HFM COMPLIANCE: What the SEC Sweep of Private Credit Firms Means for CCOs
With the global private credit market soaring from $440bn in 2015 to $560bn in 2016, the staff of the SEC appear to have embarked on an industry “sweep” inspection initiative to assess investment operations and compliance practices within the rapidly growing segment of entities that offer alternative financing, including private credit or direct lending services.
As part of their portfolio mix, many regulated investment companies (RICs), business development companies (BDCs) and hedge funds, are packaging private loans — primarily sub-investment grade debt — into publicly and privately offered credit funds and structured credit investment vehicles.
There are numerous private credit products, including syndicated, revolving and term loans. These loans are offered to end investors through public or private credit funds and structured credit investment vehicles, including CLO and/or CDO pools, and other similar vehicles.
Fund managers need rigorous compliance controls to successfully add these products to their portfolio mix, and to satisfy regulators in the event of an audit. This includes careful initial due diligence, effective compliance program management, as well as ongoing investment and credit monitoring.
Many credit fund portfolios are comprised of direct loans typically made to middle-market privately-held operating companies that are unseasoned or whose balance sheets are not suitable to pursue traditional bank lending to meet their financing objectives.
Bank consolidation and more constrained credit access following the 2008 financial crisis have driven a growing number of borrowers to alternative lenders, including RICs, BDCs and private funds. Additionally, the private credit markets have boomed as investment managers seek more innovative portfolio strategies and new sources of yield while satisfying borrower needs for financing.
Initial Due Diligence and Ongoing Borrower Monitoring
When RICs, BDCs and private fund managers conduct due diligence to assess a potential borrower, numerous factors must be evaluated, including the borrower’s organizational documents, capital structure, customer or supplier contracts, management team, assets, liabilities, and outlook. Essentially, a lender should be forming qualitative as well as quantitative measures of the transaction’s risk/return profile, including the borrower’s strengths, weaknesses, risks, liquidation values, and likelihood of repayment.
Once a lending transaction is consummated, ongoing borrower monitoring is essential to ensuring the success of a private credit fund. Fund managers must monitor a borrower’s financial performance and business-related milestones to ensure the borrower’s risk rating remains accurate over time.
Monitoring activities include:
- Tracking the company’s financial position, including cash balance and cash burn;
- Assessing changes in key management, executive talent and performance;
- Analyzing the company’s products/services and likelihood of meeting performance milestones;
- Monitoring the company’s growth potential and ability to raise additional capital.
Loans to private companies may be made in the form of immediate financing or term loan commitments. In the latter case, the fund enters into a contractual arrangement, subject to stated conditions, to provide future debt obligation funding upon the borrower’s request in consideration of the borrower’s payment of initial fees and interest upon draw-downs, often accompanied by certain equity enhancements in the form of warrants, subscription rights, etc.
Conditions that must be met in order for the borrower to draw upon the commitment (e.g., achievement of certain stated business “milestones”) help limit a fund’s exposure to the risk of borrower default. Naturally, risk is higher for loans made to sub-investment grade companies. In the event of default, a fund could lose all or part of the monies advanced or be forced to levy upon collateral with a lower value than the outstanding payment amount due on the loan.
High Stakes in a Soaring Market Sector
According to a 2016 report by Deloitte & Touche LLP and the Alternative Credit Council (ACC), a private credit industry body affiliated with the trade body Aima, the global private credit market soared from $440bn in 2015 to $560bn in 2016, with the US as the largest private credit market in terms of overall AuM and new assets raised.
The report found that “most private credit funds use little or no leverage, have low default rates and are structured in a way to prevent liquidity mismatches, bank-style runs and other financial stability problems.” Nevertheless, regulators are considering new rules to reduce risk in this market segment.
SEC Rule 18f-4: A Potential Restriction for Registered Funds Dealing in Loan Commitments
In December 2015, the SEC proposed Rule 18f-4 under the ICA that would restrict private credit lending by RICs and/or BDCs unless they comply with certain risk-limiting safeguards.
Rule 18f-4 aims to reduce risk in the asset management industry by systematizing and, in certain respects, expanding the SEC staff’s prior guidance regarding the use of derivatives which, upon the rule’s adoption as proposed, would also treat registered funds subject to outstanding direct lending funding commitments as being parties to derivative-like “financial commitment transactions.”
