National Policy 11-203 Process for Exemptive Relief Applications in Multiple Jurisdictions – Relief to permit a fund primarily investing in senior loans to borrow cash up to an amount equal to 20% of its NAV as a temporary measure to accommodate requests for the redemption of its units – relief needed due to longer settlement times for senior loans – relief subject to numerous conditions.
Applicable Legislative Provisions
National Instrument 81-102 Investment Funds, ss. 2.6(a)(i), 19.1.
August 29, 2018
IN THE MATTER OF
THE SECURITIES LEGISLATION OF
IN THE MATTER OF
THE PROCESS FOR EXEMPTIVE RELIEF APPLICATIONS
IN MULTIPLE JURISDICTIONS
IN THE MATTER OF
PURPOSE INVESTMENTS INC.
The principal regulator in the Jurisdiction has received an application from the Filer on behalf of Purpose Floating Rate Income Fund (the Fund) for a decision under the securities legislation of the Jurisdiction (the Legislation) that grants exemptive relief to the Filer and the Fund from subparagraph 2.6(a)(i) of National Instrument 81-102 Investment Funds (NI 81-102) to permit the Fund to borrow cash in an amount that does not exceed 20% of its net asset value as a temporary measure to accommodate requests for redemptions of units of the Fund (the Exemption Sought).
Under the Process for Exemptive Relief Applications in Multiple Jurisdictions (for a passport application):
(a) the Ontario Securities Commission is the principal regulator for this application; and
(b) the Filer has provided notice that section 4.7(1) of Multilateral Instrument 11-102 Passport System (MI 11-102) is intended to be relied upon in all of the provinces and territories of Canada other than Ontario (together with Ontario, the Jurisdictions).
Terms defined in National Instrument 14-101 Definitions, MI 11-102, and NI 81-102 have the same meaning if used in this decision, unless otherwise defined. In addition:
Designated Counterparty means a person or company, or the direct or indirect parent company of such person or company, whose securities have a “designated rating” as defined in NI 44-101.
Drawdown Period means any period of time during which the Fund has outstanding borrowings greater than 5% of the Fund’s net asset value.
NI 44-101 means National Instrument 44-101 Short Form Prospectus Distributions.
Unitholder means a beneficial and registered holder of a Unit.
Units means the units of the Fund, and Unit means one of them.
This decision is based on the following facts represented by the Filer:
1. The Filer is a corporation incorporated under the laws of the Province of Ontario with its head office located in Toronto, Ontario.
2. The Filer is registered under the securities legislation in:
(a) all the provinces as an investment fund manager and exempt market dealer; and
(b) Ontario and British Columbia as a portfolio manager.
3. The Filer is the manager of the Fund.
4. The Filer is not in default of securities legislation in any Jurisdiction.
5. The Fund is a trust governed by the laws of Ontario of which the Filer is the trustee and the manager. The Fund is a reporting issuer under the securities legislation of all the Jurisdictions.
6. The Fund is not in default of securities legislation in any Jurisdiction.
7. The net asset value per Unit of each class of the Fund is calculated and published daily in the financial press and on the Filer’s website at www.purposeinvest.com.
8. As the trustee and manager, the Filer is entitled to receive a fixed annual management fee from each class of Units. Such annual management fees are calculated as a fixed percentage of the net asset value of the applicable class of Units.
9. The Fund initially was a non-redeemable investment fund. At a special meeting of Unitholders of the Fund (then called Voya Floating Rate Senior Loan Fund) held on November 3, 2017, the Unitholders approved a number of changes to the Fund including converting the Fund to a mutual fund for purposes of the securities legislation of the Jurisdictions (the ETF Conversion). The ETF Conversion was completed on August 7, 2018. In preparation for the ETF Conversion:
(a) the Fund retained Neuberger Berman Investment Advisers LLC (Neuberger) as the portfolio adviser (in such capacity, the Sub-Adviser) to the Fund and Voya Investment Management Co. LLC ceased being the portfolio adviser to the Fund; and
(b) the Fund filed a simplified prospectus, annual information form, fund facts and ETF facts dated July 10, 2018 under the securities legislation of all the Jurisdictions.
