Non-bank lending, or “private credit,” has been thriving since the financial crisis of 2008. By the beginning of 2024, the amount invested in private credit has expanded to $1.4 trillion, about half the amount of commercial and industrial bank lending. As the private credit market has swelled, the environment continues to change with it.
What has happened so far in 2024 that has significance for the private credit markets and the funds that develop and invest in private lending? Below, I note developments in five areas.
Legal Environment
The most meaningful 2024 event to date in the legal framework was the February 20 denial of certiorari by the U.S. Supreme Court in an appeal from the Second Circuit's holding in Kirschner v. JP Morgan Chase Bank N.A. et al. The Second Circuit had held that a syndicated term loan is not a “security” (under the circumstances of the case).
The plaintiff was a trustee in the bankruptcy of a company that had issued notes. These notes had been syndicated by several lead banks. The plaintiff complained that company and the “underwriters” had not made disclosures (about a Department of Justice investigation) that would have been required under the state securities laws under which it sued.
The Second Circuit determined that the syndicated loans, despite being called “notes” bore a sufficient “family resemblance” to commercial loans not generally characterized as securities to avoid being subject to the relevant securities laws.
Practical effects: Not all private credit issuances are syndicated, but, following the Kirschner case, even those that are widely distributed will presumably be able to avoid coping with extraneous regulation. It is not clear whether this result will affect disclosure practices in the loan markets or merely the susceptibility to liability for various parties when failures occur. Obviously, the sale of interests in private credit funds themselves remain securities.
Operations
Perhaps the most important environmental change to occur in 2024 going forward is the effectiveness on May 28 of the T+1 trading and settlement regime. Most securities transactions from U.S. financial institutions are to be settled in one business day, instead of the previous two days.
Broker-dealers must be bound by written agreements—or establish, maintain, and enforce written policies and procedures—to effect confirmations and affirmations (pre-settlement matching) and to fulfill allocations by the end of the day of the trade (T+0). Delivery and payment will be due a day earlier than previously. These requirements were established by the SEC on Feb. 15, 2023, to “reduce latency, lower risk, and promote efficiency as well as greater liquidity” in the markets,” according to Securities and Exchange Commission (“SEC”) Chair Gary Gensler. Parties to a trade can expressly agree at the time of a transaction that their settlement date may exceed T+1, thereby “overriding” the T+1 requirement for debt and other issuances involving documentation or other complexities that hamper immediate settlement. Such agreements are quite feasible in private debt markets.
Practical effects: In effecting T+1 settlements, unanticipated processing difficulties may result in custodial overdrafts to complete timely payment, resulting in increased interest costs. Administrators should track interest expense as a measure of effectiveness of the systems for T+1 trading. European and Asian trading may not yet be on the expedited schedule, creating potential mismatches that will need to be resolved.
Fund Distribution
Private credit funds, particularly those that are registered under the Investment Company Act, are sometimes utilized to provide high levels of income for retirement plan investors. On April 23, 2024, the Department of Labor (“DOL”) issued its final “Retirement Security Rule” that defines who constitutes an “investment advice fiduciary” for purposes of “ERISA” (the Employee Retirement Income Security Act) and amended prohibited transaction class exemptions (“PTE”s) available to such a fiduciary. The rule becomes effective September 23 of this year, although there is a one-year transition period for certain conditions in the PTEs.
Under the final rule, a financial services provider will be an investment advice fiduciary if it:
• Makes an investment recommendation to a retirement investor;
• For a fee or other compensation, such as commissions;
• While holding itself out as a trusted adviser by specifically: stating that it is acting as a fiduciary under Title I or II of ERISA; or indicating that it is acting as a trusted adviser (in a manner that would be recognized by a reasonable investor as providing such an implication) to make individualized recommendations based on the investor's best interest.
There is no exception for one-time only advice, such as advising an IRA owner where to roll over the investor's IRA assets.
Under revised PTE 2020-02, when making recommendations, investment advice fiduciaries must:
• Provide prudent advice, i.e., advice that meets a professional standard of care;
• Act loyally, i.e., never put the advisor's financial interests ahead of the retirement investor's interests;
• Avoid misleading statements about conflicts of interest, fees, and investments;
• Charge no more than what is reasonable for their services; and
• Give the retirement investor basic information about the adviser's conflicts of interest (but not, as proposed in 2016, disclose all compensation arrangements with third parties on a website).
Practical effects: The new rules may reduce the willingness of certain advisers to recommend private credit funds to retirement plans, one of the key markets for high income products, as retirees often seek steady income streams rather than bet on growth. Lawsuits have already been filed to overturn the regulation. Investment advisers that distribute interests in private credit funds should ultimately be able to adjust their due diligence and recordkeeping standards if the rule is not invalidated.
Reporting
On Feb. 8, 2024, the SEC adopted amendments to the reporting form for private funds, Form PF (jointly with the Commodity Futures Trading Commission). The stated goal is to enhance the ability of the Financial Stability Oversight Council to monitor and assess systemic risk and advance regulatory oversight. The existing definition of “hedge fund” was not changed -- it remains applicable to any private fund that has one of the following three characteristics: (1) a performance fee based on market value (not just realized gains), (2) leverage, or (3) short selling.
Large hedge fund advisers will have additional reporting responsibilities with respect to qualifying hedge funds (i.e., those with a net asset value of at least $500 million), including exposures by investment, lender and counterparty, currency, country and industry, as well as risk metrics, market factors, turnover, investment performance by strategy, central clearing counterparty reporting, and liquidity (of the portfolio and of financing and investors). Advisers will report for themselves and their funds: identifying information, assets under management, withdrawal and redemption rights, gross and net asset value, inflows and outflows, borrowings and creditors, base currencies, fair value hierarchy, beneficial ownership, and fund performance.
Practical effects: Many private credit funds use leverage and therefore qualify for enhanced reporting on SEC Form PF. The Financial Stability Oversight Council (“FSOP”) has provided signs of greater aggressiveness in regulating what some see as “shadow banking.” Returning to the Kirschner case discussed at the top of this report, the inapplicability of traditional securities regulation to the loan markets traded by private credit funds may put these markets and funds under FSOP's brighter regulatory spotlight. Therefore, there will be more developments to come.
Business of Private Credit Arrangers & Fund Managers
Ultimately, the greatest change to the private fund business in 2024 may turn out to be the issuance by the Federal Trade Commission (“FTC”) of a final rule banning non-compete agreements (“noncompetes”) nationwide on Apr. 23, 2024. Existing noncompetes will no longer be enforceable after the rule's effective date of Sept. 4, 2024, except for those already in place with “Senior Executives,” defined as workers earning more than $151,164 annually and who are in policy-making positions. Advisers to private funds, among other employers, must provide notice (other than to senior executives who are bound by existing noncompetes) that they will not enforce existing noncompetes against them. Nor can they enter into, or attempt to enforce, any new noncompetes, even for senior executives. Like the DOL fiduciary rule discussed earlier, the FTC rule on noncompetes was immediately challenged.
Practical effects: Investment bankers who negotiate private credit arrangements and portfolio managers who create fund portfolios may not be “Senior Executives” of the entity that employs them. While they may be responsible for fund policies or credit terms on individual deals, they do not necessarily have a management role with the company that pays their salary and bonus. This means that a successful, alpha-generating team member could be a free agent with bargaining power to demand higher compensation or the freedom to hang out her or his own shingle. Employment lawyers are looking for solutions and strategies for their employer and employee clients, but only time will reveal how this game progresses under FTC scrutiny.