Podcast: COVID-19: Credit Funds: Valuation Risks and Other Compliance Considerations in a Pandemic Market Environment
In this Ropes & Gray podcast, Jeremiah Williams and Caitlin Giaimo discuss key takeaways from an active SEC enforcement case related to credit fund valuation, along with other areas of enforcement priority for credit funds. At times of market destabilization—when retail and real estate loans in particular face heightened risk of default—credit funds are subject to increased interest but also increased regulatory scrutiny. Jeremiah and Caitlin provide observations and advice on key regulatory compliance steps for credit fund sponsors navigating the pandemic market environment.
Caitlin Giaimo: Hello, and thank you for joining us today for this Ropes & Gray podcast, the latest in a series of podcasts discussing key compliance, enforcement and SEC priorities impacting credit funds. My name is Caitlin Giaimo, and I am an associate in the litigation & enforcement group. Joining me is Jeremiah Williams, a partner in our litigation & enforcement group with a focus on securities & futures enforcement. Before joining Ropes, Jeremiah was senior counsel with the SEC’s Division of Enforcement in the Asset Management Unit. Today, we will be talking about hot topics facing managers of credit funds. At times like these, when the economy is plagued by destabilization, credit funds are subject to increased interest, but also increased regulatory scrutiny. To that end, we will focus on a few key areas of enforcement priority for credit funds, including valuation, value protection and risk.
Let’s start with valuation. Cash flow projections depend on assumptions like default rates and recovery rates, which are particularly unstable in the current environment. And with even fewer transactions happening for illiquid assets, it can be difficult for a fund to value its positions accurately. On top of that, the SEC has an enduring focus on valuation issues. In fact, the Commission is currently in live litigation with a credit fund on this topic. Jeremiah, can you tell us a little bit about the present valuation-focused enforcement case?
Caitlin Giaimo: What are the allegations, at a high-level?
Jeremiah Williams: In that case, the fund had a lending business, providing loans and investment banking services to small businesses. Prior to obtaining funding, prospective borrowers would enter into non-binding term sheets with the fund, outlining the terms of the loan. Those terms included provisions for the borrower to pay advisory and investment banking fees once the loan was consummated. The fees could be considerable, and they ranged from hundreds of thousands of dollars to millions of dollars per transaction. The problem, and where the SEC took issue, was that the fund would recognize fee revenue at the time the term sheet was signed, rather than when that revenue was earned. Often, the borrowers did not have the ability to pay these fees, and sometimes the loans would not actually close. According to the SEC, this inflated the value of the fund until the point when the revenue was actually earned or until it was removed from the books (in the event the loans did not close). According to the SEC, the fund reported an inflated net asset value to its investors. At one point, the fund had only five percent of assets in cash, with most of its balance of assets consisting of loans to “thinly capitalized borrowers,” many of which ended up in default. This practice resulted in the fund never reporting a down month, effectively disguising multiple months of negative returns. Additionally, because the monthly management fee was a percentage of the fund’s NAV, and the general partner received a performance allocation as part of the fund’s realized and/or unrealized net profits, compensation to the fund and its affiliates increased as a result of the inflated valuations. The SEC also alleged that the fund did some creative accounting before the completion of its audit to avoid a downward adjustment. The fund’s management group corporation assigned the fund income it had received or would receive. In connection with that assignment, the fund received an allegedly back-dated promissory note. The fund’s financial statements described the assignment of income as the result of merging business practices to comply with current accounting standards. This, the SEC argued, had the effect of papering over the fund’s losses. By January 2020, the fund was not performing well and had to suspend redemptions and wind up its affairs.
Caitlin Giaimo: What’s the status of that case now?
Jeremiah Williams: The parties reached a bifurcated settlement on the basis of the non-monetary claims. Essentially, the adviser, the adviser’s GP and the funds managed by the adviser consented to a permanent injunction and to the court’s appointment of a receivership over them. But the issues of disgorgement, prejudgment interest and civil penalty are still being litigated, and the consent allows for discovery on these topics. The SEC has indicated that its investigation is ongoing.
Caitlin Giaimo: You noted that many of the underlying loans in that case ended up defaulting. The conduct alleged took place before the global pandemic and resulting market destabilization, but in this economic environment, defaults are even more likely. Did the SEC make any allegations related to a failure to write down loans that were in default?
Jeremiah Williams: The SEC did not focus on that practice in the complaint. However, news reports suggest that the fund had failed to book losses on defaulted loans in addition to recording fee revenues before they were earned.
Caitlin Giaimo: What are some of the key takeaways from this still-evolving enforcement case?
Jeremiah Williams: Valuation issues, particularly for credit funds, continue to be front of mind for the SEC. The Division of Enforcement is pursuing instances where credit funds have inflated asset values or performance returns. Valuation is particularly tricky because it is often subjective and there is an inherent conflict since management fees are based on the value of a fund’s assets. Especially in the current environment when it’s possible that portfolios may have lost value, the SEC will likely scrutinize situations where NAV or returns may be overstated – either because a fund has declined to book losses or because, as in the case we just described, it recorded fee revenues it has not actually earned, in contravention of accounting standards. For that reason, advisers are well-served by remaining attentive to valuation issues and reviewing their established processes and procedures.
Caitlin Giaimo: It’s true that valuation can be ripe for conflict, and finding a mark-to-market value for illiquid assets is difficult, but those challenges are especially heightened today. Can firms adjust their existing valuation methods to address unique economic circumstances? For example, what if following the usual valuation process does not yield valuations that are reasonable in this environment?
