March 2, 2022 - As discussed last week, the 341-page proposed SEC’s Private Fund Disclosure Rule (“the proposed rule”) would significantly impact CLOs in three main areas: Prohibited Activities, Reporting and Compliance, and Preferential Treatment. In promulgating the proposed rule, the SEC must provide a cost/benefit analysis, and, in the coming days, the LSTA and members will scrutinize the economic impact as it pertains to CLOs.  With the economic analysis weighing in at 100 pages, we are breaking our review into more digestible – if not palatable – chunks. Today, we discuss the SEC’s economic baseline and the cost/benefit trade offs in providing quarterly statements on fees, expenses and performance. We encourage members to read the following with a view to the impact on CLOs.

Why is the SEC proposing this rule? The proposed rule acknowledged that advisers already have a fiduciary duty to clients, including a duty of care and duty of loyalty. However, they do not necessarily have particularized requirements and, in light of this, the SEC has observed “business practices of private fund advisers that enrich advisers without providing any benefit of services to the private fund and its underlying investors.” The SEC also expressed concern about advisers charging “private funds fees associated with the adviser’s cost of being an investment adviser.” The proposed rule fretted about disparate treatment of investors, including scenarios where an adviser grants certain investors with better liquidity terms than others or preferentially provides information to some investors.

The solution to these issues? In part, more disclosure, says the SEC. There are many areas to be discussed, but today we cover fee, expense and performance disclosures (starting on p. 196 for the SEC-curious). While public information is available on Form ADV, there are no requirements for advisers to provide investors with quarterly statements and there are “diverse approaches to the disclosure of fees, expenses, and performance” that the proposed rule intends to address.  Moreover, advisers are not well-positioned (or incented) to collectively to agree to standard disclosures. Thus, the SEC sees benefit in mandating detailed and standardized information that would help investors evaluate performance across investments, shape the relationship with the adviser and enhance external monitoring of fund investments.

What is the fee and expense disclosure? The fee and expense information would come in quarterly statements. Advisers would disclose fees and expenses, helpfully charted in a table detailing all compensation to advisors, fund expenses, and any offsets or rebates carried forward to affect future payments to the adviser. There also would be a table detailing portfolio investment compensation and investment ownership percentage information.

What is the performance disclosure? The adviser also would prepare a standardized quarterly performance statement. It is not yet entirely clear whether CLOs qualify as liquid or illiquid funds under the SEC definition; importantly, the disclosure standards in the two regimes are quite different. Liquid funds would report annual total returns for each year since inception and cumulative total return for the current calendar year. Illiquid funds would report gross and net internal rate of return (“IRR”) and multiple of invested capital (“MOIC”), gross IRR and MOIC for realized and unrealized portions of the portfolio, and a statement of contributions and distributions. Computations would not include the effect of any fund level subscription facilities.

What are the benefits? The SEC states that the benefits of expense reporting would be that standardized minimum and easily understandable information would lower investor monitoring costs (for both fees and conflicting arrangements) and improve investor ability to negotiate terms and evaluate the value of services (though the magnitude of this benefit proved hard to measure).  The SEC further observes that the benefits of performance disclosure are i) better information to monitor investment performance and ii) even if investors already receive this information, having it in a standardized format across vehicles could improve analysis for investors and consultants.

What are the costs? The SEC’s estimated cost of compliance, as well as the compilation, preparation and distribution of information was specific down to the last dollar. All told, the SEC assesses the compliance costs for the expense and performance reporting at $313,047,108 annually. To be fair, upgrades to tracking systems or increases in quality of services may add an unquantified cost.  Notably, the cost of performance reporting may not be distributed evenly. For advisers that already provide detailed information, “the cost would likely be small”, akin to reformatting the information. However, some advisers do not provide such performance information currently and their compliance costs will be greater. Moreover, performance disclosure costs may depend on whether the fund is liquid or illiquid. Costs may be passed along to investors directly or indirectly, or may be absorbed by the adviser, the SEC adds.

What’s next? So, that is the SEC’s economic analysis on fees, expenses and performance disclosure. In upcoming missives, we will review the agency’s cost/benefit analysis of other requirements, including i) disclosure of preferential terms, ii) prohibition of certain activities, iii) annual financial statement audit and, for adviser-led secondaries, a fairness opinion and iv) additional requirements to enhance regulator and external monitoring of private funds. And, of course, in the coming weeks, we also will compare the SEC requirements to the current practices in the CLO market.

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