The changing regulatory regime for banks has subjected them to pressure to shrink their loan books, particularly longer term liabilities. This funding gap presents an opportunity for non-banks, outside this regulatory regime, looking for diverse investment opportunities with UK borrowers.
Globally, there is increasing activity in the non-bank lending market (particularly in the form of private placements). The market for non-bank lending is already well established in the USA and in Germany (Schuldschein). In the UK, the market is still developing. Tighter regulation and increased regulatory capital requirements placed on traditional lending banks in the UK has led to a growing trend of non-bank lenders, such as pension, insurance and other funds, looking to diversify their assets, and plugging the funding gap for UK corporates.
This briefing provides an overview of the UK regulatory framework and highlights some of the practical considerations in non-bank lending transactions involving a UK borrower / issuer.
What do we mean by non-bank lending?
The Financial Stability Board described shadow banking as “credit intermediation involving entities and activities (fully or partly) outside the regular banking system”. This is a very wide definition which encompasses a very broad range of investment activities.
The aim of this briefing is to give an overview of the issues relating to the placement of debt with a single or small group of non-bank investors looking for alternative, often long tenor, investment opportunities who tend to be reinvestment risk adverse.
Why is non-bank lending significant?
The changing regulatory regime for banks has subjected them to pressures to shrink their loan books, particularly the longer term liabilities.
This funding gap presents an opportunity for non-banks outside this regulatory regime looking for diverse investment opportunities. Non-banks may provide an important alternative source of funding for sectors requiring long debt tenors and able to offer inflation linked or fixed rate returns, such as energy and infrastructure, or those offering comfortable levels of security, such as real estate and asset finance.
Is any authorisation required under English law?
In the UK, wholesale lending activity is generally unregulated. However, the position is different in relation to transactions or arrangements involving debentures and other instruments creating or acknowledging indebtedness. Persons carrying out certain activities in relation to a these types of instruments investment must be authorised under the framework set out in under the Financial Services and Markets Act 2000, unless they fall within an exemption.
What regulatory capital requirements and investment restrictions may apply to non-bank lenders?
Regulatory capital requirements are not limited to banks. Insurers are also required to maintain sufficient capital to support their insurance business and to date have been restricted to investing their funds in admissible investments in order for those investments to count towards their regulatory capital requirement. From January 2016, Solvency II will replace the current regime with a ‘prudent person principle’ requiring insurers to invest their assets so as to ensure the security, quality, liquidity and profitability of their portfolio as a whole. This includes an obligation for their investment portfolio to be adequately diversified. However, insurers can only invest in assets whose risks they can properly identify, measure, monitor, manage, control and report. Solvency II encourages insurers to match their investments more closely to their liabilities, for example asset managers of a life insurance fund will be looking for investments with similarly long investment tenors, a factor likely to encourage insurers to lend across longer debt tenors common to energy and infrastructure project finance. Solvency II uses a risk-based capital requirement; this means that the risks inherent in the assets held by an insurer are taken into account in assessing its capital requirement. The challenge will be for insurers to investigate fully and determine the risk profile of their investments with Solvency II offering the option of an approved internal model, something which traditional banks have significant experience of.
Funds and/or fund managers may be subject to particular restrictions on their ability to lend (whether through investment in debt instruments or otherwise). These restrictions may be contained in applicable law or regulation (such as the investment restrictions applicable to funds regulated by the Undertakings for Collective Investment in Transferable Securities Directive and other types of regulated funds) and/or may be set out in the fund’s constitutional documents.
The trustees of pension funds are also subject to statutory investment restrictions in relation to funds held in occupational pension schemes. The Occupational Pension Schemes (Investment) Regulations 2005/3378 require trustees and asset managers of pension funds to exercise their discretion to invest generally in the best interests of scheme members and beneficiaries; to ensure the security, quality, liquidity and profitability of the portfolio as a whole; and to invest in a manner appropriate to the nature and duration of the expected future retirement benefits payable under the scheme, predominantly in investments admitted to trading on regulated markets (and where not admitted to trading, kept to a prudent level). In addition, the regulations require assets of the scheme to be properly diversified to avoid excessive reliance on any particular asset, issuer or group of undertakings and so as to avoid accumulations of risk. HMRC guidance specifically permits a registered pension scheme to make loans to third parties (persons not connected to members or sponsoring employers) provided they are made on an arms’ length basis at a market rate.
Potential tax issues
Tax treatment is often a significant consideration in deal structuring. There is a 20 per cent withholding tax on payments of yearly interest made by a UK borrower where that interest has a UK source. There are already numerous exemptions to this, the principal ones being where the lender is a UK bank (or UK branch of an overseas bank), where the lender is a UK resident company or a UK branch of a non-resident company, or where the lender is resident in a jurisdiction that has an appropriate double taxation treaty with the UK that reduces the interest withholding tax to zero. There is also an exemption for listed bonds (known as the ‘quoted Eurobond’ exemption) that is often used where it is intended that the financing may be sourced from a wider net of investors. The quoted Eurobond exemption has to date involved the additional costs of listing as well as certain disclosure requirements and the additional time associated with issuing listed securities.
