Weekly Industry Update: SEC Focus on Capital Formation & Enforcement, and What it Means for Direct Lending

By July 24, 2017Blog

Regulatory headlines and strong bank earnings dominated the headlines this past week.

Interim OCC lead Ken Noreika came out in support of the FinTech charter and re-affirmed the power of the OCC to issue such charters. SEC Chair Jay Clayton shared his guiding principlesfor the agency, and identified areas to implement these principles in Enforcement and Examinations, Capital Formation, and Market Structure.

SEC Commissioner Piwowar, at a session with David Burton at the Heritage Foundation, shared optimistic remarks on FinTech. Piwowar described FinTech as “transformational”, a global phenomenon, and cautioned on the potential for regulation to stifle innovation or capital formation.

What might a focus on the SEC’s capital formation mandate mean for investors?

  • Retail investors may have greater access to alternative investments typically reserved for accredited investors. For instance, Piwowar questioned the premise of a distinction between accredited vs. non-accredited investors.
  • Small businesses may see a reduction in disclosure obligations to encourage small businesses to tap the public capital markets. SEC Chair Clayton identified the reduction of US IPOs (in the wake of SOX and post-Enron regulations) as a serious issue.
  • ABS investors may have a reduction in the disclosure and liability requirements for publicly registered securitizations. ABS issuance has shifted to Rule 144A private placements – in fact 100% of deals in the marketplace lending market are privately placed – in part, due to the higher disclosure and attestation burdens for public deals.

The focus on capital formation and maintaining the competitiveness of the US capital markets was well received. At the same time, the SEC Chair re-iterated focus on enforcement.

This week, we highlight SEC enforcement action activity, why direct lending is seeing an increase in enforcement actions, and offer our principles to protect investment managers and LPs.

SEC Enforcement Actions & Investor Protection

After the late-2008 Madoff scandal, the SEC dialed up enforcement activities with the goal of improving investor confidence and market integrity.

In its most recent fiscal year, the SEC filed a record number of enforcement actions (868) and the highest number of actions ever involving investment companies (148). The SEC generated $4 Bn in disgorgements and penalties.

Source: U.S. Securities and Exchange Commission, PeerIQ

Direct Lending Is Prone to Heightened Scrutiny Due to Its Opacity

SEC scrutiny has focused on conflicts of interest, issuer disclosure, valuation, and representation of performance results. Funds that exhibit aberrational return profiles from their peer group, and funds that materially exceed benchmarks also receive heightened scrutiny.

All of the above issues are especially relevant for direct lending strategies where benchmarks are opaque and managers may be subject to conflicts-of-interest (e.g., self-valuation, valuation shopping, etc.) due to the opacity of the asset class.

Not surprisingly, enforcement actions on direct lending strategies has increased substantially as the sector continues to grow. (We refer reader’s to Harvard Law School’s SEC Enforcement Actions Against Investment Advisors for more information.)

Direct Lending is Prone to Valuation Negligence

A pool of unsecured personal loans may contain thousands of loans with differing and constantly shifting loan and borrower attributes. Unlike, say, a CMBS transaction where a valuation agent can visit a property, speak to an owner, and evaluate a tenant – the sheer volume of hundreds of thousands of loans requires advanced analytics to value a portfolio.

To perform a valuation, PeerIQ will perform ten thousand monte carlo simulation on a single loan using cloud technology. The high technical barrier to valuation can lead direct lending funds to adopt heuristics that may seem sensible but do not reflect fair value.

In addition to the technical complexity, the valuation of whole loans is highly sensitive to changes in discount rates, valuation methodology, aging curves, the term structure of credit spreads, and expected cashflows. The sheer range of inputs can lead to material variations in valuation estimates. There is often little transparency for investment managers on these inputs.

Also, the trigger for an enforcement action is low. Since investment managers are held to a fiduciary standard, the SEC Commission “need not show intentional, knowing, or reckless deception, and it need not show that any investor was harmed. . . negligence is enough.”

In short, investment managers “own” their valuation policy and should seek to understand and monitor their marks and valuations regularly.

What Should Investors and LPs look for in Valuation

Below we share below our principles for valuation:

  • Transparency: A well-documented valuation methodology, with clear exposition of prepayment, default, credit spread, and other assumptions.
  • Auditable: A repeatable and testable valuation framework.
  • Fair value: Fair value based on a consistent modeling framework that factors in both unobservable and observable valuation inputs from similar assets or adjacent capital markets.
  • Accounts for major risk factors: The pricing framework accounts for risk factors including default risk, prepayment risk, and credit spread risk.
  • Forward looking: Loan valuations must be driven off of expected future cashflows, where cashflows are a function of the borrower’s current credit attributes, macro conditions, payment performance, and seasoning.
  • Loan-level: The pricing framework operates on a loan-level to address granularity in credit risk of loan rather than coarse replines.

Direct lending offers an incredible opportunity for investors to achieve their return objectives in a low-rate environment. At the same time, the low liquidity in direct lending exposes the asset class to heightened risks – particularly in valuation and performance presentation.

Investment managers and LPs should demand a higher standard of rigor to promote the responsible growth of this new asset class. Feel free to reach out to PeerIQ to learn more about our valuation methodologies.

Industry Update: 

Lighter Fare: