A Review of the SEC’s Derivatives Proposal

The unintended consequences of leverage restrictions

Originally published in the March 2016 issue

Schulte Roth & Zabel (SRZ) investment management partner John J. Mahon is based in the firm’s Washington D.C. office and regularly assists clients in connection with the establishment and operation of business development companies (BDCs) and both open-ended and closed-ended registered funds. He explains that the SEC’s recent release proposing the adoption of new Rule 18f-4 under the Investment Company Act of 1940 is “the culmination of years of focus on the concept of hidden leverage.” Indeed, the SEC’s Concept Releases date back to 2011. The SEC is particularly concerned about funds where the risks of leverage may not be apparent, and is of the opinion that derivatives-related exposures should be viewed as leverage. The SEC’s initial proposal might not be ideally suited to meeting the agency’s stated aims, and could have a number of unintended consequences.

1. Fund-level leverage only one form of leverage
Investor protection is one of the SEC’s guiding stars. The SEC gives examples of three registered funds using derivative-related leverage around 2008-2009 that incurred substantial losses in the region of 70-80%. The SEC omits to mention that some wholly unleveraged funds lost as much or more during the financial crisis – in some cases because they invested in companies, such as banks, that were themselves very heavily leveraged, or bought technology, biotechnology, energy or mining stocks at the top of their respective cycles.

The fact that money-weighted returns on mutual funds tend to be a lot lower than time-weighted returns suggests that many investors are following fads and fashions to their cost. Fund-level leverage is just one type of leverage, and traditional operating companies can be financially, or operationally, very leveraged. No prohibition exists on retail investors buying the equity of highly leveraged or highly speculative operating companies (or buying mutual funds that invest in such operating companies). Risk-loving retail investors could continue to do so even if BDCs and registered investment companies were forbidden from using leverage (including indirectly through the use of derivatives or financial commitments) above certain levels (150% of net asset value) as the SEC proposes.

2. Some RICs restricted to non-retail investors
Mahon thinks that the SEC’s primary concern is that retail investors could gain access through retail-oriented BDCs and registered investment companies to complex investments, including derivative instruments and swaps, that would normally be available only to sophisticated individual or institutional investors. He points out, for example, that in accordance with long-standing SEC guidance “registered investment companies investing in hedge funds can only be sold to accredited investors.”

If the SEC does want to adopt a paternalistic stance and place a ceiling on levels of leverage that retail investors can obtain via regulated funds, the proposed rule seems a blunt and clumsy way in which to accomplish this possible objective because it would also cramp the style of regulated funds that are limited solely to non-retail investors. Applying draconian restrictions to four types of regulated investment vehicles [‘40 Act mutual funds, BDCs, closed end funds (CEFs) and exchange traded funds (ETFs)] seems an indiscriminate approach when many of these vehicles are often restricted to sophisticated or accredited investors. Just as some UCITS hedge funds (typically sold outside the United States) are restricted to professional investors (at the behest either of the manager or of particular regulators, such as Denmark’s, that sometimes apply stricter criteria for granting passports) so too many of the US regulated fund structures can be distributed in a restricted manner that precludes investment by retail investors.

For instance, Mahon points out that “many non-traded CEFs are sold exclusively via private placements, with the intent to allow the fund to exceed the 99 investor limit under Section 3(c)(1) of the 1940 Act.” Typically such non-traded CEFs are limited to accredited investors in the United States, and often invest in asset classes, such as private funds, that retail investors would not be permitted to acquire. Other regulatory or tax considerations can also make a regulated fund more attractive than a traditional private fund. Adds Mahon, “there are many reasons why institutional investors may prefer a BDC or registered fund. Not only is there greater transparency, but regulated funds can be more attractive from a tax perspective to many offshore investors.”

To the extent that investors can invest across borders, the proposal could put regulated US fund structures at a competitive disadvantage in a global arena. An effective leverage cap of 150% of net asset value, inclusive of derivatives, might lead to the closure of US-listed double and triple leveraged ETFs – but as US investors can often buy securities listed on overseas exchanges, they could simply migrate to a European-listed triple levered ETF. Those seeking a managed futures strategy could buy various London Stock Exchange-listed vehicles. However, investing in overseas vehicles could entail tax complications for some US investors if the vehicles do not break out returns in line with the US tax code. This could cause nuisance, inconvenience and expense for investors.

3. Restricts retail investor choice and access
Some institutional investors could avail themselves of private funds for greater investment freedom, but the proposal would restrict retail investor choice. In a global context, the mere concept of a hard cap on leverage seems draconian when other regulators prefer a policy of labelling to alert investors to greater risks in particular products. In Hong Kong, the SFC regulator has recently proposed that leveraged and inverse ETFs must be labelled as “L&I” products and can no longer simply be named ETFs. UCITS in Europe must estimate their risk ranking on a scale of 1 to 7 and publish this in their Key Investor Information Document (KIID), with leveraged products likely to have a higher ranking. If the concern is ‘hidden leverage,’ the most obvious and direct response would appear to be requiring funds that employ fund-level leverage to be labelled as such (amongst many other risk factors to give a holistic picture of risk).

