Direct-lending giants are forgoing a chunk of profit on “evergreen” funds as they look to build their share of the $1.5 trillion market.
(Bloomberg) — Two of the world’s biggest private credit firms have launched funds that will take far less profit than is usual for the industry — another sign of how power has started shifting toward investors in this $1.5 trillion market.
KKR & Co. and Carlyle Group Inc. won’t take the portion of profit known as “carry” on returns from two new European direct-lending vehicles, according to people familiar with the matter who weren’t authorized to speak publicly.
Both the funds have so-called “evergreen” structures, the people familiar said, meaning investors can withdraw and put in money at regular intervals, unlike this market’s more typical closed-ended funds. As a fairly novel type of instrument in the industry, evergreen funds sometimes have different profit arrangements than is the norm, although having no carry is still uncommon.
KKR and Carlyle declined to comment.
Private credit has been a magnet for firms attracted to its extravagant returns. But now they’re having to work harder to win over limited-partner investors, many of whom have less cash because of the weak economy and are restricted on what they can allocate to direct lenders. LPs can also pick from a ballooning number of private credit funds, or general partners, putting pressure on the latter to offer competitive terms on sharing profit.
Read More: Private Credit’s Lavish Profits Are Coming Under Scrutiny
“We’re seeing a pause right now in committing and I think a lot of our GPs were maybe a little surprised at how fast it slowed down,” said Karen Rode, senior partner for private investments at Aon Plc’s advisory business for LPs.
Carried interest is part of the typical revenue stream of a private credit fund. Usually once the fund reaches a pre-determined return, or “hurdle,” it can begin taking profit at a rate of 10%-15%. That’s on top of a management fee, which can be as low as 0.5% or as high as 2% for distressed-asset strategies.
Its roots come from private equity, which grew fat off a traditional mix of 2% management fee, 8% hurdle rate and 20% carry rate.
While LPs have increasingly preferred larger, established private credit firms when allocating their money, KKR and Carlyle’s evergreen funds show even the industry titans are trying different things to build market share. As investors often stick with the big guns during hard times, the leading firms’ strategy is to keep assets under management as big as possible.
Investors have also been drawn away from private credit by less risky asset classes. With the rise in interest rates, LPs can move up the risk spectrum to invest in higher-rated, more tradeable assets such as junk bonds, while still making strong returns. Many investors are wary about locking up capital for five to six years — the usual term on direct loans.
“We’re seeing some assets move from alternatives back into more traditional asset classes,” said Rode.
Read More: Direct-Lending Craze Fails to Impress $1 Trillion Fund Trio
KKR and Carlyle’s moves come amid a broader debate within private credit over how carry is calculated. The sharp rise in central bank rates has let fund managers blast through their hurdle return levels, prompting investors to ask whether they’ve earned the windfall. A few funds are pegging the hurdle to the base rate to make profit shares fairer.
Some LPs are suffering outflows themselves, or are struggling with the “denominator effect,” which limits how much a pension fund or insurer can allocate to private assets.
Private equity’s use of carry has drawn ire in the UK, where it’s taxed as a capital gain rather than income. That has resulted in a marginal tax rate of 28% rather than 45%, according to a report by tax analyst Dan Neidle, saving the industry hundreds of millions of pounds.
Rachel Reeves, who’ll become Chancellor of the Exchequer if Labour wins the next election, has targeted the practice for reform.
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