In mid-2013 the Central Bank of Ireland (CBI) issued a Discussion Paper in relation to loan origination by Irish domiciled regulated alternative investment funds.
On July 28, 2014 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”) which can engage in direct loan origination.
In order to mitigate the risks which the CBI considers apply to loan origination funds (the risk of regulatory arbitrage; the risk of runs; contagion risk with the banking sector; and the risk of excessive credit growth and pro-cyclicality) it proposes to impose quite a number of restrictions or constraints on such QIAIFs.
Loan funds are not new to the Irish environment but, to date, have only been able to acquire loans or participations in the secondary market as there has been a general prohibition on Irish regulated funds originating loans. That is what is now set to change.
This article is a summary of a more detailed briefing prepared by Dillon Eustace which can be accessed at the following link: Loan Origination QIAIFs-Central Bank Consults
Key features of the Central Bank’s proposal to allow loan originating QIAIFs include:
(i) QIAIFs with authorised AIFM
Loan originating funds will only be permitted under the QIAIF regime and will require an authorised AIFM. It will not be possible to avail of the registered QIAIF option. The QIAIF may be the authorised AIFM itself (as an internally managed vehicle) and may appoint an external credit/portfolio manager or the QIAIF may appoint an external AIFM which either itself carries on the credit management process or alternatively appoints a credit/portfolio manager to do so.
(ii) Legal Structure
Given the activity of lending, the sole activity requirement and the imposition of new regulatory requirements on the QIAIF itself, it seems clear that only QIAIF type investment companies (and not unit trusts, CCFs or ILPs) will be suitable for establishment as loan originating funds.
(iii) Sole Activity
A loan originating QIAIF must restrict its activity to the issuance of loans. It will not be able to engage in other forms of commercial activity nor will it be able to pursue any other or even a hybrid investment strategy. Loan origination must be its sole activity. It may, however, be possible to have a loan originating QIAIF as one dedicated sub-fund of a QIAIF umbrella which has other non-loan originating sub-funds.
(iv) Prohibited Loans
Loans cannot be originated to natural persons; to certain related parties (the AIFM, management company, GP, depositary or to delegates or group companies of these); to other funds; to financial institutions or to their related companies (save in limited circumstances); nor to persons intending to invest in equities or other traded investments or commodities.
(v) Portfolio Diversification
Loan originating QIAIFs are to be subject to portfolio diversification rules, unlike other types of QIAIF. Such a fund will need to specify in its prospectus that it 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. To the extent that there is a failure to achieve that strategy within the set timeframe, the QIAIF will need to go back to its investors and seek approval to continue with the level of diversification actually achieved. In the event that the investors do not approve the proposal, the QIAIF must terminate. There should be no intentional breach of the risk diversification strategy.
We view this diversification rule as unnecessary. Portfolio level diversification is generally seen as an investor protection mechanism but is not required for QIAIFs – portfolio diversification has been required for retail targeted products only.
Leverage is limited to 200% - any indebtedness by the loan originating QIAIF must have a total asset coverage of at least 200%, but there seems a capacity for other limits to apply (these could of course be higher or lower and may be for a particular fund or for a class of loan originating QIAIF).
(vii) Liquidity and Distributions
In the context of concerns regarding runs, CBI proposes that loan originating QIAIFs:
- be closed-ended and established for a finite period. The QIAIF however may have discretion to invite at dates determined at the authorisation date and without commitment and on a non-preferred basis request for redemption of holdings from unitholders; - only make distributions or provide for redemptions during its life to the extent that there is unencumbered cash or liquid assets available for distribution or redemption purpose and such distribution redemptions will not endanger the regulatory compliance or liquidity related obligations of the loan originating QAIF.
(viii) Credit Granting, Monitoring and Management
A party wishing to establish loan originating QIAIFs needs to appreciate that CBI proposes that the QIAIF itself must establish and implement a variety of documented and regularly updated procedures, policies and process in respect of a variety of credit granting, monitoring and management activities, including the setting of a risk appetite statement, the assessment, pricing and granting of credit as well as the monitoring of credit and its renewal and refinancing (including in both cases criteria, governance and decision making and committee structures), collateral management policies, concentration risk management policy, valuation, including collateral valuation and impairment, credit monitoring, identification of problem debt management, forbearance, delegated authority, documentation and security.
(ix) 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 on the AIFM, the AIFM must ensure that such access is made available on a non-discriminatory basis to all investors and not be structured so to materially mis-represent the business of the loan originating QIF. (x) Stress Testing
A loan originating QIAIF must have a comprehensive stress testing programme which includes 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 fund’s credit exposures. It also requires an assessment of the fund’s ability to withstand such changes.
(xi) Disclosure to Investors
Certain minimum information must be included in the QIAIF’s prospectus, including information on risk and reward profile, on levels of concentration, geographical location and sectors as well as risks arising from the proposed concentration.
It requires a prominent risk warning and that the capacity on the part of the CBI to tighten lending standards and leveraged limits be expressly drawn to the attention of investors in the prospectus and all sales materials (and the impact that may have on the QIAIF in following its investment strategy). It also requires a risk warning drawing attention to the potential implications from the application of CBI’s Code of Conduct for business lending to SMEs (where loans are issued to SMEs operating within Ireland).
We believe that the CBI’s proposal to permit Irish domiciled QIAIF’s to originate loans is an important development for the Irish funds industry which provides new opportunities for fund managers. We await the results of this consultation process from the CBI and we will provide further updates on this development as they are provided by the CBI.
DISCLAIMER: This document is for information purposes only and does not purport to represent legal advice. If you have any queries or would like further information relating to any of the above matters, please refer to the contacts above or your usual contact in Dillon Eustace.
Paul Moloney Dillon Eustace Hong Kong