There has been an increasing focus within Europe on alternatives to bank-based credit. Loan origination funds, which look to source loan assets for their investment portfolio by directly originating loans (rather than investing via loan participation or assignment), are a key component in addressing the funding gap that arises from an over-reliance on bank credit. This article examines the Central Bank of Ireland’s Rules – contained in its AIF Rulebook – that apply to loan originating Qualifying Investor Alternative Investor Funds (AIFs). The Rules were finalised following a lengthy consultation process.1 Included in the discussion below are comments regarding certain issues that arose during the consultation process.
While other countries do permit the establishment of loan origination funds, these funds are not subject to such a detailed and prescriptive regulatory process as in Ireland. Time will tell whether: managers embrace the certainty offered by the Irish regime; other jurisdictions (either subject to legislative prompting or of their own accord) follow the Irish lead; or those jurisdictions with less prescriptive regimes continue to hold sway. The question is of interest to policy makers and a recent report by the European Securities and Markets Authority (ESMA) commented that “this fledgling activity should develop within a harmonised EU framework that has appropriate risk mitigants in place”.2
The draft Rules would have defined a “Loan AIF” as a “qualifying investor AIF which issues loans”. However, the Rules as finally adopted include a broader definition – providing that a Loan AIF “shall limit its operations to the business of issuing loans, participating in loans, participations in lending and to operations directly arising therefrom, including handling assets which are realised security, to the exclusion of all other business”.
This description specifically incorporates the ability to acquire loans by way of assignment in a secondary market and to participate in loans.
The Central Bank’s feedback statement also clarified that “Treasury management and the use of derivatives for hedging purposes fall within ‘operations directly arising therefrom’”. This clarification is helpful as it makes the Loan AIF regime more widely applicable.
The Central Bank did clarify that a Loan AIF could not invest in other assets such as debt or equity securities, and suggested that a separate sub-fund within the umbrella could be established for such strategies. In addition, a credit fund could be established within an umbrella that would invest in a Loan AIF on a feeder fund basis. It is hoped that the Central Bank will be open to consider other credit strategies within a Loan AIF structure as the product settles down, and that the Central Bank considers representations by the funds industry with regard to the use of such strategies.
Credit Granting, Monitoring and Management
The Rules require Loan AIFs to establish and implement “bank”-level policies and procedures around credit issues, focusing on ten separate headings, broadly in line with similar requirements for credit institutions. These are:
- Risk appetite statement;
- The assessment, pricing and granting of credit (including criteria, governance and decision making, committee structures);
- Credit monitoring, renewal and refinancing (including criteria, governance and decision making, committee structures);
- Collateral management policy;
- Concentration risk management policy;
- Valuation, including collateral valuation and impairment;
- Credit monitoring;
- Identification of problem debt management;
- Delegated authority; and
- Documentation and security.
It should be noted that while the Rules state that procedures, policies and processes are required to be implemented by the Loan AIF, the reality is that this obligation will fall onto the AIF Manager (AIFM). The Central Bank has clarified that while its regulatory writ applies to Irish AIFs, such AIFs may have a non-Irish AIFM over which they would have no regulatory control.
The Central Bank will expect a level of engagement with the AIFM, irrespective of domicile, with regard to the prescribed policies and procedures. This engagement will be outside of the normal 24-hour AIF authorisation process and should be factored into any AIF approval timeline.
Due Diligence by Investors
In its research, the Central Bank determined that “due diligence by investors appears ... to supplement reliance on prospectus disclosure to a unique degree” and the rules are designed to ensure that it is “done in an orderly way”.
The Rules provide that, where an AIFM intends to provide access to its records/staff for due diligence, it must:
- do so on a non-discriminatory basis;
- not materially misrepresent the business of the Loan AIF;
- ensure compliance by a senior manager who must be satisfied that “a reasonable person relying on the access provided would not be influenced to invest in [the Loan AIF] because of lack of access to information”; and
- not conceal or fail to disclose important information.
While the AIFMD indicates that preferential treatment may be accorded by an AIFM to one or more investors provided that such treatment “shall not result in an overall material disadvantage to other investors”, the Central Bank indicated that it is not persuaded that there is any legitimate reason why preferential access should be provided. However, to address issues raised during the consultation, the Rules provide that once all unitholders are aware of the due diligence possibility, “the onus is on the unitholders to pursue this opportunity. It may arise therefore that some unitholders will have put resources into due diligence processes while others have chosen not to.”
The consultation process highlighted diversification as an important risk mitigant for Loan AIFs. The Central Bank had floated a proposed exposure limit to any one borrower of 10%, but the Rules as adopted provide for a borrower exposure limit of 25% of the Loan AIF’s assets, to be achieved within a specific timeframe that is not prescribed by the Rules. If this limit is not met within the stated timeframe for reasons beyond the control of the Loan AIF, then investor consent must be sought to enable the Loan AIF to continue to operate until the diversification level is reached.
