Despite its many attractive features, regulatory scrutiny of private credit continues to grow. Valid questions being asked around how assets are valued and how conflicts of interest are managed. Responses to a discussion paper by ASIC have focussed on the role of independent agents in reducing risks around subjectivity in valuation practices and management of conflicts. While independent oversight has a role to play in improving governance practices in private credit, a far more important consideration is the governance culture within the manager themselves.
What do Arthur Andersen, S&P/Moody’s and Link Fund Solutions have in common?
All were providers of supposedly independent oversight who were driven by the commercial relationship with their clients to overlook serious failings which ultimately led to individual investors suffering significant losses.
Arthur Andersen was the longtime auditor of Enron who signed off on Enron’s fraudulent Chewy structures. S&P failings in rating CDO’s during the GFC are well documented with an employee famously stating, “We rate every deal. It could be structured by cows and we would rate it.” Link Fund Solutions was the authorised corporate director for the Woodford Income Equity Fund which was issued an enforcement notice by the UK Financial Claims Authority (FCA) after failing to manage how easily assets in the fund could be turned to cash.
Each of these failings involved a supposedly independent oversight relationship becoming a co-dependent one driven by the commercial interests of the overseer. Push back against improper or questionable practices and risk losing the oversight role. Resource and cost the oversight role appropriately and risk losing the role to a cheaper competitor who will provide a more superficial role.
More recently, questions have been raised about the role of smaller rating agencies in providing ratings of private credit loans. In June, Bloomberg published an article which highlighted how rating agency Egan-Jones[1] rated more than 3,000 private credit deals with a team of just 20 analysts. A report issued (but since rescinded) by the National Association of Insurance Commissioners (NAIC) showed that ratings from smaller rating agencies were often three notches higher than the NAIC’s in house rating. In May, Fitch and KBRA engaged in a public dispute about the reliability of private ratings with Fitch referencing the same research by the NAIC.
The root cause of each of the failures mentioned earlier was not the failure of oversight but the failure within the culture of the firms that were being overseen. It was Andy Fastow at Enron pressuring Arthur Andersen to sign off on moving certain special purpose entities off balance sheet. It was investment bankers engaged in ratings shopping threatening S&P that they would lose business to Moody’s (or vice versa) if they didn’t give a coveted AAA rating to a CDO. It was Woodford Investment Management overweighting their portfolio with private companies even as investors were redeeming leaving the fund which offered daily redemptions increasingly illiquid.
Similarly, with private ratings it is often the insurance companies and private credit managers seeking the ratings in order to reduce capital charges or reduce the perception of risk in their portfolios that create the incentives to improve ratings. Indeed, Bloomberg reported that many larger private credit managers have excluded Egan-Jones from their list of approved rating agencies for private credit.
The challenge for regulatory bodies is that culture is hard to regulate. As critical as it is, regulating for culture is not a simple exercise which is why there is so much focus on independent oversight. However, it is not impossible. In recent years regulators have sought to improve conduct and by extension, culture within the banking system. Closer attention has been paid to leadership via CPS230 which focusses on operational risk management as well as the Financial Accountability Regime.
In early June, ASIC released the results of a review into the compliance plans of managed funds identifying widespread poor practices. ASIC called on responsible entities of managed funds to improve their compliance plans and comply with the controls contained within them. As with the banks, regulators are highlighting that operational risk controls within the funds management industry need to improve.
While these are steps in the right direction, ultimately culture comes from within. Investors can the quality of the culture within a firm by looking at things like turnover, diversity and the firm’s approach to transparency. They can look at the internal controls such as genuine board oversight, a strong and empowered compliance and risk function and the incentive structures applied to senior management and junior staff. In many cases the cultural risks are there in plain sight – Woodford Investment Management disclosed its illiquid positions and the ratings shopping that was happening pre-GFC was well known. It’s up to investors to consider how much these non-financial risks matter relative to the financial risks.
Regulation can only go some of the way. In addition to the challenges mentioned above, they are often constrained by the willingness of market participants to go along with the changes. It is little surprise that most regulatory tightening occurs following a financial event such as the GFC and indeed in all three of the examples we cite in this piece, it took significant losses of investor capital for action to occur.
If investors are concerned about practices in private lending markets, they need to act. Waiting for regulation to raise the bar or hoping for independent overseers to force change will probably be a case of too little, too late.
[1] Ironically Egan-Jones came to prominence in the early 2000s for its early warnings on Enron.
On behalf of the team, thanks for reading.
Pete Robinson
Head of Investment Strategy – Fixed Income | +61 2 9994 7080 | probinson@challenger.com.au
For further information, please contact:
Linda Mead | Senior Institutional Business Development Manager | T +61 2 9994 7867 | M +61 417 675 289 | lmead@challenger.com.au | www.challengerim.com.au
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