The top U.S. securities regulator has increased its scrutiny of private funds that make higher-risk loans over the last two years, review of SEC actions and industry and regulatory sources — just as fears of a global recession hit the booming private credit market.
The intensified oversight from the Securities and Exchange Commission (SEC) could have deeper consequences as the financial turmoil wrought by the coronavirus and an oil price war increases the risk of corporate and individual defaults and raises pressure on fund managers to hide losses.
A spokesman for the SEC declined to comment. A Commission staffer who spoke on condition of anonymity confirmed that private debt funds were an area of increased focus given money pouring in to them, increased risk in their loans, and room for pricing manipulation, especially in a recession.
“We’ve had a lot of concerns over private lending,” the person said.
Private debt funds manage hundreds of billions of dollars globally but, unlike banks, are not subject to the same stress tests and capital requirements. This, combined with relative opacity — the loans are negotiated in private or purchased through intermediary platforms — mean there is more room for abuse of fiduciary duties to investors, market analysts said.
Scrutiny of once-hotshot lender Brendan Ross is indicative of the SEC’s new focus.
Ross’ Los Angeles-area firm, Direct Lending Investments LLC (DLI), quickly amassed nearly $1 billion under management after years of unbroken monthly profits from loans to small businesses. Ross was a frequent public champion of direct lending in appearances on CNBC, Fox Business and at the Milken Institute’s Global Conference, popular with Wall Street financiers.
DLI’s marketing materials said it was “unique in its ability to deliver double-digit, unlevered returns” with little risk of default.
The results were too good to be true, according to the SEC. In March 2019, it charged DLI with a multi-year fraud, alleging that Ross had engineered falsified payments on bad loans in order to prop up returns, thereby overcharging investors on fees.
Ross has departed DLI, which is now in receivership with an expected recovery of no more than 40% of its par value.
An attorney for Ross, Jahan Raissi, said in a statement that his client denies the SEC’s allegations and “very much regrets that investors – of which he is one – are likely to suffer a loss.”
Raissi added that Ross “strongly disagrees with any implication that he was the cause of DLI’s business failing”.
DLI is not the only private debt fund to have drawn SEC scrutiny of late.
After a scattering of previous cases, the markets watchdog has asked questions of at least eight private debt fund managers over the past two years, resulting in four public enforcement actions or settlements for infractions such as ignoring loan losses or falsifying borrower payments, according to public disclosures.
“These funds are obvious targets for SEC action given the strong temptation for accounting shenanigans on loans,” said Howard Fischer, a former senior SEC enforcement attorney now working at law firm Moses & Singer LLP.
“A recession and its ripple effects on borrowers would only accelerate financial games.”
As banks retreated from risky lending in the wake of the 2008 financial crisis, investors, both small funds and major Wall Street money managers, filled the gap in search of returns (story here here).
Private debt funds managed a record $812 billion globally —more than double the amount in 2012 — with nearly $500 million in North America as of June 1, 2019, according to data provider Preqin. Direct lending is the largest sub-strategy, followed by distressed debt-focused funds.
Jiří Król, deputy CEO and global head of government affairs at trade group Alternative Investment Management Association, said private credit funds were crucial for smaller businesses but they needed the right internal controls.
“The name of the game is industrial grade infrastructure and those who don’t reach that level will struggle to satisfy not just investors but borrowers and regulators alike,” Król said in a statement.
While large money managers including Blackstone Group, Ares Management LP and BlackRock Inc control the bulk of the assets in private debt, the SEC’s recent enforcement activity has focused on smaller privately-run players.
Like DLI, Miami-area direct lender TCA Fund Management Group Corp. marketed a multi-year run of uninterrupted profits from lending to small businesses.
In January, TCA disclosed to investors that it was the subject of an SEC probe and was liquidating its main fund (story here here). TCA employees have filed multiple whistleblower complaints to the SEC over the firm’s accounting practices, including papering over loan losses and booking phantom fees for advisory work, according to a person familiar with the situation and an NBC News report here
The whistleblowers allege that TCA has far less than the nearly $500 million in assets it reported in an SEC filing last year, the person said based on knowledge of the complaints.
Founder Robert Press and TCA attorney Carl Schoeppl did not respond to multiple requests for comment. Schoeppl said in January that TCA “treats this matter very seriously” and had offered full cooperation with the SEC.
Other SEC enforcement actions include International Investment Group LLC, which consented to a settlement over charges it hid losses in its main hedge fund and sold at least $60 million in fake loans; LendingClub Asset Management LLC, which agreed to settle over charges of propping up bad loans with related-party money; and Prosper Funding LLC, which paid a $3 million penalty for “materially overstating” returns to investors without admitting or denying the findings.
There are also signs the SEC is testing lending businesses even if it does not lead to an enforcement action.
Ranger Alternative Management LP, an investment firm in Dallas, was found to have “deficiencies and weaknesses in controls,” including transparency around its direct lending positions, according to a post-examination letter from March 2018 sent to the firm’s general counsel.
One of those positions, New Jersey-based direct lender Princeton Alternative Income Fund LP, filed for bankruptcy protection around the same time and was itself the subject of an SEC investigation into “certain pre-bankruptcy transactions and practices,” according to a September 2018 court filing by the SEC.
The SEC has taken no public action on the matter against Princeton or Ranger, which is winding down its direct lending bets. Representatives for Princeton did not respond to requests for comment. A spokesman for Ranger declined to comment.