(Article from Registered Funds Alert, May 2019)
For more information, please visit the Registered Funds Alert Resource Center.
Investors, investment advisers, and the SEC alike are all focused on increasing retail access to investment strategies historically limited to wealthy individuals and institutional investors. Allowing registered funds to co-invest alongside private funds is a key prerequisite to products that allows retail investors access to such investment strategies, but a registered fund’s ability to co-invest is restricted by the 1940 Act. For co-investment opportunities that involve negotiation of terms other than price (“Negotiated Co-Investments”), the SEC historically has required that funds and their advisers apply for an exemptive order and agree to more than a dozen conditions that restrict how the funds and advisers behave with respect to identifying, entering into, allocating and approving Negotiated Co-Investments. These conditions, along with pages and pages of narrative description about how the adviser and funds will operate, form what becomes each set of applicants’ application for what we will refer to as “standard relief.”
We have argued in previous Alerts that the system for obtaining standard relief is outdated and in desperate need of a ground-up overhaul. A recent co-investment application filed by FS Global Credit Opportunities Fund, et al. (the “FS Application”), if granted by the SEC in a form similar to the application (which has been amended once as of the date of this Alert’s publication), would go a long way towards reforming the most significant issues with the standard relief. In particular, the FS Application envisions a broad, principles-based approach to co-investment relief rather than a detailed and customized application unique to the applicant’s business. We believe this would be a tremendous step forward, and encourage the SEC and its staff to consider the FS Application seriously. However, the FS Application leaves certain issues unaddressed. In this Alert, we take a look at how the FS Application would change the status quo conceptually, what benefits it provides practically, and finally offer our thoughts on certain elements that we think are missing from the application but are necessary for it to provide a comprehensive solution.
The Old Problem and the New Approach
Applications for standard relief require an unnecessary amount of detail, which has led to a situation where innovation has been plodding, unpredictable and uneven. What works for one adviser and one strategy may not work for another adviser or another strategy. Under the standard relief, the detailed descriptions, representations and conditions required from each set of applicants mean that if an applicant wants to innovate in a material way, their application needs to be different from precedent. As each adviser approaches the application process with a slightly different desired outcome in mind, these deviations happen frequently. While the SEC will occasionally accept a significant customization proposed by an applicant, those major requests (and even relatively minor requests) are often rejected. Even when changes are accepted, they usually add considerable time to the SEC’s review process, resulting in a timeline that is inconsistent with the capital formation timing goals of the applicant. As a result, an exemptive relief process that was initially designed to encourage innovation arguably is now having the opposite effect.
Investment advisers preparing to launch new products effectively have a choice between filing an application for standard relief that is in every material respect in line with what previous applicants have successfully requested—a process which still takes months to complete—or they can submit an application that modifies precedent to reflect their intended strategy and contend with the possibility that the SEC may reject their application months or even years after it was initially filed. Far too often, the result is simply that advisers will give up on fledgling products that involve co-investments between retail funds and private funds once they understand that they will need to obtain bespoke exemptive relief from the SEC to innovate in this particular space.
We believe that the SEC can more than adequately protect investors while promoting innovation that brings retail investors into private/institutional strategies by ending the historical dependence on lengthy, detailed descriptions and representations in co-investment applications that detail how each applicant fund complex and its advisers will operate. The staff of the SEC’s Division of Investment Management recommended in 1992 that SEC rules be amended to permit certain joint transactions in which a registered fund may participate on the same terms as its affiliates. In place of a revised rule, we believe a new baseline application that is similar to the FS Application will better match the spirit of the 1992 recommendation and allow advisers to innovate much more freely than under the standard relief.
The FS Application asks the SEC to grant exemptive relief that would allow registered funds to engage in Negotiated Co-Investments based on “fair and equitable principles” rather than requiring the registered fund’s board to review and approve co-investments. In other words, the application rests on principles that dictate what is and is not permitted, rather than relying on specific representations about what exactly the fund complex and adviser will do to comply with those principles. The conditions in the FS Application, which are considerably fewer in number than those in the standard relief, have been reworked almost entirely to reflect this broader and more principles-based approach. These changes should make compliance with co-investment orders more easily administrable. They also have the additional effect of furthering the SEC Staff’s laudable goal of lessening unnecessary administrative burdens on fund boards.
