In mid-2013 the Central Bank of Ireland (the “Central Bank”) issued a Discussion Paper in relation to loan origination by Irish domiciled regulated alternative investment funds. Under the rules at this time, Irish domiciled investment funds were prohibited from originating loans as part of their strategy to source assets for investment purposes. This prohibition was in place in order to mitigate the risks which the Central Bank considered applied to loan origination funds.
The Discussion Paper considered ways to facilitate effective flows of capital across the economy and to link the demand for funding from small to medium enterprises with the asset management industry. It was recognised that the asset management industry had the potential to provide an alternative lending structure to that provided by traditional bank sources.
There were further developments on 28 July 2014 when the Central Bank issued a Consultation Paper (“CP 85”) indicating its intention to allow the establishment of Irish domiciled qualifying investor alternative investment funds (“QIAIFs”) that are permitted to engage in direct loan origination. Alongside CP 85 the Central Bank also published a proposed new Chapter to the Central Bank’s AIF Rulebook applying to loan originating QIAIFs and setting out the regulatory requirements that would apply to such QIAIFs. The purpose of the additional requirements is to ensure that loan origination by investment funds takes place within a regulated framework. The additional requirements seek to ensure that the risks associated with loan origination funds are monitored and mitigated while at the same time providing an alternative source of funding for the economy.
New Regulatory Regime
On 18 September 2014, the Central Bank issued a feedback statement on CP 85 announcing that it will allow for the authorisation of loan originating QIAIFs from 1 October 2014. The Central Bank also published the final rules for the new loan originating QIAIFs in an updated version of the AIF Rulebook. Loan originating funds will only be permitted under the QIAIF regime and will be required to appoint an authorised alternative investment fund manager (“AIFM”) pursuant to the AIFM Directive. Furthermore, a loan originating QIAIF must limit its activity to the issuance of loans, participating in loans and to operations arising directly therefrom. A loan originating QIAIF will not be permitted to engage in other forms of commercial activity, nor, will it be able to pursue any other investment strategy.
The key areas applying to loan originating QIAIFs addressed in the revised AIF Rulebook relate to:
- credit granting
- monitoring and management
- due diligence by investors
- stress testing
- leverage and distributions
- leverage and disclosure
We set out below some of the key conditions which must be met under these headings:
Credit granting, monitoring and management
A party wishing to establish a loan originating QIAIF must establish and implement a variety of documented and regularly updated procedures, policies and processes in respect of a variety of credit granting, monitoring and management activities. The Central Bank rules require that the QIAIF carry out appropriate credit risk due diligence on each proposed loan prior to entering into a loan agreement as well as engaging in the regular monitoring of the overall make-up of the QIAIF’s loan portfolio.
Due Diligence by Investors
Where an AIFM of a loan originating QIAIF intends to provide access to its records/staff to an investor for the purposes of a due diligence process, the AIFM must ensure that such access is made available on a non-discriminatory basis to all unitholders. The AIFM must designate responsibility to a single person within senior management to ensure that access given is non-discriminatory.
The loan originating QIAIF will need to specify in its prospectus that it will achieve a portfolio of loans which is diversified. The QIAIF’s prospectus must state that it will limit exposure to any one issuer or group to 25% of net assets within a specified time frame. Lending is restricted to corporate lending. Loan originating QIAIFs will not be permitted to lend to individuals, connected parties, other funds, financial institutions or persons intending to invest in equities or other traded investments/commodities. There are also restrictions around the circumstances where a loan originating QIAIF can acquire a loan from a credit institution. Such restrictions will not apply if the loan has been offered to multiple parties and is acquired on arms-length terms.
A loan originating QIAIF must have a comprehensive stress testing programme. This programme must include a variety of specific requirements including a programme which identifies possible events or future changes in economic conditions that could have unfavourable effects on the QIAIF’s credit exposures. It also requires an assessment of the fund’s ability to withstand such changes.
Liquidity and distributions
Loan originating QIAIFs are to be closed ended and established for a finite period in order to mitigate against the risk of investor runs. There is scope however, subject to certain conditions, for a limited redemption facility. This allows the QIAIF discretion to invite at dates determined at its authorisation date without commitment on a non-preferred basis, requests for redemption of holdings from unitholders.
Any indebtedness of the loan originating QIAIF must have total asset coverage of at least 200%. In the event that the loan originating QIAIF breaches this limit it must, within 30 days or such longer period as the Central Bank specifies, secure the approval of the Central Bank to bring the QIAIF back into compliance with the leverage ratio.
The Central Bank rules outline minimum information which must be included in the QIAIF’s prospectus. This includes information on:
- risk and reward profile
- levels of concentration
- geographical location and sectors
- risks arising from the proposed concentration
- details of the credit assessment monitoring process
- whether the AIFM will provide unitholders or potential unit holders with access to records and staff for the purposes of a due diligence process.
The AIF Rulebook further requires that the prospectus and sales material of a loan originating QIAIF include appropriate warnings drawing attention to the risks which arise from loan origination activity. A warning must also be included drawing attention to the capacity on the part of the Central Bank to tighten lending standards and leveraged limits with the possible consequence that loan originating QIAIF may not be able to follow its investment strategy as set out in its prospectus. The AIF Rulebook also requires a risk warning drawing attention to the potential implications from the application of the Central Bank’s Code of Conduct for Business Lending to SMEs where loans are issued to SMEs operating within Ireland. The AIF Rulebook also imposes requirements as to the minimum content of periodic reports including for example, the profile of debt held.
The implementation by the Central Bank of a regulatory regime permitting regulated funds to originate loans is a very positive step for the Irish funds industry. This change in regime which will ensure that the wider corporate sector, which has witnessed a reduction in lending from traditional banking institutions, can benefit from alternative sources of funding.