February 15, 2023 - On Valentine’s Day, the LSTA submitted a comment letter to the SEC responding to its Open-End Fund Liquidity Risk Management and Swing Pricing reproposal (“Rule”). Folks watching the space carefully know that this was an issue that first arose in 2015, was commented upon at the time by the LSTA, and was resolved constructively in the SEC’s 2016 Liquidity Risk Management Rule. The SEC reopened this rule in late 2022 to address several issues including swing pricing, hard close and – most critically for the loan market – the proposed reclassification of loans as “Illiquid Investments”. We recap key issues of the rule and LSTA response below, but encourage interested parties to read our entire letter here.
What is the issue? In the wake of broader market disruptions at the beginning of the Covid-19 global pandemic in March 2020, the SEC decided it needed to review its 2016 Liquidity Risk Management Program to ensure that open-end funds could continue to meet redemption requests in timely fashion. The reproposed Rule captures – and explicitly discusses – open-end loan funds and ETFs.
What did the SEC propose? In addition to swing pricing and hard close (which were not the immediate concerns for the loan space and were not addressed by the LSTA), the SEC also proposed eliminating the Category Three, “Less Liquid Investments” classification and reclassifying those investments as Category 4, “Illiquid Investments”. The SEC notes that it is concerned about all open-end funds meeting investor redemption requests without material dilution.
Why does this matter? Leveraged loans are largely categorized as Category Three, Less Liquid Investments because while they have good trading liquidity – e.g., they trade frequently without trade activity unduly shifting their prices – they have more extended settlement times than other asset classes. The 2016 Rule acknowledged this feature of loans and created Category Three to address it because loan fund managers have many tools to bridge the time between the sale and settlement of loans. However, if this category is eliminated as proposed in the 2022 Rule, leveraged loans will be reclassified as “Illiquid Investments”. Open end funds can only hold 15% of Illiquid Investments. In effect, this would force open-end loan funds to either liquidate (more likely) or convert to a closed-end or interval fund format (less likely).
What did the LSTA say in its comment letter?
- First, we observed that at 9% market share, open-end loan funds are a modest but important part of the loan ecosystem. They provide a significant amount of secondary market liquidity and they are able to invest in loans that do not fit nicely into the parameters of CLOs. Bottom line: They play an important role in the market.
- Second, we noted that open end loan funds met redemption requests in all periods that they have been in existence, including periods of heavy outflows such as 2008, 2011, 2014, 2018 and 2020. (See Figure 1 on p. 7.) This is because open-end loan funds have robust liquidity risk management systems and tools in place already.
- Third, we note that the SEC’s observation that loan trades take an average 23 days to settle misinterprets what happens when open end funds are selling to meet settlement. Because loan settlement times are not normally distributed, the more appropriate metric is median settlement times. Second, the SEC’s 23 days reflects all purchases and sales. A number of parties may not have settlement “urgency” – particularly when buying – which can lengthen the typical settlement period. Instead “buyside sales” best represents the typical settlement period when open-end loan funds are selling assets to meet redemption requests. And, indeed, when using this more appropriate metric, buyside sale settlement times shorten to T+9 on a historical basis – and T+7 in March 2020.
- Fourth, open-end loan funds have several tools to meet redemptions, such as i) lines of credit to bridge the time from sale of a loan to the settlement of a loan, ii) a HLIM (Highly Liquid Investment Minimum of assets that can be sold and settled in three or fewer days), and iii) expedited settlement arrangements. The efficacy of lines and expedited settlement arrangements is improved because they are only attempting to bridge a 7–9-day settlement timeframe, not the 23-day average settlement time that the SEC cited.
- Fifth, even though open-end loan funds have demonstrated the ability to meet redemptions with the tools they currently have, the LSTA and its members seek to be responsive to the SEC’s concerns and are working to augment the current toolkit. The LSTA and its members support increasing the HLIM for open-end loan funds to standardized 10%. In addition, we are working with members to standardize expedited settlement arrangements to help managers more readily enter into these contracts.
- Sixth, the LSTA and its members believe the SEC has substantially overestimated the benefits of the rule (because open-end loan funds have demonstrated the ability to meet redemption requests and the SEC is regulating to a counterfactual) and underestimated the costs. We believe that the reclassification of loans to Illiquid Investments would trigger widespread redemptions and potentially liquidations of open-end loan funds. This would have a knock on effect on loan prices and the cost of credit for companies that rely on the institutional loan market.
The bottom line: Ultimately, the SEC’s proposal to reclassify loans as Illiquid Investments is an attempt to resolve a problem that doesn’t exist at a great cost to both retail investors (whom the rule purports to protect) and corporate borrowers. We hope the SEC revises the rule into a more workable form; we stand ready to engage with the agency and will continue to provide information to our membership on this important issue.