Dechert commented on the Central Bank's Discussion Paper on Loan Origination by Investment Funds in our OnPoint “After AIFMD, the Central Bank turns its attention to loan origination funds” (July 2013).
The Central Bank received 14 responses to the Discussion Paper. Subsequently, the Central Bank has consulted widely and the very welcome outcome of these deliberations is that they are minded to permit the establishment of alternative investment funds ("AIFs") whose sole strategy is loan origination. The Central Bank has published two documents. The first is a Consultation Paper (CP 85) which sets out a number of questions for consideration and the second is the draft Amendments to the Central Bank’s AIF Rulebook (the "draft Rules") for the new category of funds to be known as “loan originating Qualifying Investor Alternative Investment Funds” which for the purpose of this OnPoint will be called “Loan AIFs”. Loan AIFs will provide a valuable non-bank financing option within a regulated framework with inbuilt investor protections and safeguards aligned with banking practices.
It is pleasing to note that while the Discussion Paper ran to a lengthy 35 pages, the Consultation Paper is a much more manageable 6 pages.
A copy of the Discussion Paper and the draft Rules amendments can be found on the Central Bank’s website.
The consultation remains open until 25 August 2014. The Central Bank invites comments from all stakeholders and Dechert would be happy to convey the views of stakeholders to the Central Bank.
This OnPoint will follow the order of the draft Rules and will comment on the aspects of the Consultation Paper relevant to each of the draft Rules.
The draft Rules define a Loan AIF as a “qualifying investor AIF which issues loans”.
It goes on to provide that a Loan AIF “shall limit its operations solely to the business of issuing loans, participations in lending and to operations directly arising therefrom, to the exclusion of all other business”
This limitation appears to be very prescriptive and further analysis should be carried to ensure that loan origination can be used in conjunction with other debt or credit strategies.
Credit granting, monitoring and management
As envisaged in the Discussion Paper, the Central Bank will expect Loan AIFs to establish and implement “bank” level credit policies and procedures around credit issues focussing on ten separate headings which are broadly in line with similar requirements for credit institutions.
The Central Bank asks stakeholders if they agree with the approach adopted?
It should be noted that most of the draft Rules, which require the establishment and implementation of procedures, require these to be put in place by the Loan AIF and not the AIFM.
It does not appear that the Central Bank will be looking to review the prescribed policies and procedures but given their novel nature, some degree of engagement is to be expected.
The proposed Central Bank regime would appear to be the first Loan AIF regime that seeks to actively regulate loan origination funds. In other jurisdictions, there are no overarching rules - merely a lack of a prohibition implying reverse consent. It will be interesting to see if other jurisdictions follow suit or seek to arbitrage their less prescriptive regime and which regime investors and managers will prefer.
Due diligence by investors
Due diligence was not an area highlighted in the Discussion Paper but in its research, the Central Bank determined that “due diligence 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 draft 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.
The Central Bank asks whether they should include this Rule and whether it is a useful protection measure?
The Consultation Paper refers to the AIFMD provisions dealing with equality of treatment for investors and where preferential treatment may be accorded. These obligations are well understood by stakeholders. The Central Bank has legitimate concerns that more favourable or discriminatory treatment may be afforded as the sector grows. However, introducing terms like “non-discriminatory”, “materially misrepresent” and “reasonable person” tests would appear to apply an unnecessary and overly legalistic overlay to what is a clearly understood concept – i.e. to treat all investors fairly. We would suggest a mere cross reference to the AIFMD requirements. Here, the obligations are those of the AIFM rather than the Loan AIF.
The Discussion Paper highlighted diversification as an important risk mitigant, particularly for loan funds. The Discussion Paper floated an exposure limit to any one borrower of 10%. The draft Rules do not go this far and provide for an exposure limit of 25% of its assets to be achieved within a specific timeframe. 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 Central Bank asks stakeholders if they think this is the right approach?