The Rules confirm that the diversification limits will not apply to a Loan AIF that has reached its end-of-life phase and is closing out positions. The Loan AIF documentation should reflect this.
The Rules prohibit loans to natural persons, the AIFM or related entities, other funds of any type, institutions (with some exceptions) and persons intending to invest in equities or other traded instruments or commodities, as the Central Bank is concerned that such a structure might be used in order to circumvent the regulatory requirements. During the consultation, the Central Bank considered some other “hard-wired limits” – such as requiring loans to be fully amortised or have loan-to-value limits – but these were not included in the Rules.
The Central Bank will not permit Loan AIFs to invest in other investment funds, as this may be used to circumvent the regulatory requirements.
There are also limitations on acquiring loans from credit institutions, presumably aimed at preventing balance sheet management.
The Rules deal with the acquisition of loans and require the Loan AIF to have policies and procedures in place to monitor value and stress test the loan. In addition, the Rules contain a requirement for the Loan AIF to receive vendor warranties, including a “skin in the game” requirement of 5% of the nominal value of the loan at origination, similar to the rules in place for securitisation vehicles.
While acknowledging that “the majority of respondents were unhappy with the detailed requirements for stress testing” set out in the consultation, the Central Bank has not made any amendments to the proposed Rules. As such, Loan AIFs are required to have a comprehensive stress testing programme in place, as well as to report the results on a quarterly basis to senior management of the Loan AIF or the AIFM.
Liquidity and Distributions
Due to concerns about liquidity management, investor runs and maturity mismatches, the Central Bank requires that Loan AIFs be closed-ended. In this regard, the Central Bank has referred to the definition of a “closed-ended AIF” set out in Commission Delegation Regulation EU (No. 694/2014), which defines an “open-ended AIF” as an AIF:
the shares or units of which are, at the request of any of its shareholders or unitholders, repurchased or redeemed prior to the commencement of its liquidation phase or wind-down, directly or indirectly, out of the assets of the AIF in accordance with the procedures and frequency set out in its rules ...
A closed-ended AIF is an AIF that is not an open-ended AIF.
The Central Bank was lobbied to permit the use of the term “limited liquidity” in order to demonstrate that liquidity would be available during the lifetime of the Loan AIF – not at the request of unitholders but at “dates determined at the authorisation date, or such other dates as may be approved by the board ... without commitment and on a non-preferred basis”.
The Rules provide that Loan AIFs may only make distributions and provide for redemptions where there is available cash or liquid assets and where such distributions do not endanger the regulatory compliance or liquidity obligations of the Loan AIF.
Investor consent will be required for redemptions (but not for distributions) if the assets are valued at other than prevailing market prices.
During the consultation, the Central Bank signalled an intention to apply leverage limits to curtail “cyclical vulnerability”, while acknowledging that the imposition of leverage limits might be considered to be “gold-plating” from an AIFMD perspective. A Loan AIF “must not have gross assets of more than 200% of its net asset value” (i.e., the limit has been set at 1:1 – a Loan AIF with assets of 100 may borrow 100). This limit may be tightened to manage credit growth or threats to financial stability. The Loan AIF must consult with the Central Bank in the event of a breach.
While most respondents to the Central Bank’s Consultation Paper fundamentally disagreed with the leverage proposal, the Central Bank decided not to increase permitted leverage. The Central Bank has indicated that it will keep this limit under review if the limit prevents managers from setting up Irish Loan AIFs.
The Rules require specific disclosure as to the risks of investing in Loan AIFs, including the risk that tightening of leverage limits may impact investment strategy. The Rules also set out specific requirements for the periodic reports issued by the Loan AIF, including a breakdown of each loan and whether it is performing or subject to forbearance in line with the distressed loan criteria applied to banks. A formal reporting template will be introduced by the Central Bank.
It is notable that the Central Bank is applying its disclosure requirements to sales materials and not just the Prospectus as, typically, the Central Bank does not regulate marketing materials other than to require that they may not be misleading.
The Rules are the culmination of more than a year’s work by the Irish Central Bank and follow detailed discussions with many stakeholders and consultation with regulatory bodies such as the European Systematic Risk Board (ESRB). The Consultation Paper refers to the engagement with the ESRB, and the degree of detail in the draft Rules clearly reflects the cumulative input.
A Central Bank spokesperson commented that “In our judgment, having consulted widely, including with the ESRB, this is a substantial, detailed and robust regulatory regime.”
Other jurisdictions, such as Luxembourg and Malta, already have loan fund regimes in place. It will be interesting to see if additional domiciles follow the Central Bank’s lead, as well as the extent to which the ESRB will seek to be prescriptive in this regard.
1) For information regarding the consultation process, please refer to DechertOnPoints, After AIFMD, the Central Bank of Ireland Turns its Attention to Loan Origination Funds and A Borrower and a Lender Be! – Irish Loan Origination Funds Move a Step Closer.
2) ESMA Report on Trends, Risks and Vulnerabilities, No. 1, 2015.