The framework for Ireland’s new Loan Origination Fund Structure will transform investment funds from asset management vehicles into asset creation vehicles.
Ireland’s New Loan Origination Fund Structure
The Central Bank issued an updated version of its AIF Rulebook on 18 September, 2014 to include a new section setting out a framework for Ireland’s new Loan Origination Fund (LO Fund) Structure. This new section of the AIF Rulebook is the result of a consultation process earlier this year (CP 85), which itself stems from a Central Bank Discussion Paper on Loan Origination by Investment Funds from July 2013 (the Discussion Paper).
The goal of the Discussion Paper and its resulting changes to the AIF Rulebook is to alleviate what the Central Bank termed the ‘funding gap’, that is caused by the traditional preponderance of financial intermediation going through the banking system in Europe and a sustained period of deleveraging by European banks.
The Central Bank is not alone in its desire to bring about an alleviation of the funding gap; there are a range of fund initiatives at EU level, including EU Regulations on European Social Entrepreneurship Funds and European Venture Capital Funds and the EU Commission Green Paper on European Long Term Investment Funds (ELTIFs)
Why is this new structure important?
The asset management industry has, to date, focussed on management of existing traditional asset classes or, in private equity on fostering assets, both of which involve purchasing an existing asset. While the purpose for which loans originated by an LO Fund can be used is not restricted in any way, the LO Fund is uniquely suited to enabling asset managers to act as a conduit that could funnel fund investors away from traditional asset classes into, for example, large infrastructure projects thereby achieving a balance in their portfolios which, until now, has not been achievable.
This is an entirely new departure for Irish funds. It provides a means of bringing project financiers, who need financing to get their projects off the ground, together with asset managers, and thereby transforming investment funds from asset management vehicles into asset creation vehicles.
Who can be the manager of a LO Fund?
The AIF Rulebook provides that the manager of an LO Fund must be an authorised alternative investment fund manager (AIFM). Registered AIFMs who are subject to a lighter regulatory regime than AIFMs with a full authorisation under EU Directive 2011/61/EU on Alternative Investment Fund Managers (AIFMD) are not permitted to act as AIFM of LO Funds.
The AIF Rulebook provides that the AIFM shall be either:
- an external AIFM, which is the legal person appointed by the LO Fund or on behalf of the LO Fund and which, through this appointment, is responsible for managing the LO Fund (external AIFM); or
- the LO Fund itself, which shall then be authorised as AIFM.
An internally managed LO Fund cannot be appointed as the external AIFM of another LO Fund.
What type of fund structure can be an LO Fund and can an existing umbrella establish a sub-fund as an LO Fund?
The Central Bank's requirements on LO Funds are imposed on the LO Fund itself rather than on the AIFM under the Central Bank’s powers under domestic funds legislation. This does not seem to preclude the use of unit trusts, common contractual funds or investment limited partnerships if the Manager or general partner is domiciled in Ireland but it does mean that corporate funds (Part XIII Companies and, in the near future, iCAVs ) are likely to be the structures of choice.
LO Funds must limit their operations to the business of issuing loans, participating in loans, participations in lending and to operations directly arising from these activities, including handling assets which are realised security, to the exclusion of all other commercial business. This means that an LO Fund can engage in treasury management or hedging, but it will not be able to run a hybrid investment strategy such as investing in debt or equity securities alongside loan origination.
Who can borrow from LO funds?
Generally, borrowers will be corporates who are neither financial institutions nor connected to the LO Fund nor parties connected to its service providers. Loans cannot be originated for the purpose of investment in financial instruments. Loans cannot be originated to:
- natural persons;
- certain related parties (the AIFM, management company, GP, depositary or to delegates or group companies of these);
- other funds;
- financial institutions or to their related companies (except in limited circumstances); or
- persons intending to invest in equities or other traded investments or commodities.
In addition, an LO Fund shall not acquire a loan from a credit institution under arrangements which involve:
- retention by the credit institution or a member of its group of an exposure correlated with the performance of the loan; or
- the provision of an administration, credit assessment or credit monitoring service in relation to the loan whether on an individual or portfolio basis by the credit institution or a member of its group.
That is unless the LO Fund is satisfied that the credit institution has in place, and implements, policies and procedures, which would include monitoring the net economic interest of the vendor, valuation, performance and stress testing etc.; and credit institution retains a material net economic interest of at least 5% of the nominal value of the loan as measured at origination. In other words loan vendors must have a minimum level of their own capital at risk in order for the loan sale to go ahead.
LO Funds will also be subject to the Central Bank’s Code of Conduct for Business Lending to Small and Medium Enterprises when lending to Irish SMEs.
