Settlement times for leveraged loans are notoriously long. Weeks can elapse between the time a buyer and seller agree on a price and the buyer takes possession of the asset and begins earning interest.
Investors who acquire loans in the secondary market (post-issuance) have long been compensated for this lag. If transactions don’t settle within seven days, the buyers begin earning what the industry terms “delayed compensation” until the trade finally settles.
Not so for investors who acquire loans at issuance. If the bank that underwrites loans takes its time allocating them, buyers – and brokers who purchase loans on behalf of clients – are out of luck. They earn no interest on the funds they have committed until the trade settles, which in some cases can take weeks due to documentation and the complexity in arranging deals with hundreds of participants.
The Loan Syndications & Trading Association plans to change that. Under a protocol to be launched a little over a year from now, in January 2020, buyers who purchase loans at issuance can also earn delayed compensation on late-settling allocations from agent banks.
The idea is not only to encourage agent banks to move a little faster in allocating loans from the primary market (which has $1 trillion in new issuance this year), but to continue narrowing the settlement window in the $1.12 trillion outstanding secondary loan market – through which many of these loans are “suballocated” via brokers.
“By instituting it at this point, the idea is to once again improve settlement in the primary market which would then allow settlement in the secondary market to be assured in a timely manner as well,” said Ellen Hefferan, the LSTA’s executive vice president of operations and accounting.
The trade group announced the adoption of the protocol on Oct. 29.
The LSTA will not say how long it takes to settle transactions in the primary market. But a lawyer who represents buy-side firms says client brokers and investors often complain about waiting two or three weeks for documentation needed to complete primary asset allocations.
Not only are they not earning interest during this period; they may also be digging into their own pockets to pay receiving coupons – and may be paying delayed compensation themselves to the secondary market trades they’ve committed to as sellers.
“I've had clients’ operations personnel complain that weeks after a credit agreement has gone effective on a primary trade they’ve committed to, they still haven’t begun to earn accruing interest and fees,” said Steve Kieselstein, a founder and managing member of the Kieselstein Law Firm, a boutique law firm specializing in syndicated loan market trading. “The argument is it’s a free option for the agent/seller."
“The gripe there is that there shouldn’t be an extended period of time where a buyer is conceived to legally committed to the facility and yet is not entitled to receive anything,” until settlement takes place, Kieselstein added.
The new protocol comes two years after the LSTA created guidelines that tightened the delayed comp window for par secondary trades. Before 2016, secondary loan settlement periods were governed by “no fault” guidelines that often stretched settlement times between 18-21 days after a trade agreement. Buyers could accumulate weeks of interest without having committed capital – creating an incentive for firms to slow-walk trade settlements.
The changes did away with the no-fault concept and put the onus on buyers to commit capital within five days to gain eligibility for delayed compensation.
Prior to the guidelines, secondary market trade settlement times averaged 17.7 days, according to IHS Markit data at the time.
By the end of 2016 under the new guidelines, over 90% of par trades were settling within the seven-day window, according to LSTA data. (The guidelines exclude the more complex trades for distressed loan assets, which often take more than 20 days, per the LSTA.)
The new-issue market rules also require buyers to commit capital. Under the protocol, delayed compensation kicks in six days after a credit agreement is fully documented, which includes a three-day “onboarding” process to qualify buyers under the U.S. Treasury’s know-your-customer requirements.
The goal of the protocol, in essence, is to speed up settlement time in order to preclude the need for delayed compensation. “As long as the trades settle in a timely manner, compensation will not pass since the buyers, now lenders, will earn the coupon directly,” said Hefferan.
The LSTA believes that encouraging faster settlement of primary-market loan allocations will help reduce trade-settlement times in the secondary market, as well. The more quickly that banks fulfil allocations to brokers, the more quickly those fund managers can complete the suballocations frequently used to fill the pipeline of the secondary loan market.
The protocol calls for secondary trade delayed comp schedule to “align” with a fund manager’s delayed comp protocol, so that a manager shouldn’t have to pay more in delayed comp to a secondary-market buyer than the manager received from the primary allocation.
“The whole point of this,” added Lee Shaiman, LSTA’s executive director, “is to speed that along and make it fair to all parties so that the buyer who sets capital aside doesn’t have to wait an inordinate long period of time to settle the trade and start to earn interest on the asset.”
The longer-term development of the delayed compensation protocol for the primary market is due to the complexity of that segment of the market, Hefferan said.
The agent bank’s allocation is constructing a lending group that finances a corporate loan, and involves setting up a syndicate of perhaps hundreds of fund managers – who in turn are setting up hundreds of other lenders into the deal through suballocation in the secondary market.
“The technology has caught up to the point we can settle these trades faster and we need the behavior to equal the technology,” said Shaiman.
The LSTA has not compiled any data on average trade settlement times in the primary market, nor the number of trades completed in allocation and suballocations that would estimate the amount of compensation buy-side firms could earn in delayed compensation.
But with the goal of speeding settlement times, the greater likelihood is that buy-side firms won’t need delayed compensation since they’ll be earning directly from the coupon at a faster settlement rate.
“At the time of the primary syndication, the deal, the facilities, the contracts and the documentation must be built for the first time into the agent bank and settlement platforms,” Hefferan said. “Technology improvements that have been developed over the past few years will be helpful toward implementing the protocol and thus enhancing overall market liquidity.”
