Regulator ratchets up oversight of high-risk private debt funds

Public disclosures on at least eight managers show ‘accounting shenanigans’ that could accelerate in recession scenario

Regulator ratchets up oversight of high-risk private debt funds

As portents of recession grow stronger, so have concerns on areas of the financial markets that are carrying significant debt burdens. That includes the private debt market, which some have flagged as one of the weakest links of the global credit chain in case a downturn comes to pass.

Given the global backdrop of increased risk and volatility, private-debt fund managers must already have a long list of problems — and for those in the U.S., increased scrutiny from the Securities and Exchange Commission (SEC) could be one more.

According to a report from Reuters, the SEC has intensified its oversight of private funds that make higher-risk loans over the past two years.

Based on data from Preqin, private debt funds managed US$812 billion globally as of June 1 last year; almost US$500 million of that was in North America. The largest sub-strategy was direct lending, while distressed debt-focused funds took second place.

But as noted by different market analysts, such funds don’t face the same stress tests and capital requirements as banks do. Loans are also negotiated in private or purchased through intermediary platforms, which could potentially allow some managers to skirt their fiduciary duties to investors.

“These funds are obvious targets for SEC action given the strong temptation for accounting shenanigans on loans,” Howard Fischer, a former senior enforcement attorney at the SEC who’s not at law firm Moses & Singer LLP, told Reuters.

Based on public disclosures and its own review of information and documents, the news outlet said at least eight private debt fund managers have been the subject of SEC inquiries over the past two years. Those have reportedly given rise to four public enforcement or settlements for breaches such as ignoring loan losses or falsifying borrower payments.

“A recession and its ripple effects on borrowers would only accelerate financial games,” Fischer said.

The upshot, as stated by a spokesman for the Alternative Investment Management Association (AIMA), is this: As much as private credit funds have been crucial for small businesses — in the wake of the 2008 financial crisis, banks have shied away from lending to such “risky” enterprises — those alternative lenders also need 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,” Jiří Król, AIMA’s deputy CEO and global head of government affairs, told Reuters in a statement.


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