Credit Granting, Monitoring and Management
Fund promoters should be aware that the Central Bank looks for the LO Fund to establish and implement a variety of documented and regularly updated procedures, policies and processes in respect of a variety of loan origination and maintenance activities. These policies are in addition to the policies and procedures implemented separately by the LO Fund’s AIFM and include:
- setting a risk appetite statement;
- assessing, pricing, granting credit, monitoringcredit, credit renewal and refinancing (including criteria, governance and decision making and committee structures);
- setting collateral management policies;
- setting concentration risk management policies;
- valuation, including collateral valuation and impairment;
- identification of problem debt management;
- delegated authority; and
- documentation and security.
Due Diligence by Investors
Where an AIFM intends to provide access to its records/staff to an investor for the purposes of the investor carrying out due diligence, the AIFM must ensure that the access is made available on a non-discriminatory basis to all investors and not be structured so to materially misrepresent the business of the LO Fund. The AIFM is required to nominate a single senior manager to ensure that information provided is non-discriminatory.
It is worth noting that the Central Bank is not obliging LO Funds to provide due diligence or what should be included in due diligence disclosures, merely that it be non-discriminatory. If it does provide access to records then the AIFM of the LO Fund shall not intentionally or negligently conceal or fail to disclose information that a reasonable person would be likely to have considered important in considering an investment in the LO Fund.
LO Funds must disclose in their prospectus that they will achieve a portfolio of loans which is diversified and must state that it will limit exposure to any one issuer or group to 25% of net assets within a specified time frame. The LO Fund should not intentionally breach this level of diversification. If the LO Fund is unable achieve this level of diversification within the set timeframe, the LO Fund will need to go back to its investors and seek approval to operate with the level of diversification actually achieved. If investors do not approve the proposal, the LO Fund must terminate.
LO Funds must have comprehensive stress testing programmes covering a number of key risks including:
- assessment of possible events or future changes in economic conditions that could have unfavourable effects on the LO Fund’s credit exposures and its ability to withstand such changes;
- assessment of transactions and aggregate exposures across all forms of counterparty credit risk at the level of specific counterparties in a sufficient timeframe to conduct regular stress testing; and
- exposure stress testing of principal market risk factors such as interest rate, FX and credit spreads for all counterparties should be carried out at least monthly.
The Central Bank also requires at least quarterly multi-factor stress testing under a variety of proscribed scenarios which must be addressed. The results of these tests must be reported, at least quarterly, to management of the LO Fund and LO Fund’s AIFM.
Liquidity and Distributions
The Central Bank does not consider it appropriate that LO Funds, due to the nature of their assets, should have to face redemptions. Therefore, it has decided that LO Funds must be closed ended for a finite period. Eventually this may change but in the meantime an LO Fund may, at its sole discretion, invite redemptions at dates determined at its inception and/or other dates without commitment and on a non-preferred basis. An example would be on the maturity of a loan when the LO Fund might either invite redemption requests or simply make a pro rata distribution to investors.
Either way, distributions or redemptions may only be made during the life of an LO Fund to the extent that there is unencumbered cash or liquid assets available and doing so will not endanger the regulatory compliance or liquidity related obligations of the LO Fund.
Interestingly, whereas invited redemptions require a full market valuation, this is not required for pro rata distributions to investors.
LO Funds may use leverage but up to 200% of NAV only, unless, presumably on application the Central Bank agrees to a higher level. Interestingly, the Central Bank has clarified in CP85 that it considered this limit to apply as an ongoing limit (rather than at the time leverage is incurred only) , which means that changes in market conditions bringing about reductions in the value of the assets will necessarily trigger a need to manage leverage so that the limit is not breached.
Where there is a breach of leverage limit, LO Funds must seek Central Bank approval of a formal plan to bring the fund back into compliance.
Bear in mind too, that the Central Bank does retain the capacity to tighten lending standards and that action taken by the Central Bank on a macro level can impose across the board limits, impacting upon each LO Fund's operations.
Disclosure to Investors
The LO Fund’s prospectus must include:
- a prominent risk warning in relation to the unique risks involved in loan origination;
- information on risk and reward profile, on levels of concentration, geographical location and sectors as well as risks arising from the proposed concentration;
- information on whether the AIFM will provide investors with access to records and staff for the purpose of a due diligence process together with the terms and conditions under which such access will be made available;
- details of the credit and monitoring process described above;
- a statement explaining that the Central Bank may tighten lending standards and leverage limits,which may have an impact on the LO Fund’s ability to follow its investment strategy (this statement must also be included in any sales materials); and
- 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, when loans are issued to SMEs operating within Ireland.
There are also a range of technical requirements in relation to debt composition that must be included in periodic reports, e.g. breakdown of originated loans between senior secure debt, junior debt and mezzanine debt; loan-to-value for each originated loan etc.
Ireland's LO Fund initiative makes Ireland ready for when the proposed ELTIF regulation becomes law. It will be interesting to see how the Central Bank’s LO Fund structure requirements evolve in the run up to the implementation of the EU Commission’s ELTIF proposal.