As money managers push to bring private credit to public markets, investors in a new breed of exchange-traded fund will want to know how they can get out when markets are stressed. Their early plans aren’t resolving doubts. 

The Securities and Exchange Commission is set to review three recent filings for private-credit ETFs, including a proposed partnership between Apollo Global Management Inc. and State Street Corp. Securities law experts say the lack of information on how retail investors can easily withdraw money from funds loaded with illiquid assets will likely prompt scrutiny, while consumer advocates are already drawing comparisons to securities that imploded.

“The lack of details in the filing is pretty staggering,” said Elisabeth de Fontenay, a law professor at Duke University. “It feels like a cut-and-paste job from your usual ETF filing.”

The SEC could reject or approve the plans in the next few months, with the caveat that the agency is likely to experience policy shifts regardless of who wins the US presidential election. A denial from the regulator risks drawing another legal challenge by industry. A green light would open the floodgates for similar funds, adding fuel to the $10 trillion US ETF market and letting the average investor tap opportunities often reserved for institutions and the wealthy.

But first, the firms must clear hurdles that will include sharp scrutiny of liquidity, conflicts of interest and disclosures. Regulators’ concerns about the rapid growth of the broader private fund sector, which exceeds the size of the US bank industry, could also cloud the picture for the State Street-Apollo ETF and other proposals by Virtus Investment Partners Inc. and BondBloxx.

The SEC, Apollo, State Street and Virtus declined to comment. BondBloxx didn’t respond to requests for comment.

The novelty of private-credit ETFs and the big liquidity question have alarmed investor advocates. In a letter to the SEC, the Consumer Federation of America described a hypothetical scenario where stressed markets lead to liquidity strains on the State Street-Apollo ETF. The group made comparisons to the implosion of the auction-rate securities market during the 2008 financial crisis. 

In that case, investors had depended on investment banks to provide liquidity for the market. But when the banks experienced their own liquidity crises, they retreated and auctions collapsed, Micah Hauptman, the CFA’s investor protection director, wrote in the Oct. 4 letter.

“What had previously been considered highly liquid, ‘cash like’ assets suddenly became illiquid, causing significant financial hardship for tens of thousands of investors,” he said.

15% Cap

The planned State Street-Apollo ETF will have to comply with SEC rules that impose a 15% cap on illiquid investments in a fund’s net assets. But the agreement between the two firms isn’t public, making it hard to determine how they will ensure the ETF doesn’t go past the limit, Hauptman said.

At least 80% of the fund’s net assets would be in a portfolio of investment grade debt securities, including those from private credit investments sourced by Apollo, based on the filing. That’s an indication that State Street and Apollo intend to treat the private credit portions of the fund as though they were liquid, according to SEC observers. 

“That’s not the way we usually define liquidity,” Duke’s de Fontenay said.

The disclosures, she said, don’t indicate whether that treatment applies to all or only a portion of the assets held in the fund.

SEC staff typically ask issuers for additional disclosures on their products. But for the private-credit ETFs, the agency may push for more details on how the firms will navigate conflicts of interest and how they select the underlying private credit assets. Many of those assets will be comprised of collateralized-loan obligations, a $1.3 trillion market that repackages leveraged loans into securities of varying risk and size. 

The agency will home in on whether any conflicts can be addressed through simple disclosures, or if they need to be resolved, said Val Dahiya, a partner at the law firm Morrison Foerster and a former branch chief in the SEC’s Division of Trading and Markets. If they can’t be addressed, the agency is more likely to deny the proposals, she said.

Apollo plans to source some of the private credit assets wrapped into an ETF, provide valuations for those assets and offer intraday trading liquidity for those assets, according to the SEC filing. The money manager has pledged to purchase a certain amount of the asset-backed and corporate finance investments held by the ETF, up to a daily limit, at prices that it sets.

State Street will serve as the investment adviser for the fund.

CLO Market

The BondBloxx and Virtus private-credit ETFs would include a significant amount of collateralized loan obligations in their investment mixes. In BondBloxx’s fund, CLOs could represent up to 80% of net assets. The firm’s filing didn’t specify the debt ratings of the CLO assets. Virtus said it would keep at least 80% of its portfolio in AAA-rated CLOs “under normal market conditions.”

“The idea that CLO ETFs will be able to convert their assets into cash to service redemptions — it’s difficult to see how that would really work in a distressed environment,” said Christopher Jackson, a partner at the law firm A&O Shearman in New York who specializes in private credit issuance. 

The filings acknowledged the issue. Virtus wrote that the fund’s “ability to acquire or dispose of CLOs at a price and time the fund deems advantageous may be impaired” during periods of limited liquidity or higher price volatility. 

The new frontier of ETFs follows decades of expansion by the private credit market. SEC Chair Gary Gensler said last week that private credit benefits capital markets and investors by encouraging greater competition in lending, but he also highlighted possible risks in its intersection with the insurance and banking sectors.

“Though private credit has existed in some form for years, given its size has increased significantly, how will it weather times of stress at today’s or greater magnitude?” he asked during the Bloomberg Global Regulatory Forum.

Apollo Chief Executive Officer Marc Rowan recently said he anticipates that the firm’s ETF plan will further blur the lines between retail and institutional markets. “Once that happens, what’s the difference between public and private?”