October 14, 2016 - October 14, 2016 – On October 13th, the SEC voted to approve their long-anticipated Open End Mutual Fund Liquidity Risk Management Rules, which have the potential of profoundly impacting loan mutual funds. The 459-page rule was published last night. Today, we share our initial impressions. (Fair warning: we are still reading it.) For a deeper dive, we invite you the attend next Wednesday’s 4 pm ET webcast on The SEC’s Final Liquidity Rules and read a full analysis in next Friday’s Newsletter.
Based on our initial review, we identify five key takeaways that are detailed below. First, the final rule appears more workable than the original proposal. Second, while loans and loan mutual funds are singled out throughout the text of the rule, loans still are permissible investments for open end mutual funds. Third, while the SEC’s concerns about settlement permeate the text, the definition of “illiquid assets” – which are limited to 15% of mutual fund assets – does not include a settlement test. Fourth, both Commissioner Stein’s statement and the rule text suggest that managers and boards should take settlement times into consideration when forming open-end mutual funds. Finally, while we are heartened that the final rule definitively permits open-end loan mutual funds, the SEC’s intense focus on long settlement times is further evidence that the industry and the LSTA must continue working on shortening settlement times (see the Delayed Comp section for more details).
Now, into a few early weeds. First, despite onerous reporting requirements, the final rule seems more workable. The proposed rule required a bottoms-up analysis, with the manager determining the number of days it would take to convert every asset to cash (e.g., sell and settle) and then dividing the assets into six “convertible to cash” day-count buckets: i) 1 business day; ii) 2-3 business days; iii) 4-7 calendar days; iv) 8-15 calendar days; v) 16-30 calendar days; or vi) in more than 30 calendar days. All market commenters – from equity funds to loan funds – felt this was unworkable. So, in a massive improvement, the final rule requires funds to divide their assets into four liquidity categories: i) highly liquid investments (cash and investments convertible to cash in three days), ii) moderately liquid investments (investments convertible to cash in four to seven days), iii) less liquid investments (investments that can be sold within seven days, but whose settlement takes longer), and iv) illiquid investments (those that cannot be sold within seven days). Loans generally fall into category three, “less liquid investments”, and therefore are a permissible investment.
While the definitions clearly permit loans as investments, that’s not to say the SEC is enamored of loan settlement times. Despite the fact that loan mutual funds are a mere $120 billion of an $18 trillion open end mutual fund market, loans are mentioned throughout the final rule. Sightings include p. 38 (discussing that some bank loan funds do not consider their holdings to be illiquid, despite settlement times longer than redemption periods), p. 119 (discussing that loans’ settlement times puts them in the “less liquid investments” category), p. 131 (noting that some “low quality loans” may not settle for months, and funds investing in them must develop liquidity risk management programs to deal with settlement risk), and p. 314 (discussing that while fund redemption times have become shorter, loans still see longer settlement periods).
And while loan mutual funds clearly are permissible, the rule reiterates that the SEC is aware of possible settlement and redemption mismatches for open end funds. For instance, p. 69 states that funds that hold securities with extended settlement times may face challenges operating as open-end funds, and should consider whether an open-end structure is appropriate, particularly if the fund has not established other adequate forms of liquidity. (At this juncture, we would point to the LSTA Chart of the Week that shows that loan mutual fund AUM has undergone substantial swings due to fund flows, and funds have never missed redemptions. As the LSTA’s research and comment letter reported, this is due to funds’ liquidity management procedures, including stress testing, funds holding a median 3.5% in cash plus 6.1% in T+3 securities, as well as having substantial lines of credit to bridge any gap between the sale and settlement of loans.)
While we are gratified that loans remain a permissible mutual fund investment, it is clear that our work on improving settlement times must continue. As members know, the LSTA and the industry have been working hard to improve settlement times. The most recent effort is the new Delayed Compensation regime for par/near-par trades. Last week’s Newsletter reported that the implementation of Phase 1 anecdotally has reduced settlement times for the new crop of trades. But no resting on laurels! The next phase goes live on November 1st, and we are hosting a webcast Thursday afternoon on Delayed Comp: What You Need to Know to Be Ready for Phase II.