Significant Practical Benefits of the FS Application
The FS Application streamlines the current approach to co-investment relief with its principles-based conditions and focus on an adviser’s fiduciary duties. We highlight certain of the significant practical benefits of this change below.
Lack of Detailed Representations Regarding Co-Investment Program
Unlike standard relief, the FS Application does not have a section in the body of the application describing the mechanics of the co-investment program and the allocation principles. The FS Application lacks a description of allocation methodology, described in standard relief as “available capital” or “order size,” which have historically been used as a framework to allocate participation in Negotiated Co-Investments between registered funds and affiliated funds. Instead, the FS Application requires only that an investment adviser develop policies to allocate Negotiated Co-Investments “fairly and equitably” among participating funds, which is a standard equivalent to an adviser’s existing obligations under the Advisers Act and the 1940 Act.
The sections outlining mechanics and allocation methodology, which typically range from five to ten pages, make up a substantial portion of most applications for standard relief and contain material representations that the SEC often includes when it publishes a notice of its intent to grant an application for exemptive relief. The streamlined nature of the FS Application, if approved by the Staff and the SEC, will likely lead to a more generic, “one-size-fits-all” order than the current particularized orders associated with the standard relief. This will not only have the effect of a more efficient process for seeking relief, but will also allow evolution of a firm’s co-investment program over time to rest on more basic fiduciary principals, rather than compliance with potentially outdated representations.
Sharing Co-Investment Opportunities
The FS Application does not include a requirement to compel sharing of Negotiated Co-Investments among affiliated funds. Under standard relief, if an investment adviser considers an Negotiated Co-Investment opportunity for a private fund that is part of the co-investment program, it must also consider that same opportunity for every registered fund (under older exemptive orders) or every registered fund for which the opportunity satisfies certain “board-established criteria” (a feature of more recent orders). This requirement was designed to ensure that registered funds could not be excluded from any “good deals,” and that registered funds are not only brought in to co-invest on “bad deals.” Rather, the registered funds and private funds are forced by this condition to have equal access to an adviser’s entire pipeline of opportunities.
The FS Application does not require that an adviser will offer its registered funds access to all of the Negotiated Co-Investments (or all of such opportunities that fall within the board-established criteria) it considers for the affiliated funds; instead, the FS Application only requires (i) that an adviser implement policies to ensure that opportunities to participate in Negotiated Co-Investments are allocated in a manner that is fair and equitable to every registered fund and (ii) that the adviser negotiating the transaction considers the interests of any participating registered fund. Thus, the FS Application relies on the adviser’s pre-existing fiduciary duties to manage conflicts and allocation determinations. This avoids the need to offer, consider and report opportunities that are not appropriate for a registered fund but nonetheless may have been captured by the expansive language that is present in standard relief.
Role of the Regulated Fund Board
The conditions of the FS Application also require considerably fewer specific board actions and overall involvement in Negotiated Co-Investments than under the standard relief, consistent with the approach we recommended in our October 2018 Alert and recent SEC initiatives. The standard relief requires prior approval of every Negotiated Co-Investment by the boards of each registered fund participating in the transaction. The FS Application, on the other hand, contemplates that a participating registered fund’s board would not be required to approve most Negotiated Co-Investments. The FS Application provides instead that registered funds may participate in Negotiated Co-Investments so long as the registered fund’s board has (i) reviewed the co-investment policies of the participants in the investment and determine that the registered fund would not be disadvantaged and (ii) approve the adviser’s policies and procedures, which must be designed to ensure compliance with the requested order.