The Chancellor’s announcement on 3 December 2014 in the Autumn Statement contained good news for non-bank lenders in the form of a new targeted exemption from withholding tax for interest on private placements. This is expected to be a further boost to non-bank lending in the UK. Under the proposals, there will be a new exemption applying to payments of interest on a ‘qualifying private placement’. A qualifying private placement is defined as a security which:
- is issued by a company and is a ‘loan relationship’ (effectively a loan of money) with the company as borrower
- has a tenor of at least 3 years
- is unlisted.
It is also expected that the minimum denomination will be £100,000, that the security must not be subordinated to other unsecured debt, have a maximum tenor of 30 years and have no right to conversion into shares, although these details remain to be confirmed.
Further conditions are likely to be introduced via secondary legislation. It is currently proposed that the additional conditions will relate to both the issuer and the holder of the securities. Some detail is given on the current expectation of these conditions but it is subject to change as the legislation progresses through Parliament.
Conditions relating to the issuer: It is currently expected that, in order to qualify for the exemption, the issuer of the securities must:
- be a trading company (which would, it is hoped, include the holding company of a trading group), rather than an investment company
- have qualifying issuances of between £10million and £300million.
Conditions relating to the holder of the security: These conditions are likely to be as follows:
- the holder must not be connected with the issuer
- the investor must be a qualifying UK-regulated financial institution or the equivalent in other territories
- the investor must be based in an appropriate qualifying territory (which is generally defined by reference to characteristics of the double taxation treaty between that territory and the UK).
There are also likely to be anti-avoidance rules preventing artificial structuring of transactions to obtain the benefit of the exemption.
In addition, in the case of a UK borrower, caution will need to be exercised to ensure that where the debt carries certain characteristics that are redolent of equity (such as profitdependent interest rates, rights of conversion into equity, or arguably in some circumstances, limitations on recourse), this does not cause the instrument to be subject to UK stamp duty on transfer. Stamp duty is chargeable at a rate of 0.5 per cent of the consideration for the transfer. This or stamp duty reserve tax will generally not be relevant in the case of straightforward debt financings.
Loan or bond?
Whether a transaction is structured as a loan or as an issue of debt securities is an important consideration to be determined early-on in the transaction. Factors influencing the choice of structure include:
- tax treatment – as noted above, withholding tax is an important driver, and in addition, transfers of securities may attract stamp duty
- capacity – whether the investor has the necessary power either to lend or purchase securities. Funds may have limits in their constitutional documents or investment criteria with respect to the nature and type of investment they are able to make
- regulatory treatment – as noted above, wholesale lending is not generally regulated in the UK, but debt securities are likely to be regulated investments. From the issuer’s perspective, companies that are not public limited companies are limited in their abilities to offer debt securities to the public
- disclosure – offers of bonds to the public require the publication of a prospectus, and have ongoing disclosure requirements
- transaction cost and timing – initial transaction costs for standalone bond issues may be higher, although larger bond issues can make transaction costs smaller relative to proceeds raised. Issuing bonds under existing note programmes can also be less costly. Public bond issues tend to have a longer turnaround time than do loan agreements, which is driven by marketing ‘roadshows’ and due diligence requirements
- credit analysis – the credit analysis for loans is conducted in house by banks or funds, while rated bond issues also depend on external credit rating agencies (which can add to transaction cost and timing).
Investors may prefer to purchase bonds because of an established secondary market, and existence of supporting infrastructure. Borrowers / issuers may find it advantageous to issue bonds instead of entering into a loan because the capital markets allow for direct access to a large, diverse, and potentially international pool of investors and traditionally bonds carry a lighter set of undertakings and financial covenants than those found in loans.
When documenting transactions for non-bank lenders, there are various factors requiring consideration which differ from traditional bank loans. Non-bank lenders often prefer a fixed rate of return and may want to restrict prepayments, or if permitted, require make-whole provisions to ensure that the expected rate of return from the investment over the full term is achieved. This may increase the cost of refinancing compared with traditional bank lending.
In addition, non-bank lenders are unlikely to have the administrative back-office function of a bank or the ability to hold and process payments. As a result, loans are often advanced on a bilateral basis or privately placed with a small group of lenders with perhaps just a paying or calculation agent rather than a facility agent, and it is helpful to draft on the assumption that limited consents, waivers or amendments will be feasible over the term as the monitoring function will be limited. It is likely that any loan from a non-bank lender will be a simple term loan with minimal drawdowns due to their restricted ability to keep capital available and bullet repayment at the end of the term or simple amortisation. Other ancillary facilities such as overdrafts, revolving facilities or hedging, if required, are likely to be provided by a traditional lender.
Non-bank lenders dealing with corporate borrowers may also request a most favoured nation or more favourable terms provision so that if a borrower or issuer grants more favourable financing terms to another creditor, it must also offer those more beneficial terms to the initial lender.
The use of standard form documentation has been partly credited with the success of the USA non-bank lending market. In order to reduce barriers to non-bank lending in the UK and Europe, the Loan Market Association (LMA) has recently published precedent loan and bond documentation adapted for use in pan-European private placement (PEPP) transactions, based on a simplified version of the LMA investment grade facility templates which will be fairly familiar to the banking market. The LMA PEPP documentation is intended to be used for corporate lending to investment grade borrowers or groups on a guaranteed and unsecured basis. It will need significant adaptation for use in other markets and many key terms, such as make-whole provisions, have been left for the parties to specify. However, the LMA PEPP documentation does provide a useful framework and is a positive step towards the standardisation of documentation for private placements in the UK and more generally across Europe.