Key Takeaways
- • Hedge funds have reportedly amassed €40 billion to invest in European distressed debt, according to Bloomberg, as cited by Ernst & Young in The Hedge Fund Journal.
- • Ernst & Young's Darrin Henderson and Thomas Lloyd-Jones argue that the default UK hedge fund structure, with its redemption rights and NAV-based fees, may be sub-optimal for distressed debt funds.
- • Illiquidity in distressed debt and the question of whether such investing counts as trading under UK tax rules are central to structuring decisions, since the investment manager exemption (IME) applies only to trading funds.
- • Private equity-style structures, with performance fees paid on asset realisations and taxed as capital gains (maximum 28% rate), are presented as an alternative to the 52% income tax treatment on NAV-based fees.
- • A hybrid model, pairing a corporate feeder for liquid assets with a partnership feeder for illiquid assets, is offered as a way to combine redemption rights with capital gains treatment.
Summary
Hedge funds have amassed a reported €40 billion to invest in European distressed debt, according to Bloomberg, as cited in an Ernst & Young analysis published in The Hedge Fund Journal. The authors contend that structures built for traditional hedge fund strategies are not automatically appropriate for distressed debt, and that the choice of fund vehicle and the delivery of performance rewards should be reviewed against the specific strategy and investor expectations.
The article describes the traditional UK-managed hedge fund structure as shaped by liquidity, investor redemption rights, and tax considerations. Under that model, the fund may be treated as trading and so needs the investment manager exemption (IME) to avoid direct UK tax exposure. To qualify, the manager receives customary remuneration, typically a management and performance fee based on NAV movements, which is taxed as income at headline rates of up to 52% where the management vehicle is an LLP.
The authors identify three challenges for distressed debt. Illiquidity is inherent in the asset class, so unrestricted investor redemptions may not be appropriate. Whether distressed debt investing constitutes trading is not automatic; the authors say it depends on strategy, selection methods and realisation profiles, and in their experience many distressed debt funds have concluded they are investing rather than trading. If the fund is not trading, the IME does not apply, which opens up performance reward structures delivered as a share of fund profits and taxed as capital gains, though deep discounted bond, offshore fund and accrued income scheme rules can still impose income tax.
To address these issues, the article describes a hybrid master-feeder structure. A partnership (Fund LP) with two classes of interest would hold illiquid investments through a tax-transparent partnership feeder that delivers capital gains treatment but limited liquidity, while liquid investments sit in a corporate feeder offering regular redemptions, yearly NAV-based fees and the IME benefit. The authors conclude that the typical hedge fund structure may be sub-optimal for distressed debt from both investor and manager perspectives, and that funds should begin structuring from their own activities rather than from assumptions borrowed from other strategies.
The article describes the traditional UK-managed hedge fund structure as shaped by liquidity, investor redemption rights, and tax considerations. Under that model, the fund may be treated as trading and so needs the investment manager exemption (IME) to avoid direct UK tax exposure. To qualify, the manager receives customary remuneration, typically a management and performance fee based on NAV movements, which is taxed as income at headline rates of up to 52% where the management vehicle is an LLP.
The authors identify three challenges for distressed debt. Illiquidity is inherent in the asset class, so unrestricted investor redemptions may not be appropriate. Whether distressed debt investing constitutes trading is not automatic; the authors say it depends on strategy, selection methods and realisation profiles, and in their experience many distressed debt funds have concluded they are investing rather than trading. If the fund is not trading, the IME does not apply, which opens up performance reward structures delivered as a share of fund profits and taxed as capital gains, though deep discounted bond, offshore fund and accrued income scheme rules can still impose income tax.
To address these issues, the article describes a hybrid master-feeder structure. A partnership (Fund LP) with two classes of interest would hold illiquid investments through a tax-transparent partnership feeder that delivers capital gains treatment but limited liquidity, while liquid investments sit in a corporate feeder offering regular redemptions, yearly NAV-based fees and the IME benefit. The authors conclude that the typical hedge fund structure may be sub-optimal for distressed debt from both investor and manager perspectives, and that funds should begin structuring from their own activities rather than from assumptions borrowed from other strategies.
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