Months of hand wringing about bond market liquidity couldn’t prevent one of U.S. regulators’ worst fears: The freezing up of a $788 million mutual fund that was meant to provide small-time investors with easy access to their cash.
While hedge fund liquidations are taken for granted, the failure of the Third Avenue Focused Credit Fund last week and its decision to halt redemptions is the type of situation the Securities and Exchange Commission dreads. By Monday, SEC staff were calling around to mutual funds with similar holdings, while fellow regulators pored over Third Avenue’s books at its offices in New York.
The collapse of the fund that focused on high-yield and distressed debt is expected to have consequences, said fund executives, academics and lawyers who represent asset managers. Industry groups may now have trouble beating back the most aggressive aspects of an SEC proposal that would force firms to set aside more cash and detail how long it would take to sell every asset they hold.
The plan’s outcome is being closely watched by the Federal Reserve, which has long warned that risks previously housed at big banks have gravitated to fund managers that could struggle to return investors’ money during a market rout.
“You can expect to see a lot of focus on liquidity,” said Jay Baris, a partner at Morrison & Foerster and chair of the law firm’s investment management practice. “Some of it is driven by the concerns of the federal banking regulators that want to regulate investment funds and investment managers like systemically important financial institutions.”
The SEC said Monday it was “on site” at Third Avenue and closely evaluating the wind-down process of the credit fund, which saw investors yank $734 million of its assets over the past four months.
After Third Avenue said Monday that Chief Executive Officer Dave Barse had left the firm, Massachusetts Secretary of the Commonwealth William F. Galvin said his state had sent out a subpoena as part of an investigation into the fund’s liquidation plan. The credit fund’s assets were concentrated in the debt of distressed companies, with 82 percent of its assets in bonds rated CCC or lower or that had no ratings at all.
SEC rules limit mutual fund illiquid investments to 15 percent of the portfolio.
Democratic Commissioner Kara Stein, who wants tougher regulations, has said that funds have gamed the agency’s rules to deem investments liquid that probably aren’t. What happens “when financial conditions get rocky, redemption requests surge, and the fund is primarily invested in illiquid assets?” she said in a June speech.