Jeremiah Williams: In the post-pandemic environment, with much uncertainty and loss of value, credit funds may face increased pressure to reexamine their valuations and their valuation processes. Circumstances like this make clear how helpful it is to have a valuation policy that is flexible and has been written to encompass a wide range of economic conditions. This reduces the need to revisit or rewrite the policy in response to changes in the business cycle. Any changes to a fund’s valuation model or policies and procedures will be closely scrutinized by the SEC, so they should be clearly documented with the understanding that they could be looked at under a microscope. In particular, the SEC will look for changes or adjustments to valuations at quarter end or in response to the pandemic. The key will be ensuring care in monitoring portfolio valuations, consulting with the valuation committee, reviewing their valuations, adhering to policies, maintaining thorough documentation of the valuation rationale and disclosing any changes to investors as appropriate. Funds may also get some comfort from working with a third party valuation agent who specializes in illiquid assets. That can provide a rational basis for the valuation, as well as some protection and documentation down the line. It sometimes happens that the adviser will vary from the recommended valuation range. That may be permissible, but they will want to have a clearly documented rationale that has been approved internally by the valuation committee.
Caitlin Giaimo: Retail and real estate in particular have been hit hard in this economic environment. With malls across America shut down and anchor stores that serve as their backbones having declared bankruptcy (or at risk of doing so), they are more vulnerable to default. Credit funds holding these assets face an increased risk of default, but there may be some instances where writing down defaulted loans is not always the right answer. Can firms protect the value of their portfolio rather than writing it down, and what enforcement risks does default raise for credit funds?
Jeremiah Williams: Default is a true risk in this environment, and retail—particularly smaller companies—are especially vulnerable. Distressed companies are likely dealing with issues related to lines of credit, and they may be requesting amendments or extensions to get through the current situation. Some lenders have been using discretion and have been reluctant to foreclose, instead choosing the path of forbearance. In this climate, managers who have retail or real estate debt in their portfolio may decide to wait to write down assets because they do not believe that there has been a fundamental change in value. Firms can use discretion in choosing when to write down assets. The key message is that it is important to have a process in place for when and how to write down assets and to adhere to that process. If the adviser decides not to write down an asset despite apparent weaknesses, that should be well-documented, and there should be justification that it is consistent with the policy.
Caitlin Giaimo: Another topic that seems especially relevant today is the potential for certain risks that were at one point theoretical to now become more concrete. For example, certain strategies, like CLOs, may not have been especially risky before, but in the event of default on underlying loans and resulting downgrades, their risk profile could increase. In theory, this could lead to losses in areas that were otherwise considered relatively safe by investors. How should credit funds address the potential for evolving risk, or the chance that a theoretical risk materializes?
Jeremiah Williams: Risk evolves in an environment like this. As defaults increase, risk may increase as well. For this reason, advisers will want to stay on top of their risk disclosures and risk monitoring, and be vigilant about risk testing and consistent documentation of their process. They should ensure that the risk profile of the portfolio has not changed dramatically from what has been advertised and disclosed. Advisers should be mindful of risk controls disclosed to investors and should stay on top of any assumptions they are using in risk projections, because they could change rapidly. In recent speeches, the SEC has emphasized the importance of accurate risk disclosures that make clear where the company stands operationally and financially during the pandemic. Disclosures should reflect the current state of affairs as much as possible.
Caitlin Giaimo: Jeremiah, we focused on valuation and risk issues today, the sources of some key conflicts of interest relevant to credit funds. Are there other conflicts that you think are worth raising?
Jeremiah Williams: There are a few other general conflicts of interest that are worth keeping an eye out for.
First, allocation decisions continue to be a key focus for the SEC. Credit funds will want to ensure fair and equitable allocation to their clients in a way that is well-disclosed and consistent with their allocation policy. This means avoiding preferential allocation to new clients, higher fee-paying clients or proprietary accounts unless there is adequate disclosure. Where there are side letter arrangements providing for preferential treatment, advisers should disclose this to investors.
Second, affiliate relationships continue to be of interest. It is wise to ensure that a fund and its affiliates are not acting as both lenders and borrowers. The SEC will scrutinize any transaction that could be considered self-dealing, so advisers will want to avoid making loans to the firm or to its affiliates without clear authority and disclosure.
Third, we talked about default today. In the event an adviser has fund groups invested at different levels of the capital structure, it should be mindful of the potential conflict amongst funds. The investor at the top of the capital structure, as an equity holder, will have different incentives from the debt holder. In situations like this, it will be wise to refresh on disclosures around this issue.
Caitlin Giaimo: Before we go, do you have any advice for private fund managers who are thinking about focusing more on credit as part of their investment strategy?
Jeremiah Williams: Advisers should be mindful of investment mandate drift issues. The SEC will examine how a fund has described its mandate in fund documents, marketing materials and its Form ADV. For the avoidance of doubt, advisers may choose to communicate a shift in strategy with a message to investors, or to solicit consents from investors or a limited partner advisory committee.
Caitlin Giaimo: Thank you, Jeremiah. And thanks to our listeners. For more information on the topics we discussed or other topics of interest to the asset management and credit funds communities, please visit our website www.ropesgray.com. And of course, if we can help you navigate any of the topics we’ve discussed, please don’t hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.