Many upper- and middle-market private credit managers now manage a constantly expanding platform of funds and SMAs across a range of strategies. Within any given strategy, a manager may be allocating investments across multiple funds with overlapping investment policies, as well as a raft of SMAs investing alongside those funds.
As the number of funds and SMAs managed by a manager proliferates, the scope for transfers of assets between those funds and SMAs – commonly known as cross trades – increases. There is a wide range of reasons why a manager might believe a cross trade is in the best interests of both the buying and selling fund or SMA:
Cross trades inherently give rise to conflicts of interest. Investors in funds and SMAs on both sides of a cross trade will want comfort that the transaction is in their best interests, that the price is fair and reasonable and that any negative impacts on manager alignment are appropriately handled.
The price for a cross trade of warehoused assets or for rebalancing purposes will typically be agreed in advance with investors under the relevant fund and SMA documentation. Equalisation interest is often seen as a useful proxy for setting that price. The analogy is that if a selling fund is in its fundraising period, subsequent investors into that fund would buy into a pro rata share of its portfolio at cost plus equalisation interest. There is therefore logic in saying that investors on the other side of a cross trade should be able to buy into warehoused or rebalancing assets at an equivalent price.
However, where a cross trade is for reasons other than rebalancing among accounts fundraising concurrently, valuation can be a thornier issue. Most private credit assets are Level 3 assets, so there is no market by reference to which the price for a cross trade can be set. Valuation is therefore typically determined by the manager in accordance with its valuation policy and procedures (although for particularly large cross trades, or where conflicts of interest are most acute, an external valuation might be appropriate).
Valuation of private assets is currently a hot topic for the FCA. On 5 March 2025, it published its Review of Private Market Valuation Practices – please see our recent article on best practice in private capital valuations. That review makes clear that the FCA expects any firm valuing private assets to have robust valuation practices evidencing independence, expertise, transparency and consistency. Specifically in relation to cross trades, the FCA expects managers to perform valuations impartially and with all due skill, care and diligence.
A conflict might also arise where a cross trade crystallises carried interest in a selling fund or SMA. Investors in that fund or SMA can fairly argue that a cross trade is not a “true” realisation and investors in a buying fund or SMA that still holds the asset, and is indeed increasing its exposure, might balk at the manager realising carried interest on that asset before a “true” realisation.
Whilst not appropriate in every case, one way we have seen these concerns addressed is by:
As with all potential conflicts of interest, transparency is key. Unless cross trades are expressly prohibited under the fund documentation, the possibility of cross trades should be noted in pre-contractual investor disclosures, as well as the potential conflicts they may give rise to and how the manager intends to manage those conflicts. Where conflicts in relation to a cross trade are material, the manager should consider whether advisory committee (or SMA investor) consultation, or even consent, is appropriate.
We have seen fundraising periods for closed-ended credit funds grow longer in the past few years. The final closing of a typical direct lending fund might now fall 18 months after its first closing, as compared to 12 months just a few years ago, and a longer fundraising period usually means more closings. Equalisation mechanics – which seek to ensure the fair allocation of fund assets and liabilities between investors across different closings – need to be fit for purpose to cater for investors admitted to the fund months apart with the fund making multiple investments in between those closings.
Under a traditional closed-ended equalisation mechanic, subsequent closing investors are drawn down to the same extent as existing investors and, in addition, pay the fund (for the benefit of existing investors) equalisation interest calculated by applying an interest rate to the amounts of capital that would have been drawn down from the subsequent investor if it had been admitted to the fund at first closing.
Private credit strategies, particularly those closer to the direct lending end of the risk/return spectrum, principally derive returns from interest yield rather than capital growth. Compared to asset classes that principally target capital growth, there is therefore less strain on the traditional closed-ended equalisation mechanic as it is applied over a longer fundraising period. Notwithstanding that, equalisation is administratively burdensome and many managers seek to minimise it by delaying calling capital from investors for as long as possible during the fundraising period and instead using a subscription facility for all of the fund’s cash needs, including investments. One thing for managers to bear in mind if taking this approach is that it is generally accepted that any borrowing by an AIF that is outstanding for more than 12 months is considered to be leverage for AIFMD purposes even when fully covered by undrawn commitments.
We generally see two different approaches to equalisation in credit funds:
To take direct lending as an example strategy, we would typically see equalisation interest rates for full equalisation in the 6.5% to 8.5% range, either as a flat rate or as a floating reference rate (such as Euribor) plus a margin. Where subsequent investors do not equalise into income, equalisation interest rates are commensurately lower (by perhaps 3.5% to 5%).
Capital deployment in private credit strategies is generally smoother than in asset classes like private equity, infrastructure and real estate. A relatively small proportion of total commitments will be invested in any single deal and the process of negotiating and closing deals is typically more straightforward. Managers will therefore diligence, and funds will invest in, a higher volume of investment opportunities.
The manager’s and investors’ interests are largely aligned in wanting a fund’s portfolio to be built up, or “ramped”, as quickly as practicable, and to remain ramped throughout the fund’s life. There are several reasons for this:
Having a strong deal pipeline is essential to enable a manager to ramp their funds and SMAs. It is also possible to achieve accelerated ramping through cross trades. For example, a manager wanting to launch a fund in a new strategy could build up a seed portfolio before first closing of that fund by persuading SMA investors to warehouse assets on behalf of the fund. We have also seen evergreen funds ramped through cross trades from existing closed-ended funds within a manager’s stable.
The benefits of ramping a credit portfolio quickly always need to be balanced against the need for appropriate risk management. Controlling the pace of ramping allows the manager to monitor the performance of its earlier investments and market conditions and adjust the portfolio accordingly. Ultimately, the goal is to deploy capital in such a way as to ensure that the fund’s portfolio remains adequately diversified and aligned with its investment policy and objectives.
