SEC private fund proposal seems unsuitable for CLOs

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The recently proposed rule to seek more disclosures and bans from private funds would negatively impact the secured loan obligation (CLO) market and could even lead to trade redemptions, even though CLOs do not appear to be its target. Thirteen of the largest financial services trade associations sent a letter last month asking to extend the comment period.

The Securities and Exchange Commission (SEC) proposed a rule on February 9 under the Investment Advisors Act of 1940 titled “Private Fund Advisers; Documentation of Registered Investment Advisor Compliance Examinations”, which impacts private fund advisors registered with the regulator. Comments are due 30 days after publication in the Federal Register, but have not yet occurred as of Monday.

The SEC says in an accompanying fact sheet that the proposal rule “is important” because private funds, with more than $18 trillion in assets, play a key role in financial markets, and some of their largest fund investors include public, municipal and private pension plans. .

The majority of the assets in question are managed by private equity funds and hedge funds. Technically, CLOs also fall under the umbrella of private funds, although they do not appear to be the intended target of the proposed rule. Elliot Ganz, general counsel for the Loan Syndication & Trading Association and co-head of public policy, noted that the 341-page proposal mentions private equity and hedge funds 82 and 79 times, respectively, and CLOs not once. and “securitized funds” only once. in the cost-benefit analysis.

“There are pages and pages dealing with private equity and hedge funds, but no issues are raised regarding CLOs,” Ganz said. “Whether or not you agree with what the SEC is proposing in terms of private equity and hedge funds, it’s not suitable for CLOs.”

Assuming the proposal is published soon in the Federal Register, the comment period would be unusually short given the magnitude of the proposal, Ganz said. Thirteen trade associations, including the Securities Industry and Financial Markets Association (SIFMA), the United States Chamber of Commerce, the Managed Funds Association (MFA) and the LSTA, sent a letter to the SEC when the proposal was published on the regulator’s website asking for an extension of the comment period to 120 days after the proposal’s publication in the Federal Register, to better understand its implications.

The lack of grandfather clauses in the proposal is particularly problematic for CLOs, Ganz said.

“CLO contracts are notoriously difficult to change,” he said. “Investors of all tranches, from stocks to AAA, will have to agree, and some may even be hard to find.”

CLO managers should also provide new information on existing and new CLOs, including a quarterly statement in addition to the current monthly trustee reports which already detail information on the level of performance of each asset in the portfolio. Quarterly statements should also include details of advisor compensation and fees, as well as fees and expenses paid by the fund. And managers would be required to report performance information depending on whether the fund is liquid or illiquid, onerous tasks in both cases that provide little valuable information, Ganz said.

The proposal includes several other disclosures that would be costly, particularly burdensome for mid-sized and small managers, and seemingly inappropriate for CLOs. For example, Ganz said, the proposal requires third-party “equity opinions” for secondary transactions.

“With CLOs, you’re probably talking about refinancing or repricing loans in a portfolio, and there’s no need for a fairness opinion in that context and that can get in the way of practice,” he said. declared.

Daniel Wohlberg, director of CLO equity investor Eagle Point Credit Management, said the extensive disclosures would be excessive and add “significant costs”.

“Unlike other registered investment advisers, CLO managers do not retain signature control over assets under management, leaving much less need for such review,” he said.

Perhaps most problematic, Ganz said, is a provision that would prohibit exculpation and indemnification provisions. Ganz said most agreements made today indemnify managers for gross negligence, and the rule could invalidate those clauses at law, rendering them unenforceable. The absence of a grandfather clause means that managers of existing agreements can suddenly find themselves liable for such claims.

“Managers don’t get paid to take that kind of risk,” Ganz said. “You’re taking a private right to contract and saying, ‘We’re not going to recognize that anymore, even for existing agreements,’ and that’s no small feat.”

Wohlberg, on the contrary, welcomed the language, at least to some extent.

“Some of the additional legal protections are arguably overdue,” he said, adding, “The idea that CLO managers receive broad compensation from investors for any action other than gross negligence is a standardized overshoot of the market that deserves to be corrected.”

The proposed rule also prohibits preferential treatment of investors, so that, for example, a CLO manager would have to disclose any fee-sharing arrangements it may have with first-risk equity investors, both for existing and potential investors, even if these fees are negotiated in the middle of an agreement. Ganz said the existence of these agreements is generally disclosed today, but not in detail, and that any side deals in existing agreements should suddenly be disclosed in detail.

“It was not something the managers considered or agreed to when they negotiated the transactions,” he said.

The proposal also prohibits “unequal” disclosure agreements between investors, which Ganz says effectively prohibits communications with investors seeking additional information about their investments.

“Most investors may be satisfied with the information contained in the directors’ reports, but whether these conversations are decisions that investors and portfolio managers need to agree on,” Ganz said, and their ban is detrimental in the context of CLOs.

Ganz said the LSTA is still in extensive discussions with members to more accurately determine the impact of the proposal, but under the current wording, issuing CLOs would almost certainly be more expensive, potentially reducing supply, and the lack of grandfathering would be disruptive.

“A lot of deals can just be bought out because they might not pay anymore for deals that were pre-negotiated to adopt a whole set of rules that no one had considered and no one is paying for. “

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