Private markets in a public fund, and the line at 50%

On 3 September the SFC issued Circular 26EC55 to management companies of SFC-authorised funds. The observation behind it is simple: funds are reaching for private market assets — private credit and private equity — for asset allocation and yield enhancement, and they are getting there by two different routes.

Directly, through bank or non-bank direct lending, in the form of loans or equities to unlisted companies. Direct exposure of that kind falls inside the 15% of NAV limit under 7.3 of the UT Code, so it is bounded already. Indirectly is where the room is: business development companies (BDCs), collateralised loan obligations (CLOs), and financial derivative instruments such as total return swaps on leveraged-loan indices, or significant risk transfers whose underlying assets are corporate loans.

The SFC’s concern splits along the same line. Direct investment carries higher inherent risk than listed securities — illiquid, hard to value, subject to limited regulatory oversight, higher credit risk and so a higher risk of default. Indirect exposure may not be as risky, but recent market developments have raised their own concerns: rising default risks in the underlying investments of private credit funds, and a widening price-to-NAV discount on listed BDCs. And because indirect exposure arrives through layered structures and complex instruments, it can simply lack transparency — a retail investor may not reasonably understand what they are holding.

• Who’s in scope: management companies of funds authorised by the SFC for offering to the public in Hong Kong, with direct or indirect exposure to private market assets. Listed closed-ended alternative asset funds are carved out and have their own circular. If you distribute rather than manage, skip to the last two paragraphs — the target market and distributor passages are pointed at you.
• What to do: make the offering document, including the key facts statement, disclose three things clearly. First, the extent and the means of access — the circular’s own worked example is a line reading “up to [x]% of the Fund’s NAV is invested in listed BDCs which primarily invest in private market assets”. Second, the nature and characteristics of the underlying assets: the minimum credit rating of the CLOs the fund invests in, what a TRS is actually written on. Third, the key risks of that specific exposure, with the impact and implications spelled out for the fund and its investors — the example given is that limited liquidity and opacity in a BDC’s underlying assets make them harder to value, and that valuation uncertainty feeds through to the BDC’s NAV and therefore the fund’s.
• By when: there is no deadline date, and the wording is doing the work instead. For existing authorised funds, managers are expected to undertake a review, take appropriate action including updating offering documents as soon as practicable, and communicate properly with distributors. For new funds, the consequence is felt at authorisation: closer scrutiny, and the SFC may decline to process the fund under FASTrack at all.

Then the number that will decide most of these conversations. A fund will be considered a complex product where its total direct and indirect exposure to private market assets amounts to 50% or more of NAV. Below that line it is case by case, and the SFC says it takes a holistic view: aggregate exposure, the fund’s overall strategy, portfolio composition and liquidity and risk profile, the specific asset types involved — the tranches and credit ratings of the CLOs, the structure and underlying of the SRTs — and any distribution restrictions or conditions imposed by the fund’s home regulator.

Crossing that line is not a labelling exercise. A fund classified as a complex product falls under the SFC’s prevailing requirements for the sale of complex products, which include ensuring suitability for the investor irrespective of whether solicitation or recommendation is involved. The execution-only escape hatch closes.

Two reminders ride along. Managers are pointed back at the guidance on the internal product approval process for target market identification and distributor selection: identify a target market that would generally understand the fund, its underlying investments and its risks; and make sure the distributors chosen can cover that market, have the product knowledge to understand the fund — including whether it is a complex product — assign an appropriate risk rating, and advise investors accordingly. And marketing materials must still comply with the Advertising Guidelines: fair, balanced, with adequate risk disclosure. Managers in doubt about complex-product classification are encouraged to consult the SFC early.