10. The Fund currently is a mutual fund subject to and complies with the requirements of NI 81-102 applicable to mutual funds, subject to any exemptions therefrom that have been, or may be, granted by the applicable securities regulatory authorities.
Investments by the Fund
11. The investment objectives of the Fund are to generate current income and preserve capital by investing primarily in floating rate debt securities, short-term debt securities, high yield debt securities and asset-backed and mortgage-backed securities. The Fund invests primarily in senior secured floating rate corporate loans (Senior Loans) which generally are rated at or below BB+ by Standard & Poors, or Ba1 or less by Moody’s Investor Services, Inc., or a similar rating by a “designated rating organization” (as defined in NI 44-101). The Filer expects that approximately 60% of the Fund’s assets will be invested in Senior Loans under normal market conditions.
12. When selecting Senior Loans, the Sub-Adviser uses fundamental analysis to evaluate the investment opportunities of each issuer. When monitoring the risk associated with portfolio investments, the Sub-Adviser considers whether the Fund is over or under represented in a specific industry sector. The Fund’s investments are typically held until maturity but may be sold if attractive opportunities arise or for other reasons.
13. The Sub-Adviser has access to quotations with bid-ask spreads from major broker-dealers active in the Senior Loan market, allowing the Sub-Adviser to monitor the liquidity of the Fund’s portfolio assets and the market as a whole. The Sub-Adviser actively monitors earnings reports, price movements and bid-ask spreads of the Fund’s portfolio as part of its active management, and monitors compliance to the investment strategy in real-time. The Fund’s portfolio of Senior Loans is actively monitored by the Sub-Adviser, and the Sub-Adviser processes the information available to it as part of its daily portfolio management activities.
14. In addition to the ongoing monitoring of the markets and the Fund’s portfolio assets described above, each individual investment by the Fund undergoes a fundamental credit analysis, which includes an analysis of the possible downside of the investment, which may be referred to as stress tests, before the actual investment. These analyses include, amongst other things:
(a) revenue/EBITDA projections and sensitivity analysis including break-even point;
(b) margin projections and sensitivity analysis;
(c) impact of interest rates on cash flows;
(d) free cash flow analysis; and
(e) any other specific analysis appropriate for a particular sector and/or investment.
15. Because they are secured against specific collateral of the borrower, Senior Loans offer a higher likelihood of recovery in the event of a borrower default compared to equivalently rated unsecured high yield bonds. In addition, Senior Loans have a higher priority claim relative to certain other debt instruments, increasing the chances of recovery relative to more junior instruments in the event of bankruptcy or reorganization.
16. The vast majority of sales of Senior Loans between the Fund and a Designated Counterparty are subject to the standard terms and conditions for par / near par trade confirmations published by the Loan Syndications and Trading Association (the Terms), which Terms are binding on the parties to the transaction and do not contain any “outs” for force majeure or the stress or dislocation of the senior loan market (the foregoing does not apply in the case of a distressed loan). During any Drawdown Period, the purchaser of a Senior Loan from the Fund will be a dealer that is a Designated Counterparty.
17. The Fund also invests in collateralized loan obligation securities (CLOs and, together with Senior Loans, Loan Securities). A CLO is a security issued by a special purpose vehicle where payments typically from Senior Loans are pooled together and paid to holders of the CLOs issued by the special purpose vehicle. Typically, the special purpose vehicle issues multiple classes of CLOs with different priorities relative to each other in terms of rights to payments. The Filer expects that approximately 20% of the Fund’s assets will be invested in CLOs under normal market conditions.
18. When selecting CLOs, the Sub-Advisor undertakes: (i) a fundamental credit review of the individual, underlying loan holdings in CLO portfolios; (ii) a detailed analysis of the collateral managers of each CLO, in terms of the quality of the manager’s personnel and resources, historical investment performance and investment style; (iii) a detailed review of the CLOs’ structure and documentation; and (iv) an assessment of the general CLO market.
