The complex funding arrangements of Chelsea Football Club (and to be fair, they’re not alone in having complex funding arrangements), there’s an increasingly public discussion as to how much is funded by debt, how much is funded by equity.

Outside of public, and fan interest, of course this is increasingly becoming an area of interest to football regulators adjudicating over the sustainability of clubs and the source and type of funding provided by owners.

The debt funding of Blueco 22 Limited and 22 Holdco Limited is discussed in detail in a previous Analysis Series article here: 

The funding provided by Clearlake has always been described as equity. However the emergence of funding via COP III (Clearlake Opportunities Partners III, LP), an “opportunist credit” fund has raised the question: is the funding debt, equity or a combination of both?

Clearlake COP III Investment Memorandum

To answer the question we must first look at what is debt? What is equity? This is further complicated by the three jurisdictions applicable to this discussion, England & Wales, Cayman Islands and the US.

Across all three jurisdictions, the terms “debt” and “equity” are not comprehensively defined in a single statute. Instead, different bodies of law,  corporate law, tax law, insolvency law, securities regulation, and accounting standards, each apply their own frameworks. 

This is precisely why hybrid instruments (convertible notes, preferred equity, payment-in-kind facilities, mezzanine structures) have become so commercially powerful: they can be engineered to achieve a particular characterisation for one legal purpose while achieving a different characterisation for another.

England and Wales

Corporate law. The Companies Act 2006 does not define “debt” or “equity” as such. It refers instead to shares (s.540, defined as shares in a company’s share capital) and debentures (s.738, defined broadly to include debenture stock, bonds, and any other securities of a company, whether or not constituting a charge on assets). These are operational definitions for registration and filing purposes, not substantive economic tests.

Accounting. The most analytically rigorous definition comes from IAS 32 (as adopted under UK-adopted IFRS and reflected in FRS 102). Under IAS 32, an instrument is a financial liability (i.e. debt) if it creates a contractual obligation to deliver cash or another financial asset; it is equity if it represents a residual interest in the assets of an entity after deducting all liabilities. Critically, classification depends on the substance of the contractual arrangement, not its legal form. A preference share that mandatorily redeems on a fixed date is a financial liability under IAS 32, even though it is legally a share.

Tax law. The Corporation Tax Act 2009 governs the taxation of corporate debt through the loan relationships regime, which applies to any money debt arising from a transaction for the lending of money. Equity returns are typically dealt with through the distributions rules. HMRC will look through the form of an instrument to its economic substance when characterising it for tax purposes, and the distinction between interest and dividends is closely scrutinised in related-party situations.

Insolvency. The Insolvency Act 1986 draws a fundamental distinction between creditors (holders of debt claims) who rank for payment ahead of contributories (shareholders). This hierarchy is the most legally consequential consequence of the debt/equity distinction.

Cayman Islands

The Cayman Islands Companies Act (2023 Revision) follows its English common law heritage closely and similarly avoids comprehensive definitions. It refers to shares in the context of share capital and to the ability of companies to issue bonds, debentures, and other debt obligations, but does not offer substantive tests for characterisation.

Cayman courts apply English common law principles when determining whether an instrument is debt or equity, with the substance-over-form principle being paramount. Given that the Cayman Islands is the dominant jurisdiction for offshore funds and special purpose vehicles in the private equity and private credit markets, the practical question of debt/equity characterisation arises most frequently in the context of fund structures, particularly whether investors hold limited partnership interests (equity) or loan notes (debt), and whether carried interest arrangements or preferred return mechanisms re-characterise the economic relationship.

Notably, the Cayman Islands has no corporate income tax, which means the tax-driven motivation for characterisation (interest deductibility vs. non-deductible distributions) that is so dominant in the UK and US is largely absent at the Cayman level. Characterisation in Cayman structures is therefore driven primarily by investor rights, insolvency waterfall positioning, and the tax treatment in the investors’ own home jurisdictions.

United States

The US is the most complex jurisdiction because the federal/state split creates multiple overlapping frameworks.

Corporate law (Delaware). The Delaware General Corporation Law (DGCL) governs equity through the concepts of “stock” and “shares,” while debt instruments, bonds, notes, and debentures, are authorised under separate provisions. As in England and Wales, there is no single definitional test; the DGCL simply grants corporations broad authority to issue both categories.

Securities law. The Securities Act of 1933 and the Exchange Act of 1934 define security broadly to include both equity (stocks, shares) and debt (notes, bonds, debentures), as well as investment contracts under the famous Howey test. The relevant question in securities law is not debt vs. equity per se, but whether an instrument is a security at all and therefore subject to federal registration and disclosure requirements.

