NEW YORK, July 20 (Reuters) - Two pieces of regulation designed to protect investors could make it more difficult and expensive for funds to lend to mid-sized US companies as managers try to meet rules that require them to hold some of their funds’ risk.
Investment managers are trying to navigate their way through an overlapping web of rules and regulations, which were put in place after the credit crisis, some of which have competing demands. Risk-retention rules are part of the Dodd-Frank Act and require managers to hold 5% of their funds.
Managers seeking to raise Collateralized Loan Obligation (CLO) funds as part of their strategy to lend to smaller, middle-market companies are finding that their plans to use a Business Development Company (BDC) to hold the retention are falling foul of the Investment Company Act of 1940 that governs the specialized closed-end vehicles.
“It’s a material conflict between two regulatory regimes,” said Sean Solis, a partner at law firm Dechert. “The provision in risk retention that allows for a CLO to use the BDC for risk retention conflicts with limitations on affiliate transactions set forth in the” Investment Company Act of 1940.
Market participants have asked the Securities and Exchange Commission (SEC) for clarity on the issue, sources said.
BDCs, which typically lend to privately-owned US mid-sized companies, have previously used CLOs as a financing mechanism as it is typically cheaper than raising a loan.
Under Dodd Frank, a sponsor may allocate risk-retention holdings to the originator of the loans. In this case, the BDC’s external manager may allocate the required retention to the BDC, if the BDC originated at least 20% of the assets in the CLO, Solis said.
This provision clashes with the Investment Company Act of 1940, which established the regulatory framework for registered investment companies and funds. Under Section 57 of that rule, an affiliate – in this case the BDC’s external manager – cannot sell securities to the BDC. This means that using the allocation to the originator option is prohibited, Solis said.
“For that have traditionally used CLOs as a source of attractive, long-term balance sheet financing for portfolios of middle-market loans, this conflict presents a real issue,” he said.
Investment managers have already contacted the SEC. Several are suggesting that the only way that a firm could use its BDC to hold the retention of future CLOs would be if the regulator issues a formal, no-action letter, according to sources.
“The combination of the [Investment Company Act of 1940] and the CLO risk-retention rules have, for externally managed BDCs, created a Catch 22 – you can be in compliance with one or the other but not both,” said David Golub, chief executive officer of Golub Capital BDC. “I’m cautiously optimistic the SEC will fix this.”
The SEC can issue a no-action letter in response to a request about whether an action would constitute a violation, according to its website. It previously issued a no-action letter to the CLO market in 2015 to allow some funds to refinance without forcing managers to hold risk retention. In 2016 the regulator issued a letter saying a refinancing using a unique CLO feature would not require managers to hold additional retention.
An SEC spokesperson declined to comment.
The surge in rulemaking following the credit crisis may lead to more discrepancies, as new regulations are layered on existing rules.
“You have a lot of regulators pushing the gaps really hard to get regulations out the door, both directed rule-making and discretionary rule-making, and regulators are not always talking to each other,” said Travis Norton, policy advisor and counsel at Brownstein Hyatt Farber Schreck. “That is a byproduct of a view that more regulation is better instead of going back and doing smart regulation in a coordinated way.”
The CLO and BDC markets will have to wait for now until the SEC weighs in. (Reporting by Kristen Haunss and Leela Parker Deo; Editing By Tessa Walsh and Michelle Sierra)