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SEC’s private funds proposal appears ill-fitting for CLOs

The recently proposed rule seeking more private-fund disclosures and prohibitions would impact the collateralized loan obligation (CLO) market detrimentally and could even prompt deal redemptions, even though CLOs do not appear to be its target. Thirteen of the largest financial-services trade associations sent a letter last month seeking to extend the comment period.

The Securities and Exchange Commission (SEC) proposed a rule, on February 9 and under the Investment Advisors Act of 1940, titled “Private Fund Advisers; Documentation of Registered Investment Advisor Compliance Reviews,” that impacts private fund advisers registered with the regulator. Comments are due 30 days past publication in the Federal Register, yet to occur as of Monday.

The SEC states in an accompanying fact sheet that the proposal rule “matters” 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 state, municipal and private pension plans.

The bulk of the assets in question are managed by private-equity and hedge funds. CLOs technically fall under the private-fund umbrella as well, although they do not appear to be the proposed rule’s intended target. Elliot Ganz, the Loan Syndication & Trading Association’s general counsel 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-benefits analysis.

“There are pages and pages discussing private equity and hedge funds, but no issues whatsoever are raised about CLOs,” Ganz said. “Whether you agree or not with what the SEC is proposing in relation to private equity and hedge funds, it is ill-fitting for CLOs.”

Assuming the proposal is published soon in the Federal Register, the comment period would be unusually short given the breadth of the proposal, Ganz said. Thirteen trade associations, including the Securities Industry and Financial Markets Association (SIFMA), the U.S. 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 that requested an extension of the comment period to 120 days after the proposal’s Federal Register publication, to better understand its implications.

Particularly problematic for CLOs, Ganz said, is the proposal’s lack of grandfathering provisions.

“CLO indentures are notoriously difficult to amend,” he said. “Investors in all the tranches, from equity to AAA, will have to agree, and some may be difficult even to find.”

CLO managers would also have to provide new disclosures on existing and new CLOs, including a quarterly statement in addition to the current monthly trustee reports that already detail performance-level information for each asset in the portfolio. The quarterly statements would also have to include details about adviser compensation and fees, and fees and expenses paid by the fund. And managers would be required to report performance information based on whether the fund is liquid or illiquid, onerous tasks in either instance that provide little valuable information, Ganz said.

The proposal includes several other disclosures that would be costly—especially burdensome for midsize and smaller managers—and seemingly inappropriate for CLOs. For example, Ganz said, the proposal requires third-party “fairness opinions” for secondary transactions.

“With CLOs you’re probably talking about refinancing or repricing loans their liabilities, and there’s no need for a fairness opinion in that context and it may hinder the practice,” he said.

Daniel Wohlberg, director at CLO equity investor Eagle Point Credit Management, said the expanded disclosures would be excessive and add “considerable costs.”

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

Perhaps most problematic, Ganz said, is a provision that would prohibit exculpation and indemnity provisions. Ganz said most deals today indemnify managers for gross negligence and the rule could nullify those clauses as a matter of law, making them unenforceable. The lack of a grandfathering provision means managers of existing deals may suddenly find themselves liable to such claims.

“Managers are not paid to take that kind of risk,” Ganz said. “You’re taking a private right of contracting and saying, ‘We’re not going to recognize that anymore, even for existing deals,’ and that’s not a small thing.”

Wohlberg, instead, welcomed the language, at least to a degree.

“Some of the additional legal protections are arguably overdue,” he said, adding, “The notion that CLO managers receive a broad indemnification from investors for any action short of being grossly negligent is market-standardized overreach worth correcting.”

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

“This was not something that managers had contemplated or agreed to when they negotiated the transactions,” he said.

The proposal also prohibits “uneven” disclosure arrangements among investors, which Ganz said effectively forbids communications with investors seeking additional information about their investments.

“Most investors may be satisfied with information from the trustee reports, but whether to have those conversations are decisions investors and portfolio managers should agree to,” Ganz said, and prohibiting them is detrimental in the context of CLOs.

Ganz said the LSTA is still talking at length to members to determine more precisely the proposal’s impact, but under the current language issuing CLOs would almost certainly be more expensive, potentially reducing supply, and the lack of grandfathering will be disruptive.

“Many deals may just get redeemed, since it may not pay anymore for deals that were negotiated in advance to adopt a whole set of rules that no one had contemplated and no one is paying for.”

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