Tax law. This is where the US framework is most developed and most contested. The Internal Revenue Code does not define debt or equity comprehensively, but the distinction is commercially critical because interest payments on debt are deductible for the corporate borrower while dividend payments on equity are not. 

The IRS and the courts have developed a multi-factor test (articulated in cases such as Fin Hay Realty Co. v. United States and further developed through subsequent case law and Treasury regulations, including the §385 regulations) that considers factors including: the presence of a fixed maturity date; an unconditional right to payment of a fixed sum; the right to enforce payment; the degree of subordination to other creditors; whether the holder participates in management; and the intent of the parties. 

No single factor is determinative, and the analysis is highly fact-specific. Section 385 of the IRC gives the Treasury authority to issue regulations re-characterising purported debt as equity, which it has used particularly aggressively in the context of related-party instruments.

Bankruptcy law. The Bankruptcy Code (Title 11 USC) distinguishes between claims (debt obligations) and interests (equity interests), with claims ranking ahead of interests in the distribution waterfall. This is the US equivalent of the English law creditor/contributory distinction and is often the most consequential legal line in a stressed or distressed situation.

Why the distinction Is blurring in practice

In private equity and private credit both terms are being blurred to reflect deliberate financial engineering rather than conceptual confusion. Several structural features drive the blurring:

Preferred equity instruments with fixed liquidation preferences, mandatory redemption features, and cumulative accruing returns can be economically indistinguishable from senior debt, yet they sit structurally below the debt stack and may be classified as equity for accounting and tax purposes. 

Conversely, unitranche or deeply subordinated mezzanine facilities with equity kickers (warrants or profit participation rights) have equity-like upside while being legally structured as debt. Direct lending funds originating loans with significant covenant packages and control rights are exercising influence over portfolio companies in ways that were historically associated with equity sponsors.

The practical consequence is that legal characterisation increasingly depends on the specific question being asked: the same instrument may be treated as equity under IAS 32 (because its returns are discretionary), as debt under US tax law (because it has a fixed maturity and priority on liquidation), and as a quasi-equity interest under insolvency law (because it is deeply subordinated to all other creditors).

Summary

None of the three jurisdictions provides a single, comprehensive statutory definition of debt or equity that applies universally. England and Wales and the Cayman Islands rely primarily on common law substance-over-form analysis, with IAS 32 providing the most rigorous accounting definition. The US has the most developed regulatory and judicial framework, particularly in the tax context, but even there the analysis is multi-factorial and fact-specific. 

The definitional ambiguity is not an oversight, it is a feature that has been deliberately exploited by the private markets industry to create the spectrum of hybrid instruments that now characterises private equity and private credit. 

Clearlake COP III Investment Memorandum 

What the investment memorandum tells us about COP III

The investment memorandum is unusually candid about the hybrid nature of the Fund’s strategy. It explicitly states that the Firm maintains a flexible investment philosophy and will invest across the capital structure in debt and/or equity securities, and that potential investments involve complex structures that may include convertible, participating or redeemable preferred equity and debt with warrants, earnouts, or other equity-linked features. Three instrument categories are defined:

Opportunistic Credit is structured as senior secured debt, but augmented with warrants or other equity participation mechanisms, or alternatively as discounted debt in stressed capital structures. The investment memorandum confirms these take the form of credit instruments with cash or payment-in-kind (‘PIK’) yield characteristics.

Structured Equity is described as preferred equity, convertible, participating, or redeemable, with board representation rights, cash and/or PIK dividends, distribution and liquidation preferences, and negative covenants. The investment memorandum notes that an investment may include a contractual return or current yield component and/or a significant equity ownership stake.

Reorganisation Equity is plain equity received upon completion of a debt restructuring, where the Fund shepherds distressed credit investments through reorganisation.

Under IAS 32 (Accounting)

Applying IAS 32, as adopted under IFRS and the most substantively developed accounting framework for this question, the characterisation turns on whether the instrument creates a contractual obligation to deliver cash (a financial liability / debt) or represents a residual interest (equity).

The dominant instrument class, Structured Equity,  would almost certainly be classified as a financial liability under IAS 32 in the hands of the Cayman portfolio company, notwithstanding its legal label as equity. 

The key indicators are the cumulative PIK dividend mechanism (an obligation to deliver economic value), the liquidation preference (a priority claim senior to common equity), and most decisively, the redeemable structure. A preference share that is mandatorily or optionally redeemable triggers liability classification under IAS 32, because the issuer has an obligation or the holder has the right to demand repayment of a fixed sum. This is the same analysis that caused numerous preference share structures to be reclassified from equity to debt when IAS 32 was first adopted across European markets.

The Opportunistic Credit instruments are more straightforwardly debt (financial liabilities), although the warrants attached would be separated and measured as an equity component under IAS 32’s split accounting rules.