In addition to a notable reduction in deal-by-deal information presented to the boards of registered funds, other reporting obligations are also curtailed in the FS Application. Under the standard relief, a summary review of all Negotiated Co-Investments considered for the registered fund is required to be presented to the board quarterly. Instead of receiving specifics about all co-investment transactions offered to the registered fund (both those it passed on and those it participated in) on a quarterly basis, as is the case under the standard relief, the FS Application contemplates that each registered fund’s board would receive an annual report of the registered fund’s participation in Negotiated Co-Investments from the fund’s chief compliance officer along with information regarding any material changes to how affiliated funds and advisers have decided what opportunities to allocate to the registered fund.
Proprietary Accounts
The FS application changes the limitations on who may participate in a Negotiated Co-Investment so that advisers and control affiliates of advisers acting in a principal capacity may participate. Under the standard relief, proprietary accounts are only permitted to participate in Negotiated Co-Investments on an overflow basis—meaning that they can only buy portions of an opportunity that client funds do not want. The FS Application contemplates that the same general principles governing allocations between client funds would also apply to allocations involving proprietary accounts. This change essentially allows proprietary accounts to have pari passu allocations with registered funds and other client accounts. So long as the allocation determination is performed in a manner that is fair and equitable to participating registered funds, the FS Application does not place any further limitations on the involvement of proprietary accounts. This change avoids the need for an adviser to make unnecessary determinations regarding what constitutes overflow, and will permit firms with capital markets affiliates to provide registered funds with access to investment opportunities that might otherwise not have been available given the practical way in which firms compete for opportunities to originate loans.
Inclusion of BDC Joint Ventures
The FS application specifically contemplates that joint ventures formed by BDCs may participate in Negotiated Co-Investments. Under the standard relief, it is not clear that joint ventures may participate in Negotiated Co-Investments because they are neither registered funds, wholly owned subsidiaries of registered funds, private funds advised by the adviser or proprietary accounts, which are the only categories of participants that may explicitly join a Negotiated Co-Investment. The FS Application removes that ambiguity by explicitly defining joint ventures as permissible participants to Negotiated Co-Investments made under the exemptive relief. This should have a positive effect for fund returns, since it would increase the access of joint venture subsidiaries to the high-quality loans in which a sponsor has the highest conviction (and thus desires to place into several accounts at once).
Follow-Ons Treated as Co-Investments
The FS Application does not draw a distinction between follow-on investments and any other type of Negotiated Co-Investments, which eliminates many of the restrictions currently associated with follow-on investments under the standard relief. Currently, if the proposed participants to a Negotiated Co-Investment have any pre-existing investments in the issuer, another Negotiated Co-Investment in that same issuer is only permitted if the pre-existing investments were either:
(i) obtained pursuant to the standard relief or
(ii) (a) acquired prior to the fund complex relying on the standard relief, (b) in a transaction in which the only term negotiated was price, and (c) acquired either (1) in reliance on MassMutual[1] or (2) in a transaction occurring at least 90 days apart and without coordination between the funds.
Moreover, and perhaps more problematically, it is not possible for a fund to participate in a follow-on transaction if it was not involved in the original Negotiated Co-Investment. This effectively prevents newly established funds from participating in follow-on transactions alongside older funds. These restrictions are largely eliminated under the FS Application, and instead the board of participating registered funds must determine that the transaction is in the best interest of the registered funds and that it would not involve overreaching by the registered fund. This change will benefit firms that have launched new funds since an initial investment.
Pre-Existing Investments
The FS Application eliminates the outright prohibition on Negotiated Co-Investments in issuers in which an affiliated fund holds a pre-existing investment. Under the standard relief, Negotiated Co-Investments in an issuer in which an affiliate currently holds a position are not permitted (unless such investment is considered a follow-on investment, discussed above).
Instead of prohibiting Negotiated Co-Investments in issuers in which an affiliate holds a position, the FS Application contemplates that such Negotiated Co-Investments may proceed if the boards of any participating registered funds determine that the transaction is in the best interest of their respective registered fund and that it would not involve overreaching. This practical innovation will allow large, multi-strategy firms to manage different strategies more effectively, without need to worry about unrelated and immaterial investments in the issuer by other funds pursuing different strategies.
