terms to reach an agreement that is a bit more attractive:
- Put a condition on the minimum margin of the portfolio loans;
- Push down the management fees. Fair ones should be around 50-75 bps, while incentivizing the manager to optimize the underlying margins;
- Structure the fund as different “layers” of shares with corresponding annual dividends;
2) Sourcing and investment policy: The question to always ask is why would a company get a loan from a debt fund based in Amsterdam, Washington DC or Singapore, instead of getting it from the nearby bank? Are the managers more knowledgeable than local banks? What is their value add? Are they able to offer more flexible terms? How do they avoid adversely selecting bad prospects?
What you usually see is that debt funds are not as strictly regulated as local banks so they can indeed offer more flexible products (no collateral, longer terms) that add real value to the market without the rigidity of regulated banks. They might also be able to offer “venture debt” to companies that are not mature enough for commercial banks. Some might actually partner with local banks and invest alongside them.
Another question is why invest through a fund and not directly? Make sure to reflect this in the investment policy: geographies, company stages, investment sizes, sectors and impact should be complementary to your own investment activities. Unfortunately, it happens too often that, as LP, you find yourself crowded out by your own funds.
3) Reinvestment: Some of the underlying loans can be short term. Will you allow the fund managers to reinvest the proceeds into new loans? Or repay your investment as soon as possible? This really depends on your alternatives. What would you do with the cash-flow? Is the IRR higher if you get the proceeds at once at the end of the fund life?
Some of the above might be obvious. I have not touched on the other classic clauses (Governance, Conflicts etc) that should not be different from the usual PE fund. I hope this helps and that you can do something with it! And please do share other important attention points according to your experience!