Reorganisation Equity would be classified as equity, it represents a true residual interest in the issuer,  but the investment memorandum positions this as a tail outcome rather than the primary investment thesis.

IAS 32 verdict: Predominantly debt (financial liability), with an equity component attributable to conversion rights and warrants.

Under Cayman Islands Law (Substance over form)

As noted in my earlier analysis, Cayman courts follow English common law and apply a substance-over-form approach in the absence of comprehensive statutory definitions.

The structured equity instruments, despite being labelled as shares or preferred equity, exhibit the following debt-like characteristics that a Cayman court would weigh heavily: a contractual and largely fixed return (40–70% of targeted returns are described as contractual in nature), priority on liquidation over common equity holders, negative covenants (which in English and Cayman law have historically been associated with creditor protection rather than shareholder rights), and board representation rights that are governance protections characteristic of a lender seeking to protect a fixed-income position rather than an equity owner participating in upside.

The floating rate feature, the investment memorandum specifically notes the Fund’s focus on floating rate securities, further underscores the debt characterisation, as floating rate pricing is a hallmark of debt instruments rather than equity participation.

Set against this, the conversion mechanisms and equity kickers, the absence of a hard legal obligation to redeem on a fixed date in all cases, and the fact that these instruments are subordinated to all senior debt in the capital structure are the principal equity-pointing characteristics.

On balance, and applying the substance-over-form principle that Cayman courts would use, the structured equity instruments are more creditor-like than equity-like in economic substance, even though their legal form is that of preference shares. 

A Cayman court examining these instruments in an insolvency context would likely treat holders as occupying a position between senior creditors and common equity, a mezzanine position, but with a strong argument for creditor treatment given the contractual return and priority features.

Cayman law verdict: Hybrid, but with sufficient debt characteristics to be treated as quasi-debt for most substantive legal purposes, including insolvency waterfall positioning.

Under US tax law

Although the Cayman Islands has no corporate income tax (making this less directly relevant at the Cayman entity level), many of COP III’s portfolio companies will be US-based or US-connected, making the IRC §385 multi-factor analysis relevant at the portfolio company level.

Applying the Fin Hay Realty factors and subsequent case law to the structured equity instruments:

The presence of a contractual return (40–70% of targeted return is described as contractual) and the PIK dividend mechanism both point toward debt. The liquidation preference and priority over common equity holders point toward debt. The negative covenants and board representation rights are consistent with creditor protections. 

However, the absence of a fixed maturity date with unconditional repayment obligation, the convertibility feature, and the equity-like upside participation all point toward equity. The fact that these instruments are subordinated to all senior creditors cuts both ways: it weakens the debt characterisation (senior creditors would not exist if this were pure debt) but also distinguishes them from common equity.

The IRS would likely characterise these instruments as equity for tax purposes in many fact patterns, which is precisely why mezzanine and preferred equity structures often achieve favourable treatment for the recipient, distributions are not interest (not deductible to the issuer) but the return profile economically resembles debt.

US tax verdict: Likely equity for IRC purposes at the portfolio company level, meaning returns would be non-deductible distributions rather than interest, a significant structuring consideration for US portfolio companies.

Overall opinion

COP III is most accurately characterised as a hybrid or mezzanine funding vehicle that is economically debt-like but legally equity-like, and the definitive characterisation depends entirely on which legal framework is applied and for what purpose.

For a Cayman corporation receiving capital from COP III, the practical consequences of this analysis are as follows. Under IAS 32 accounting, the instruments will likely appear on the portfolio company’s balance sheet as financial liabilities (debt), reducing reported equity. 

Under Cayman insolvency law applying substance over form, COP III would rank ahead of common equity holders but behind senior secured creditors, a true mezzanine position. Under US tax law, the returns paid to COP III will likely be treated as non-deductible equity distributions at the portfolio company level. 

PSERS itself has reached an analogous conclusion by allocating the Fund to its mezzanine sub-bucket within the private credit portfolio, which is precisely the correct classification, mezzanine being the space where debt and equity frameworks converge and overlap.

The document’s disclosure that 40–70% of returns are contractual in nature is particularly telling. This single figure encapsulates the Fund’s design philosophy: enough contractual, debt-like certainty to underwrite strong downside protection and minimise J-curve drag (as the investment memorandum explicitly states), while retaining enough equity-like upside through conversion mechanisms and warrants to generate the 20% gross return target. 

No purely debt or purely equity characterisation can capture this accurately, which is precisely the point of the structure.

Note: This analysis is based solely on the Public Investment Memorandum as uploaded and does not constitute legal or tax advice. A definitive legal opinion would require review of the full Limited Partnership Agreement, any relevant Cayman constitutive documents, and instrument-level term sheets, and should be provided by qualified legal counsel in the relevant jurisdictions.