19. The Fund may invest in securities and instruments other than Loan Securities (Non-Loan Securities) including up to 10% of its net asset value in illiquid assets (the Non-Loan Securities excluding illiquid assets being the Liquid Non-Loan Securities). The Liquid Non-Loan Securities can be sold and settled within two trading days. Under normal market conditions, between 10% to 20% of the Fund’s assets will be comprised of cash and/or investments in Liquid Non-Loan Securities.
Settlement Gap Funding
20. The Filer believes that the Loan Securities held by the Fund can be liquidated in an orderly fashion during normal market conditions, given the size and depth of the overall market for such investments. However, the time to settle a sale of a Loan Security typically is longer than normal settlement periods for equity and debt securities. As a non-redeemable investment fund, the length of time required to settle a sale of a Loan Security does not present an obstacle to the Fund for funding the redemptions of Units from time to time since Unitholders currently are required to provide the Fund with not less than 60 days’ notice of their request to redeem Units, and the Fund has up to 10 business days to pay the redemption price to Unitholders after the Units are redeemed.
21. Unitholders generally are entitled to redeem their Units on any business day by delivering notice to that effect by 4:00 p.m. (Toronto time) on that business day (the Redemption Date), and are entitled to receive the redemption price within two business days after the Redemption Date. Upon receiving requests to redeem Units, the Fund may (depending upon the amount of cash and Liquid Non-Loan Securities it holds at the time), on the next business day, sell Loan Securities to fund the redemption. However, this will create a timing gap since (i) the Fund will be obligated to pay the redemption price to the redeeming Unitholder by the second business day following the Redemption Date, but (ii) typically will not receive the proceeds from selling Loan Securities until five business days or more after the Redemption Date. The Fund therefore faces the possibility that it may be require to pay the redemption price for Units that have been redeemed at a time when the Fund has insufficient cash to do so.
22. For the reason provided above, the Filer has concluded that it would be in the best interests of Unitholders for the Fund to have the ability to borrow up to 20% of its net asset value to fund redemptions of Units while the Fund is awaiting receipt of proceeds from the sale of Loan Securities (Settlement Gap Funding).
23. Settlement Gap Funding will not create leverage in the Fund because Settlement Gap Funding will not be used to purchase additional investments for the Fund. Settlement Gap Funding will be used only after the Fund has executed a sale of a Loan Security and only to the extent that the Fund is awaiting the proceeds from such sale. From the moment the Fund executes a sale of a Loan Security, the Fund no longer has investment exposure to such Loan Security. Settlement Gap Funding only will provide the Fund with quicker access to such sale proceeds.
24. Paragraph 2.6(a)(i) of NI 81-102 allows a mutual fund to borrow cash in certain circumstances (the Borrowing Exceptions) where the borrowing does not add leverage to the mutual fund and only is intended to bridge a timing gap that exists between the time a mutual fund is required to pay an amount (either on the redemption of its securities or following the purchase of securities) and the time when the mutual fund will receive proceeds from selling portfolio securities. The same policy rationale applies to Settlement Gap Funding.
25. The Borrowing Exceptions assume that the sale of portfolio securities by a mutual fund generally settle within the same timeframe (e.g. two business days) as settlement for redemptions of securities of the mutual fund. Accordingly, interim financing is needed mainly to bridge the one business day gap between the date a redemption order is received by the mutual fund and the date the mutual fund sells portfolio securities to fund the redemption. On the assumption that a mutual fund typically will not receive requests on any given day to redeem more than 5% of its outstanding securities, the Borrowing Exceptions limit the amount of funding to 5% of the mutual fund’s net asset value.
26. The Borrowing Exceptions did not contemplate that a mutual fund may invest a large portion of its assets in securities which settle on a timeline longer than for settlement of redemptions of the mutual fund’s securities. It is consistent with the policy rationale of the Borrowing Exceptions to grant the Exemption Sought in order to reflect a multiple of 5% representing the anticipated longer settlement cycle of the Fund when selling Loan Securities compared to redeeming its Units.
