Since the 2008 financial crisis, a tangle of regulations has forced banks to step back from providing credit to companies and individuals. Recognizing a market opportunity, other financial intermediaries – including hedge and private equity funds – have stepped in to fill this void. These new lenders are often referred to as “shadow banks” because, although they are not regulated like banks, they perform bank-like activities such as making loans to companies. As asset managers continuously search for yield, the investment strategy of direct lending – generally characterized as “non-bank finance” – has risen in popularity, with alternative lenders typically charging higher interest rates than traditional lenders. However, engaging in these direct lending practices can pose a number of challenges from a tax perspective, particularly for non-U.S. investors, that impact hedge fund managers undertaking these efforts. This article, the first in a three-part series, discusses the prevalence of hedge fund lending to U.S. companies and the primary tax considerations for hedge fund investors associated with direct lending. The second article
will explore structures available to hedge fund managers to mitigate the tax consequences of pursuing a direct lending strategy. The third
article will provide an overview of the regulatory environment surrounding direct lending and a discussion of the common terms applicable to direct lending funds. For additional insight on the prevalence of direct lending in the hedge fund industry, see “Dechert Panel Discusses Recent Hedge Fund Fee and Liquidity Terms, the Growth of Direct Lending and Demands of Institutional Investors
” (Jul. 14, 2016).