(Bloomberg) -- The U.S. Securities and Exchange Commission is looking to make private funds safer for investors, and the steps it's considering might be severe enough to drive smaller loan fund managers out of the business, lawyers say.
In early February, the SEC published a sweeping 341-pages of proposed rules directed at private equity firms and hedge funds, but the regulations also affect money managers that package loans into bonds known as collateralized loan obligations. The proposed reforms are designed to protect investors from money managers that don't disclose fees, and engage in potentially fraudulent behavior that could harm investors and is contrary to public interest, an SEC official said, asking not to be identified publicly discussing pending rulemaking.
But some CLO lawyers fear the proposal could end up hurting the market more than improving it, especially with a rule concerning liability clauses. Under that regulation, money managers would become liable to investors not only for willful misconduct, such as intentionally buying a security prohibited under deal documents, but also mere negligence, which “could be as simple as pressing the wrong key on your keyboard” when buying a loan, said Christopher Jackson, partner at law firm Allen & Overy.
Compliance Costs
The SEC thinks these firms may have taken advantage of the lack of liability. But forcing money managers to be subject to litigation for honest mistakes could push smaller CLO managers out of the business, said Jackson. The more established ones could end up requesting higher compensation from investors for facing the risk of litigation.
“The same investors the SEC is claiming to protect with these rules would ultimately bear the costs of compliance,” he said.
Comments on the rules are due on April 25. And some industry participants agree with the SEC that these rules will bring more transparency.
“This is a regulatory shot from the SEC to straighten the ship,” said Thomas Majewski, managing partner at Eagle Point Credit Management, in an interview, adding that CLOs are catching up with the reality of other pooled investment vehicles. “No one is walking away from the business because of changes in liability limitations.”
Even if no one drops out of the market, the heightened risks could strengthen the consolidation trend the CLO sector has been going through, said Dagmara Michalczuk, CLO portfolio manager at Tetragon Credit Partners, in an interview. “Some CLO managers may want larger firms to back them but I don't think firms will leave the market on account of this change alone.”
Mergers and acquisitions on the CLO market have heated up over the past couple of months, with Carlyle Group Inc. nabbing Todd Boehly's CBAM Partners to become the biggest manager of CLOs and Blue Owl Capital Inc. buying Wellfleet Credit Partners to enter the space.
Read more: CLO Managers Defy Deal Slowdown to Head for Record M&A Year (1)
Other Changes
The proposal includes other changes to the sector, such as prohibiting CLO managers from charging their investors for certain expenses like compliance fees or requiring each CLO to provide annual audits. This latter norm could become an unnecessary burden to managers, say lawyers, as CLOs already offer monthly and quarterly reporting. Still, that reporting is not audited by a third party at the moment.
Other considerations would mean CLO managers will no longer be allowed to provide preferential treatment to equity investors who usually have letters of arrangements in place, meaning managers offer them better terms in return for them taking a controlling majority position in the equity.
“This prohibition could have a chilling impact on the ability of managers to continue open dialogue with their investors regarding portfolio holdings,” wrote Elliot Ganz, general counsel at the Loan Syndications and Trading Association, in a Feb. 24 note.
Still, CLO managers could easily bypass this rule by arranging a separate class of notes within a deal that replicates the fee interest previously included in those letters and syndicating it to equity investors, said Jackson.
Another proposal that rankles some lawyers is the requirement for private funds to obtain third-party fair opinions for “adviser-led secondary transactions.” These are deals in which the interests of the buyer and the seller conflict, such as the adviser owning a stake in the fund or CLO it is managing. According to the SEC official, the premise behind the provision is to make sure the investors are getting a fair price. If the adviser has a conflict of interest, the investor could end up disadvantaged, the person said.
But in the case of the CLOs the rule could be tricky, say lawyers, as managers own a portion of the equity tranche in most CLOs, meaning deals such as resets or refinancings would fall under the purview of “adviser-led” and require third-party opinions, slowing down the market.
Relative Value: Securitized Credit
- The securitized credit landscape generally looks attractive versus corporates, said Daniel Lucey, senior portfolio manager at SLC Management
- Down-in-credit CMBS spreads still look wide, in Lucey's opinion
- SLC likes the non-agency mortgage sectors better than agency MBS right now. They are similar structures but the firm is more comfortable with the principal risk in non-agency
- Lucey also likes seasoned conduit CMBS, especially at the BBB level
- In the midst of upcoming rate hikes, SLC pefers CLOs, especially at the single-A level. There is a lot better price preservation versus 2- or 3-year corporate debt, he said
- SASB CMBS deals are still offering a lot of value, Lucey said. It's possible to still see wide pricing on quality properties
Quotable
Regarding leveraged-loan fundamentals and the risk of eventual downgrades: “If you think the U.S. economy will grow at a 3% or 4% rate, then fundamentals still look pretty solid,” said Jeff Darfus, a credit research analyst at Barclays Plc. “But to the extent that there are concerns with inflation, labor costs, or input costs, you could see fundamentals deteriorate in the medium term.”
What's Next?
ABS deals in the queue include Trinity Rail (railcar leasing), Pretium Partners (single-family rental), and America's Car-Mart (subprime auto)
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