27. The Exemption Sought will be used by the Fund only to borrow prudent amounts for Settlement Gap Funding purposes. In particular:
(a) the Fund will borrow using the Exemption Sought only after it has:
(i) sold all of its Liquid Non-Loan Securities and used all of its available cash in order to satisfy requests to redeem Units; and
(ii) entered into a fully binding agreement with a Designated Counterparty(s) to sell a Loan Security in order to satisfy requests to redeem Units, but where the settlement period for the sale of the Loan Security exceeds two business days;
(b) the amount of cash that the Fund borrows using Settlement Gap Funding will not exceed the amount of cash that it will receive in respect of the sale of the Loan Security referred to in paragraph (a)(ii) immediately above;
(c) the Fund will not borrow cash to fund payment of expenses or to fund payment of a cash distribution to Unitholders. Such payments instead will be funded through the net assets of the Fund;
(d) the Fund will not pay a cash distribution to Unitholders where that distribution would impair the ability of the Fund to repay the funds borrowed; and
(e) the maximum percentage of assets of the Fund represented by borrowing will not exceed 20%.
28. Open-end investment companies registered under the Investment Company Act of 1940 (as amended, the 1940 Act) are permitted to borrow cash from a bank provided certain requirements are met including, as relevant to the Exemption Sought, there is asset coverage of at least 300% for all borrowings. This effectively allows an equivalent U.S. mutual fund to borrow up to 50% of its total assets, measured after the borrowing, for temporary or emergency purposes, which may include funding redemptions of its securities.
29. It is common in the 1940 Act registered mutual fund industry to enter into credit facilities for temporary or emergency purposes, including liquidity needs. Such facilities can assist funds in paying redeeming investors without the need to sell portfolio securities under circumstances that could impair the fund’s net asset value. Neuberger currently manages open-end investment companies (the Neuberger Funds) using substantially the same investment strategies and techniques that it intends to apply to the Fund. The Neuberger Funds are party to a syndicated credit facility along with other series of other investment companies in the Neuberger mutual fund complex that may be used for such purposes. Borrowing under such facilities is subject to the asset coverage requirements described above, and any other commercially imposed requirements.
30. The Fund’s current simplified prospectus discloses:
(a) that the Fund invests primarily in Senior Loans and also may invest in CLOs; and
(b) that a risk of investing in Loan Securities is that such investments may have longer than normal settlement periods, and that such settlement periods exceed two business days.
The Fund’s future simplified prospectuses will disclose the foregoing and:
(c) the terms of the Exemption Sought including the maximum percentage of assets of the Fund that the borrowing may represent and the Fund’s intended use of borrowing for Settlement Gap Funding;
(d) the material terms of the overdraft facility through which the Fund may borrow for Settlement Gap Funding; and
(e) the risks arising from Settlement Gap Funding.
The principal regulator is satisfied that the decision meets the test set out in the Legislation for the principal regulator to make the decision.
The decision of the principal regulator is that the Exemption Sought from the Borrowing Requirement is granted, provided that:
(a) the Fund does not make a distribution to Unitholders where that distribution would impair the ability of the Fund to repay the funds borrowed for Settlement Gap Funding;
(b) the Fund’s next renewal prospectus or amendment to prospectus to be filed in connection with the continuous distribution of Units discloses:
(i) the terms of the Exemption Sought;
(ii) the maximum percentage of assets of the Fund that the borrowing may represent;
(iii) the Fund’s intended use of the amounts borrowed for Settlement Gap Funding;
(iv) the material terms of the overdraft facility and the risks arising from Settlement Gap Funding; and
(v) the risks arising from Settlement Gap Funding; and
(c) the Fund may only borrow cash in excess of 5% of net asset value if all of the following conditions are satisfied:
(i) after giving effect to the borrowing, the outstanding amount of all borrowings of the Fund does not exceed 20% of the net asset value of the Fund;
(ii) the Fund has entered into a fully binding agreement with a Designated Counterparty(s) to sell a Loan Security(ies) in order to satisfy redemption requests, but the settlement period on the Loan Security(ies) exceeds two days;
(iii) the amount of cash that the Fund borrows does not exceed the amount of cash that it will receive in respect of the sale of the Loan Security(ies) referred to in paragraph (c)(ii) above; and
(iv) the Fund has sold all of its Liquid Non-Loan Securities and has used all of its available cash in order to satisfy redemption requests.
Manager, Investment Funds & Structured Products Branch
Ontario Securities Commission