Unresolved Issues in the FS Application
While the FS Application is a very positive step toward a principles-based approach to co-investing for registered funds, it leaves a few key issues unaddressed.
Multiple Classes of Securities
As drafted, the FS application would retain the standard relief condition that Negotiated Co-Investments only involve the same class of securities for all participants, to be acquired at the same time, for the same price and with the same conversion, financial reporting and registration rights, and with substantially the same other terms (provided that settlement dates may differ up to ten business days, consistent with current orders). This general condition is designed to ensure that co-investing funds have the same incentives and that their interests are aligned. While that is in keeping with the spirit of the SEC’s prior statements on the issue, the inclusion of a specific requirement that all of the participants invest in the same class of security remains potentially problematic.
In many Negotiated Co-Investments, the participants are investing in multiple tranches of debt, a subset of which may not be a permitted investment for certain funds. For example, a Negotiated Co-Investment involving a term loan may also involve a revolving loan facility or an equity kicker. Six funds may want to co-invest in the term loan, but perhaps only five of those six want to acquire the revolver or equity kicker because the sixth fund’s strategy prevents it from acquiring revolvers or because the fund is potentially restricted from acquiring equity securities. Or the sixth fund may be a regulated fund that does not want a revolver due to the unfunded nature of the commitment or an equity kicker due to the target level of current income it seeks to achieve. Under both the standard relief and the FS Application, if the sixth fund participates but does not take the revolver or equity kicker, none of the other five funds can acquire the revolver or equity kicker (which likely would result in a borrower going with different lenders, as revolvers and, to a lesser degree, equity kickers, are a key part of many financing arrangements). Alternatively, the registered fund could be excluded from the transaction entirely, and the other five funds could invest pursuant to the limitations of their organizational documents without issue. None of these outcome serves any true investor protection rationale, and we believe a new default template should address this type of scenario more gracefully than an outright ban. We believe a narrow exception for revolvers or equity kickers would be appropriate, or a broader exception with greater board oversight.
Equity Investments
In some cases, often without intent (i.e., because of restructurings), a fund (together with its affiliates) may become the holder of greater than 5% of the equity of a borrower, and the issuer might then be considered an affiliate of the fund. Transactions with affiliates are restricted by the 1940 Act. A subsequent follow-on investment would be permitted if an issuer were an affiliate of only registered funds (under Rule 17a-6), but the participation of private funds in the Negotiated Co-Investment would potentially prohibit the follow-on investment as there is otherwise no applicable 1940 Act exemption. We believe any new form of co-investment relief should address these affiliation concerns for equity investments so that investments in equity and debt are treated in the same manner, or the SEC Staff should separately confirm that Rule 17a-6 may be applied to situations where a portfolio company is an affiliate of both registered funds and private funds that are affiliated with the registered fund.
Next Steps
As of the date of this alert, no one else has filed an application that follows the template laid out by the FS Application. But if the form of the application does not address other outstanding issues that advisers have with the proposed relief in the FS Application, it is entirely possible that other applicants may consider filing a modified form of the FS Application to address their concerns directly with the SEC Staff. If that were to happen, it may slow the SEC’s review process considerably. The changes contemplated by the FS Application also could require a formal SEC vote for approval, which would add additional time to the process, although it is also possible that the Staff believes it has adequate delegated authority in the co-investment space to approve an order itself. If the FS Application is granted, we expect a substantial number of applicants will seek the same relief immediately thereafter. In the meantime, however, investment advisers that need to obtain co-investment relief on a predictable timeline would be best served by seeking the standard relief, since novel exemptive relief in this area has in the past taken years to resolve. The SEC’s mission includes a mandate to protect investors and a mandate to facilitate capital formation. We believe this form of relief would be a catalyst for capital formation without sacrificing investor protection, and we strongly urge the SEC to move forward quickly on this form of relief. formation without sacrificing investor protection, and we strongly urge the SEC to move forward quickly on this form of relief.
[1] Transactions referred to as “MassMutual” transactions are those where all of the affiliated parties participate on the same terms and there are no terms negotiated other than price, a reference to the seminal no-action letter on this topic.