Though some types of UCITS do have a leverage cap of 200%, others can allow for substantial leverage in strategies, such as managed futures that are instead subject to a Value at Risk (VaR) limit of 20% at the 20 day, 99% confidence level. The SEC proposal, as it stands, could make it very difficult for retail investors to access strategies such as managed futures and CTAs that rarely employ balance sheet leverage, but do obtain notional leverage through a highly diversified portfolio of long and short futures contracts. This would be unfortunate if it resulted in US retail investors facing a more restricted choice of investment strategies than do retail investors in Europe, Asia, Latin America and elsewhere. In particular, both 2008 and early 2016 demonstrate how managed futures strategies can sometimes perform well during periods of extreme risk aversion and thus provide investors with a valuable diversification benefit versus conventional asset classes. The spectacular growth of assets in ‘40 Act hedge funds clearly demonstrates the investor appetite for liquid alternatives.

4. Limits scope for hedging and risk reduction
The proposal could also have unintended effects if it turned out to be an obstacle to many commonly used hedging strategies. The proposed limit for exposure where derivatives are used for risk reduction is somewhat higher, at 300%, but Mahon does not “think it makes sense to have any limit on derivatives used for risk reduction purposes, as by definition those derivatives are reducing the overall risk exposure investors face.” For instance, if a credit or convertible arbitrage fund had 100% long exposure to overseas corporate bonds offering a cash yield in excess of the credit default swap cost, and used derivatives to hedge out currency, interest rate, and credit risk, the sum of these three hedges could easily be 300%, taking gross exposure to 400% and thus breaching the limit. Though there can be some basis risk between hedges and the risk factors they are intended to offset, a hard cap on leverage could force funds to reduce or remove some hedges. In the above example, only by removing one of the three types ofhedges could the fund get back inside the 300% limit – but it could then be exposing investors to some degree of one or more of currency, interest rate, and credit risk.

5. Cash segregation rule a drag on returns
The proposal on segregating cash against derivatives could increase both the quantum and the quality of collateral held, Mahon explains. It would require funds to set aside not only mark to market margin, to cover current valuations of derivatives, but also a risk-based amount to provide for stressed conditions. “The board of each fund will have some freedom to determine how it applies stress tests, so the risk-based reserve amount will likely vary from fund to fund,” says Mahon. The test itself need not force funds to de-lever into a downturn in a pro-cyclical way as it would only be applied at the time of borrowing or entering into a new derivative position, so a passive or accidental breach arising from declining values of a fund need not force remedial action. But Mahon thinks that “typical tests applied by providers of leverage could have pro-cyclical impacts, as the terms of credit agreements often turn incurrence tests into maintenance tests.”

Though the proposal leaves funds with some latitude to determine the appropriate amount of collateral, the proposal is far more prescriptive over what constitutes acceptable collateral. Forcing funds to hold only cash or cash-equivalent assets would “potentially be a huge drag on returns,” warns Mahon. Indeed, returns on cash are already negative in some currencies in which funds may denominate share classes. Mahon suggests that permitted collateral could be broadened to allow for a wide range of liquid assets – “anything you can sell easily” – without changing the underlying purpose of the collateral requirement.

6. Threat to BDC middle market lending
Mahon has advised many BDCs, which are a type of closed-end fund that is regulated, rather than registered, under the ‘40 Act. The structure has been around since 1980 and he recalls how “BDCs really came into their own in the mid-2000s” as larger asset managers began to use the BDC structure as a way to expand their overall credit platforms. BDCs have recently attracted attention from the SEC due to their creative leverage structures, , including the use of form of financial commitments, Total Return Swaps (TRS) and so on. Therein lies the concern – “there is very real potential for the financial commitment aspect of the proposed rule to reduce lending by BDCs,” says Mahon. Should new rules require restructuring of loans in the venture lending and middle market lending spaces, “it could become harder for middle market companies to borrow on favourable terms,” warns Mahon – and harder for investors to access these sources of alternative income. This would seem particularly unfortunate in early 2016 when the rout in US credit markets could already be making it more difficult and expensive – or even impossible in some cases – for companies to raise capital.

The SEC deadline for comments is in March 2016. Many in the industry hope that the proposal will be modified, but without a wholesale volte face, there is a potential that the proposal, if implemented, could restrict both the ability of regulated funds to generate attractive returns using hedging strategies and freedom of choice and scope for portfolio diversification for retail investors. In any event, new rules around derivatives use will result in implications for regulated funds’ compliance and reporting obligations.

7. Compliance and reporting
Mahon advises BDCs and registered investment companies on both compliance and reporting obligations. The proposal would require those trading complex derivatives to put in place a formal derivatives risk management programme. This would include a designated derivatives risk manager, who Mahon envisages could easily be the CCO or CFO. Mahon thinks that ‘40 Act funds using derivatives as an active investment strategy are already likely to have policies in place given current SEC positions and might only need to add a few pages to their compliance manual.

A greater potential burden of reporting could arise from separate SEC proposals to increase closed end funds’ disclosure requirements towards those applying to operating companies, and BDCs. Specifically, compared to operating companies and BDCs, which report detailed financial information on a quarterly basis, closed end funds currently are only required to file annual and semi-annual reports, along with a schedule of investments on off quarters.

8. Confidentiality not completely guaranteed
The SEC’s new proposed portfolio reporting form for registered investment companies, N-PORT, would replace the current Form N-Q quarterly portfolio report with a more detailed monthly portfolio disclosure. Notably, while a Form N-PORT would be required to be filed each month, only the final Form N-PORT for each quarter would become publicly available, with the remainder destined only for the regulators’ eyes and not for the public. But the wrinkle here is that anybody can make an FOIA (Freedom of Information Act) request for any government record and Mahon worries that “it is quite a high hurdle to request that the information be kept confidential because it is proprietary.” Thus there is some danger that even non-public N-PORT filings could at some point percolate into the public domain.