If adopted, Rule 18f-4 would impose alternative limits on the aggregate leverage allowed for registered funds and BDCs engaging in loan commitment transactions.
This Rule, as proposed, would call for such arrangements to be treated as constituting the fund’s issuance of “senior securities” under the 1940 Act to the extent that a fund fails to maintain specified levels of “qualifying assets” as “coverage” for its aggregate unfunded loan commitments. The Rule aims to help prevent funds from engaging in portfolio transactions, which the SEC considers to employ leverage, thereby making the activity subject to the senior security capital structure restrictions of the Act.
BDCs have commented that Rule 18f-4 contradicts the goals set out by Congress nearly four decades ago when BDCs were established to facilitate access to capital by BDC-eligible, privately held companies. The 1940 Act allows BDCs to employ more leverage in their investment activities than mutual funds and traditional registered closed-end funds.
If Rule 18f-4 is adopted as proposed, BDCs engaging in direct lending via term loan commitments will no longer have the same flexible, portfolio company growth promoting investment latitude as they do today.
Compliance and Risk Management Controls
Successful credit fund management starts at loan origination and continues with ongoing fund monitoring. Fund managers must ensure before entering into new loan commitments that they have sufficient draw down on their lines of credit to cover the risk of borrower default, and that they have built in performance goals, which borrowers must achieve at predetermined milestones.
Some fund managers are establishing controls that compare their exposure to unfunded loan commitments with the fund’s overall funding capacity, including cash on hand, lines of credit, loan commitments that are about to expire as well as those subject to financial and/or operating milestones unlikely to soon be achieved. This way, direct-lending fund managers are able to demonstrate to actual and potential investors, as well as regulators, that a prudent liquidity risk management program is in place to compare the fund’s current effective funding capacity with the aggregate bona fide forecasted draw-down exposure incurred across its full loan commitment portfolio.
As regulators mull stiffer private credit asset management rules, funds should develop and implement a written risk management program to assess and manage the associated risks.
This program should result in a detailed inventory of risks and associated controls, the designation of an individual responsible for developing and overseeing the compliance program, and — in the case of registered funds — oversight by the fund’s board of directors or trustees.
Whether or not SEC Rule 18f-4 is enacted, having an effective “match” funding capacity or other liquidity risk management program in place, including the personnel and other resources to implement it, is a prudent course for private direct-lending fund managers to protect their brand in the view of investors and their representatives, and to withstand ever-increasing regulatory compliance scrutiny.
Registered and private direct-lending funds should adopt and implement comprehensive compliance policies and procedures (“P&Ps”) in order to duly manage the compliance as well as market and other risks posed by participating in this asset sector niche. Among the compliance risks that must be addressed:
- Proper investment and credit risk disclosures must be made to fund investors;
- Funds must have investment talent to identify, structure and monitor loans;
- P&Ps should spell out, in detail, both the methodologies and protocols (e.g., use of independent valuation agents) used for valuing the loans in a fund’s portfolio;
- Diversification and portfolio allocations must be appropriately balanced; and,
- Liquidity and, for registered funds, “leverage” risk must be managed by
effective and documented controls.
Satisfying Regulators by Maintaining Appropriate Compliance Controls
As evidenced by the apparent SEC sweep exam, regulators are homing in on compliance practices at registrants that offer private financing solutions. According to entities that have been examined, regulators are aiming to understand the investment, operational and associated compliance risks to investors in privately as well as publicly-offered fund vehicles holding sub-investment grade debt in their portfolios. While these exams have primarily targeted registered investment advisors of exchange-traded BDCs, certain SEC exam focus areas have had a bearing on private fund managers pursuing direct lending investment strategies. Key focus areas where private funds have been probed include:
- Fund Governance; Compliance & Risk Management Controls
- Capital Structure; Financial Records
- Valuation of Fund Portfolio Assets
- Compensation, Fees and Expense Reimbursement Arrangements
- Bankruptcy Workouts; Forbearance Arrangements
Regulators are asking for a list of all loans made between direct lending firms and their portfolio companies. They are evaluating the terms of such loans, loan amounts and dates, current balances and collateral, if any.
They are also asking registrants to explain the calculations used to ensure sufficient asset coverage, in compliance with Section 18 of the IC Act. Hedge funds that offer direct lending services must likewise ensure they have proper controls in place to satisfy regulators, in the event of an audit.
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