The Consultation Paper indicates that the solution that it has devised guards against an overly concentrated strategy. There are well established principles and guidance for dealing with both advertent and inadvertent breaches that are familiar and known to industry stakeholders. For breaches which occur beyond the control of the Loan AIF (an “inadvertent breach”), the AIF Rulebook already provides that “if these limits are subsequently exceeded for reasons beyond the control of a Qualifying Investor AIF or as a result of the exercise of subscription rights, the Qualifying Investor AIF must record such matters and adopt as a priority objective the remedying of that situation, taking due account of the interests of its unitholders.”
The draft Rules also prohibit regulated loans to natural persons, AIFMs or related entity, other funds, institutions (with some exceptions) and to persons intending to invest in equities or other traded investments or commodities. In its Discussion Paper, the Central Bank considered some other “hard-wired limits” such as requiring loans to be fully amortised or having LTV limits, but these have not been added.
There are also limitations on acquiring loans from credit institutions presumably aimed at preventing balance sheet management.
The draft Rules also deal with the acquisition of loans and requires the Loan AIF to have policies and procedures in place to monitor value and stress test the loan and to have received vendor warranties including a "skin in the game" requirement of 5% of the nominal value of the loan at origination for vendors.
The draft Rules require Loan AIFs to have a comprehensive stress testing programme in place and they are required to be report the results on a quarterly basis to senior management (of the Loan AIF or the AIFM?). It is worth noting that while stress testing is clearly something of considerable importance in the wider banking sphere; it was not something that was discussed in much detail in the Discussion Paper.
Liquidity and distributions
Because of concerns about liquidity management, investor runs and maturity mismatches, the Central Bank had flagged in the Discussion Paper that the Loan AIFs may be closed ended and this has been confirmed. However, while the funds must be structured as closed ended funds and have a finite period, they may have discretion to invite, “at dates determined at the authorisation date without commitment and on a non-preferred basis, requests for redemption of holdings from unitholders”.
The draft Rules provide that Loan AIFs may only make distributions and provide for redemption 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 or distributions if the assets are valued at other than prevailing market prices.
The Central Bank does not appear to raise any questions regarding its liquidity proposals.
The draft Rules provide for a relatively illiquid Loan AIF structure. Clarification will be needed with regard to the statement that redemption dates will need to be pre-determined. It is difficult to see how these dates will be known in advance. We would query the feasibility of obtaining investor consent where assets cannot be valued at prevailing market prices as there will not be a ready market for most private loans in a fund portfolio and that is why Loan AIFs are generally closed ended. To address this, it will be necessary to ensure flexibility e.g. by providing that distributions are made out of available cash to all investors pro-rata to their original commitment. Having an investor vote to determine whether a redemption should take place may pit investors with a particular need against another class with regard to an issue (liquidity) for which the AIFM has statutory responsibility.
In the Discussion Paper, 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 “golf-plating” from an AIFMD perspective. The limit has been set at 1:1 i.e. 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.
The Central Bank asks stakeholders do they think this is the appropriate level of leverage and whether there is sufficient detail around the process in respect of a breach?
A key issue for the consultation is whether a greater degree of leverage should be provided for. The Central Bank will need convincing reasons if it is to change from the intended leverage limit but many institutional investors may prefer a greater level of leverage.
The draft Rules require specific disclosure on the risks of investing in Loan AIFs, including the risk that tightening of leverage limits may impact the investment strategy. The draft Rules also set out specific additional reporting requirements, including a breakdown of each loan and whether they are performing or subject to forebearance in line with the criteria applied to banks with regard to distressed loans.
The Central Bank asks stakeholders if this is the correct approach.
While the disclosure requirements do not give cause for concern, what is significant is the fact that the Central Bank has sought to apply its requirements to sales materials and not just the Prospectus.
The draft Rules and Consultation Paper 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. It will be interesting to see if other domiciles follow the Central Bank lead and the extent to which the ESRB will seek to be prescriptive in this regard.
Despite the Rules being in near final form, it is clear that there are issues that are worth addressing as part of the Consultation which, as we advised, closes on 25 August 2014.