Associate Kerill O'Shaughnessy discusses direct lending funds in Ireland and how they can offer alternative finance for SMEs. This article first appeared in HedgeWeek.
In the aftermath of the financial crisis, the implementation of the Basel III agreement in the EU as part of the Capital Requirements Directive IV (CRD IV) legislative package has resulted in widespread deleveraging by EU banks. As a result of the limits placed on the capacity of banks to lend, small and medium-sized enterprises (SMEs) have been experiencing difficulty in accessing funding for operations, expansion and investment. Although the effects of bank deleveraging are being experienced in all of the world's major economies, the effects have been particularly sharply felt in the EU where it is estimated that bank debt accounts for 75% of third-party funding to SMEs. The EU's reliance on bank debt is in sharp contrast with other world markets such as the US where it is estimated that 80% of corporate lending is derived from capital markets.
While bank lending still dominates in Europe, there is evidence that European SMEs are increasingly turning to alternative lenders to access funding. A 9% year-on¬-year increase in European middle-market alternative lending deal flow was recorded in Q4 2015 in a survey of 42 leading alternative lenders operating across Europe1. This survey covered transactions of up to €350m in size. Notably, 83% of those transactions involved senior secured lending, rather than being limited to mezzanine or other subordinated debt structures which represent the more traditional lending structures employed by alternative lenders. This trend demonstrates that alternative lenders are moving into the lending territory of banks in the EU and targeting opportunities to provide a range of debt funding structures to SMEs.
Positive developments at European-level in recent months have re-ignited the discussion on alternative lending and the role of Europe's capital markets in providing finance to the under-serviced SME sector.
In September 2015, the European Commission published its 'Action Plan on Building a Capital Markets Union' targeting the development of a single capital market in Europe to help stimulate investment and job creation. The Commission's action plan has identified the promotion of loan origination funds while safeguarding investors and stability as one of the measures to assist European SMEs in accessing funding. The need for a pan-European framework for loan origination funds, closer integration through regulatory convergence, the removal of barriers to accessing capital markets and improvements to the European fund marketing passport system will also be assessed as part of this plan.
To contribute to the Commission's assessment of an EU framework for loan origination funds, ESMA issued an opinion in April 2016 expressing its view that such a framework would facilitate loan origination by investment funds and reduce the potential for regulatory arbitrage. ESMA examined the national practices in Member States and found that loan origination by funds is allowed in the majority of Member States subject to varying conditions. Several Member States including Ireland have established bespoke loan origination fund regimes for funds domiciled in their own jurisdiction. ESMA advocated the implementation of a level playing field for funds originating loans on a cross-border basis. ESMA also outlined the topics that should be covered by the Commission's consultation on an EU-wide framework for loan origination funds including:
- whether AIFMs of loan origination funds should be required to be fully-authorised;
- whether loan origination funds should also be subject to a specific authorisation including the assessment of the loan origination capabilities of the portfolio manager;
- whether such funds should be excluded from operations other than the origination of loans;
- whether a mandatory limit on leverage should apply; and
- whether specific requirements such as mandatory risk diversification and additional risk management systems and controls should apply.
ESMA supported the introduction of transitional arrangements should an EU framework be adopted, and recommended that the Commission assess whether changes to the Annex IV reporting requirements for loan origination funds would be appropriate in order to ensure the activities of these funds are adequately monitored.
Ireland's loan origination Qualifying Investor AIF (QIAIF) regime already reflects a number of ESMA's recommendations. Irish loan origination funds are required to be closed-ended and must disclose a risk diversification strategy which would limit exposure to any one issuer or group to 25% of net assets. Irish loan origination funds are permitted to employ leverage provided that gross assets do not exceed 200% of net assets. Loans may not be originated to natural persons, other collective investment schemes and certain connected parties.
Interest in Ireland's QIAIF as a debt fund structuring solution has increased in recent months, with a number of managers establishing loan origination QIAIFs and indirect lending QIAIFs such as fund of debt fund structures to target Irish and European lending opportunities. Managers are also raising Irish QIAIFs which benefit from the AIFMD marketing passport to target lending opportunities in the US with European investors being attracted by the prospect of higher yields as the potential for further Fed interest rate hikes increases.
Furthermore, an Irish QIAIF structured as an ICAV or an investment company is treated as a resident of Ireland for the purposes of the US/Ireland double tax treaty and thus may be eligible to claim US treaty benefits to eliminate any US tax exposure on its US lending activities and/or reduce US withholding tax on interest from 30% to 0%, subject to passing the limitation on benefits provisions in the treaty.
The appeal of loan origination funds from a borrower's perspective is clear – these funds can offer greater flexibility of debt structure, tailored terms, speed of execution and a more analytic approach to lending than conventional banks. Borrowers often perceive direct lending funds as a strategic funding partner, with follow-on funding opportunities a possibility.
Loan origination funds will also typically target a higher yield on lending than banks, and this accounts for the increased appeal of these funds to investors including pension funds seeking yield in the low interest rate environment of recent years.
The Commission is targeting Q4 2016 for the development of a co-ordinated approach to loan origination funds and a decision on whether an EU-wide framework is required. The target for achievement of capital markets union is 2019. Initiatives at EU-level in the pursuit of capital markets union over the coming months will be monitored with interest by vested parties, with the possibility of an EU-wide loan origination fund framework being widely viewed as a positive development.
Originally published by HedgeWeek.
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