The regulation blocking a windfall

Canada’s Northleaf is raising an evergreen senior debt vehicle that has attracted the country’s mutual funds, providing a glimpse of what life for US managers could look like if a key rule were rolled back.

Beating back the Acquired Fund Fees and Expenses (AFFE) rule has been a top priority for US business development companies, and it’s not hard to see why after Northleaf Capital Partners’ latest fundraise.

The Toronto-based firm announced last week it had locked down more than $500 million for its open-ended Northleaf Senior Private Credit fund. Announcing the capital raise, the firm listed the types of investors attracted to the fund, and one stood out: Canadian mutual funds.

Mutual funds are not your garden-variety private debt investor – those are the institutional investors such as pension plans and insurance companies. Mutual funds represent an investor base that has yet to realise its full potential.

But the AFFE rule, which critics say overstates the costs associated with investing in a BDC, has been a barrier to accessing mutual funds for many US private credit managers.

For its part, Northleaf received inbound inquiries about an investment vehicle that did not have the common drawdown fund structure most credit funds are comprised of, according to a source familiar with the situation.

To continue bringing new constituencies into the asset class, the firm designed a bespoke structure that catered to the individual needs of specific investors, or groups of investors.

Canadian mutual funds typically have a 10 percent illiquidity bucket, a source explained. This is the home for alternative investments, such as private credit funds. The focus has been on how to best utilise this part of the mutual funds’ portfolio, given the returns environment today, this person added.

BDC managers have made strides with the regulators – or at least been given glimmers of hope – in pressing for repeal of the AFFE rule.

The BDCs of Ares Management and Apollo Global Management have submitted an application to the Securities and Exchange Commission asking it to reconsider the AFFE rule. “The application of the AFFE rule to BDCs, has caused a dramatic reduction in institutional ownership in BDCs,” the filing stated.

The SEC has proposed a new rule liberalising restrictions on the amount of stock one BDC can hold in another. This, Apollo BDC general counsel Joseph Glatt said, provided an opening for BDCs to argue against the AFFE rule.

Tapping mutual funds represents a natural extension of the private credit investor base. An oft-quoted statistic about the asset class comes from a report by the Alternative Credit Council: private debt will reach $1 trillion of assets under management by next year.

It’s a staggering figure for an asset class that was barely on the periphery of institutional investors’ portfolios pre-global financial crisis. While there is still room for geographic growth of the asset class – particularly in the Asia-Pacific region, which is immature in its development – mutual funds represent a key constituency for the further growth of US private credit managers. The blocks should be dismantled.