While there are many unusual challenges straining the global market under the weight of COVID-19, it seems some things never change in moments of economic downturn. Blocker subsidiaries, used in pooled investments like Collateralised Loan Obligations (CLOs) or private funds, appear to always make a comeback in stressed market circumstances. Especially during an economic crisis or global pandemic, a manager's priority is to insulate their portfolios from undue risk or additional costs that may arise due to defaults on underlying investments. Being astute and savvy to the advantages of blocker subsidiaries is helpful.
But what is the advantage of this simple structure, and why do managers utilise blocker subsidiaries during challenging economic conditions?
When credit-spreads widen and default rates increase, blocker subsidiaries can be a smart solution for structures that have investments generally categorised as debt securities. Incorporating subsidiaries to house loans that are either non-performing or at risk of becoming non-performing can be a prudent, cost-saving decision. Should an insolvency procedure convert a debt asset into an equity position, a manger may face very different regulatory treatments for the newfound equity asset, suffering hefty costs and regulatory burdens associated with the conversion. For CLO issuers, the repercussions can carry even more weight as one equity position could impact the whole structure.
If an issuer faces an underlying collateral default, they could be forced to accept an equity conversion of the outstanding loan balance, or some percentage thereof in the asset underlying the debt instrument. But for US tax purposes, holding equity positions in even one underlying asset may be seen as the CLO issuer being engaged in US trade or business, which is considered differently from the issuer's core business. The result is unexpected increased taxation. However, use of a blocker entity in the event that a bankruptcy results in a payment in kind (for example, the creditor taking possession of a plane in the case of aviation financing) means the asset could be managed and operated exclusively within the blocker, limiting tax impact to the entity only.
Again, blocker subsidiaries offer a remedy to the entire CLO book being deemed engaged in US trade or businesses, and such blockers are especially advisable for assets at risk of default. Rather than entering a forced sale at a discount to pre-empt default, the CLO issuer gains more flexibility by holding the instrument in the subsidiary. A judicious decision can then be made—hold onto the instrument in the subsidiary until the loan's default is cured, or if converted into an equity position, until advisable from a commercial point of view.
Blocker subsidiaries are simple in structure and execution, and it makes sense why these structures resurface consistently during market dislocation—being able to hold the debt assets through the stressed, uncertain times can prove to have economic benefits down the line. Intertrust can not only assist in setting up such structures but also provides domiciliation and independent managers and/or directors to the jurisdiction of your choice.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.