In a very welcome development, the Central Bank of Ireland has launched a formal consultation exercise on the requirements it intends to impose on the origination of loans by Irish authorised funds. The consultation paper (CP 85) was published on 28 July 2014 and responses should be submitted to the Central Bank by no later than 25 August 2014.
Permitting direct lending by Irish funds is particularly timely, not least because many fund promoters point to the evident need to provide for alternative sources of funding to the real economy across Europe. The diversification of such funding sources should also result in a corresponding reduction in the concentration of credit risk within the European banking sector. While the extent of the risk mitigation measures that the Central Bank proposes to apply to loan origination funds may be viewed as somewhat cautious, these measures should be understood in the context of the dramatic stresses felt within the European financial system in the recent past and the obvious regulatory objective to avoid introducing new sources of financial stability risk.
To date, certain Irish authorised funds have been permitted to acquire or participate in loans in the secondary market (whether or not such loans are securitised or collateralised) but a general prohibition has applied on the origination of loans by Irish funds. The Central Bank has now indicated that it is relaxing its policy in this regard and the current consultation exercise is focused on the precise scope of the proposed rules to be applied to loan origination funds.
In response to representations from a number of fund promoters, the Central Bank published a Discussion Paper in July 2013 (see Central Bank Consults on Loan Origination by AIFs), inviting interested parties to offer their views on whether the prohibition should be relaxed and, if so, what requirements should be imposed by the Central Bank to address the regulatory risks associated with such funds. The Central Bank received fourteen detailed submissions in response to this paper, which have now been published on its website and can be viewed here.
In addition, in framing its proposed requirements the Central Bank consulted with specialists in this particular asset class as well as various other bodies, including other European regulators and the European Systemic Risk Board. Accordingly, it is clear that the core policy considerations underpinning the Central Bank’s proposed requirements have already been the subject of a detailed and broad ranging consultation exercise and this may well inform the Central Bank’s willingness to make fundamental changes to its proposed requirements at this stage in the process.
As might have been anticipated, the Central Bank does not envisage that loan origination funds would be available to retail investors. Accordingly, loan origination funds will only be permitted under the Qualifying Investor Alternative Investment Fund (QIAIF) regime (where investors must certify that they fall within the Qualifying Investor criteria and must make an initial investment or commitment of at least Euro100,000). Furthermore, loan origination funds must have an Alternative Investment Fund Manager (AIFM) that is authorised by the competent authorities in an EU Member State in accordance with the EU Alternative Investment Fund Managers Directive.
It should be noted that the QIAIF itself may be authorised by the Central Bank as an internally-managed vehicle. This may be an attractive structure for certain fund promoters, particularly in view of the fact that compliance with many of the Central Bank’s risk mitigation requirements will fall on the fund itself (as opposed to the manager or another service provider to the fund), which introduces its own complexities.
The Central Bank is proposing that loan origination funds will be required to limit their operations solely to the business of issuing loans, participations in lending and to operations directly arising therefrom, to the exclusion of all other activities. This will clearly restrict a fund from pursuing loan origination as part of a multi-strategy fund or, indeed, as part of a hybrid strategy. However, it may be possible to establish a dedicated loan origination sub-fund within an umbrella structure that accommodates other strategies.
Policies & procedures
The Central Bank is proposing to prescribe certain policies and procedures that loan origination funds must document and regularly update relating to items such as:
- Risk appetite
- Pricing and granting of credit
- Credit monitoring, renewal and refinancing
- Collateral management
- Concentration risk monitoring
- Valuation, including collateral valuation and impairment
- Debt management and forbearance
A loan originating fund will also be required to have a comprehensive stress testing programme in place to address a number of specified scenarios.
It is interesting to note that the Central Bank does not propose to introduce any additional rules in relation to the valuation of loan assets over and beyond the general requirement that the AIFM ensures that there are fair, appropriate and transparent valuation methodologies in place.
While the diversification requirements generally applicable to retail funds are dis-applied by the Central Bank for QIAIFs, some limited requirements in this regard are proposed for loan origination funds. In particular, the fund will be required to specify its risk diversification strategy in its prospectus and will be required to limit its exposure to any one issuer or group to 25% of net assets within a specified timeline. In the event that the fund is unable to achieve its risk diversification strategy within the timeline set out in its prospectus for reasons beyond its control, the fund must seek the approval of its unitholders to continue to operate at the level of diversification that has been achieved. While the proposed 25% rule does not strike us as being particularly onerous, we would anticipate that interested parties may wish to make representations to the Central Bank regarding the necessity and practicality of this requirement, having regard for the nature of the assets held by such funds and the sophistication or risk appetite of their target investor base.
The Central Bank is also proposing to prohibit funds from advancing loans to natural persons, other collective investment schemes or financial institutions, traders in equities or commodities and certain service providers to the fund (including its AIFM and depositary). These proposed restrictions are obviously intended to address perceived systemic financial stability risks and consumer protection concerns.
It is proposed that each loan origination fund will be required to limit leverage at all times to 200% of its total assets or such other limit as may be set by the Central Bank from time to time. In the event that this limit is breached, the fund must secure the approval of the Central Bank for a formal plan to bring the fund into compliance with the specified leverage ratio. While the proposed leverage cap does not, on the face of it, appear to be overly restrictive, we would anticipate that interested parties will want further clarification on precisely when the leverage calculation must be performed, how leverage is to be determined and what can be included in the asset calculation.
To address the risk of runs by investors, the Central Bank is proposing that loan origination funds must be closed-ended and established for a finite period. However, the fund may at its discretion, on dates to be determined at authorisation, invite redemptions without commitment and on a non-preferred basis. Furthermore, loan origination funds may only make distributions or provide for redemptions (presumably at the discretion of the fund) during its life to the extent that there is unencumbered cash or liquid assets available for distribution that will not impact the regulatory or liquidity related obligations of the fund.
Certain prescribed information must be detailed in the fund prospectus, including details of the fund’s risk/reward profile, levels of anticipated concentration, geographic and sectoral exposure. Details of the applicable credit monitoring process must be included and the prospectus must include a prominent risk warning to the effect that the Central Bank may tighten lending standards and leverage limits applicable to the fund.
The fund prospectus must also disclose whether the AIFM will provide investors with access to records and staff for the purposes of investor due diligence. Where such access is to be provided for due diligence purposes, the Central Bank is proposing that such access must be provided by the AIFM on a non-discriminatory basis. Furthermore, the AIFM must 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 fund. It is not entirely clear how the Central Bank could enforce these proposals in respect of an AIFM that has been authorised by a regulator in another EU Member State. Furthermore, aspects of the proposed due diligence rules as expressed in the consultation paper appear to us to be somewhat contradictory.
A specific Central Bank Code of Conduct will also apply where loans are made to SMEs in Ireland and, where relevant, the prospectus should draw the attention of investors to the implications of this Code.
Finally, the Central Bank is proposing requirements in terms of the details of the fund’s loan book to be included in periodic statements. This will require a breakdown to be provided in terms of loan seniority, repayment terms, loan-to-value ratios and loan performance. The Central Bank also proposes that this information be provided to unitholders at each net asset value calculation point which may prove problematic from a practical perspective. An intention to put in place similar reporting requirements to the Central Bank in respect of individual loans as currently applies to the banking sector is also noted in the consultation papers.