Following the discussions on loan-originating funds within the European Securities and Markets Authority ("ESMA") and the recent legislative developments in many EU Member States (including Germany) and the Commission's Action Plan on Building a Capital Markets Union (CMU) in September 2015, ESMA published today an opinion to the institutions setting out its view on the necessary elements for a common European framework for loan-originating funds ("Loan-Originating AIFs"). ESMA is of the view that a common approach at EU level would contribute to a level playing field for fund sponsors and investors as well as reducing the potential for regulatory arbitrage.
ESMA's opinion addresses the Commission's Action Plan of September 2015 where the Commission had outlined its goal to work with the Member States and the European authorities to assess the need for a coordinated approach. The Commission intends to consult on the elements of an EU framework on loan-originating funds in the second quarter of 2016 (the "Consultation") and has requested ESMA's advice on the elements which should form part of such Consultation.
ESMA is of the view that the elements presented in the opinion should ideally form part of a harmonized EU framework on loan origination and hence should be further assessed in the Commission's Consultation.
ESMA states that the implementation of such a framework could be achieved in different ways, e.g. through a legislative proposal or by way of an ESMA instrument supplementing the AIFMD. ESMA sees the merit in developing a grandfathering regime and/or transitional provisions for AIFs that no longer meet the requirements of the loan origination framework.
The elements which in ESMA's view should be considered as part of a legislative framework relate to:
- authorization requirements of the AIFM and the AIF;
- requirements as to the types of AIFs which may originate loans (only closed-ended or also open ended?);
- requirements as to the types of investors which may invest in a loan-originating AIFs (also retails investors or only professional investors?);
- organizational requirements of the AIFM managing such AIFs (risk management procedures);
- leverage limitations;
- liquidity requirements (in case of open ended AIFs);
- stress testing requirements;
- diversification requirements; and
- eligible debtors requirements (no individuals, no consumers and no financing institutions or related parties as debtors).
We have summarized the above requirements as suggested by ESMA in a bit more detail:
I. The Legal Framework
ESMA's advice focuses on loan origination and does not seem to cover AIFs which buy and restructure loans. It also seems to suggest – without going into detail - that like in certain EU Member States there may be exemptions for private equity funds, venture capital funds and hedge funds to the extent they engage in loan origination.
1. Authorization Requirements relating to the Loan-Originating AIF and its AIFM
ESMA is of the view that the framework should ensure that the national competent authorities have the necessary powers to monitor, supervise, and enforce the requirements set for AIFMs and their AIFs. ESMA suggests that it should be assessed in the Commission's Consultation whether a registration of the AIFM as sub-threshold AIFM is deemed sufficient or whether a full AIFM authorization is required and/or whether further requirements should be imposed.
As to the AIF itself, ESMA states that while Loan-Originating AIFs themselves are subject to authorization requirements in certain Member States, no additional authorization requirements apply in others. ESMA leaves it open whether it deems it necessary to impose also authorization requirements with respect to the AIF itself but suggests that this should be further assessed in the Consultation.
2. Types of Loan-Originating AIFs
Because of the illiquid nature ESMA is of the opinion that loan-originating AIFs should generally be set up as closed ended vehicles without the right to redemption. It suggests, however, to further asses in the Consultation to what extent redemption rights would be acceptable.
3. Types of Investors
ESMA sees risks in making Loan-Originating AIFs available to retail investors on a general basis. ESMA states that if investments in such AIFs was open to retail investors the rules should at the very least afford protections similar to those in the ELTIF Regulation.
4. Risk Management Requirements
As Loan-Originating AIFs could be a source of systemic risk, ESMA sees a merit in establishing a risk management framework for Loan-Originating AIFs and their AIFMs which contains rules to mitigate risks arising from liquidity and maturity transformation, as well as risks related to imprudent lending.
In particular, ESMA is of the opinion that AIFMs managing Loan-Originating AIFs should be required to have specific policies, processes and procedures in place, governing among others:
- risk management procedures, taking into account specific risks arising from loan origination,
- the assessment, pricing and granting of credit (including criteria, governance and decision making committee structures),
- credit monitoring, renewal and refinancing (including criteria, governance and decision making committee structures),
- collateral management policy,
- operational risk control appropriate to loan origination,
- assessment and scoring of borrowers, valuation,
- identification of problem debt management,
- capability and experience of staff in regard to the specific tasks connected with loan origination.
5. Leverage Limitation, Liquidity and Stress Testing, Reporting
While ESMA seems to be of the view that Loan-Originating AIFs should be allowed to have a certain level of leverage, there should generally be limits to leverage. It further recommends that the Commission's Consultation should aim to assess whether Loan-Originating AIFs should, for the purposes of borrowing, rely on financing by credit institutions alone of whether other ways of financing should be open for them as well.
In case the AIFs permit redemptions liquidity requirements should be established.
ESMA deems it necessary that the AIFs should be required to conduct regulator stress tests tailored to their type and level of activity.
Finally ESMA also suggests to assess the need for changes to the AIFMD reporting requirements (Annex IV of the AIFMD Level 2 Regulation).
6. Diversification, eligible investments and eligible debtors
ESMA considers that mandatory diversification should be required while still allowing specialization of loan-originating funds.
ESMA is further of the view that Loan-Originating AIFs should not engage in short selling or securities financing transactions and they should not make use of derivatives except for hedging purposes.
Finally Loan-Originating AIFs should not be able to lend to individuals, financial institutions, collective investment schemes and the AIFM and related parties and consumers.
The requirements set out by ESMA remind very much of the requirements adopted recently in Germany. This is not surprising as ESMA has outlined key issues around loan origination that have been identified through work at ESMA level and by analysing the framework in place in Member States. Generally an EU wide harmonised legislative regime can improve legal certainty and encourage cross border business. However, the future of Loan-Originating Funds in Europe (and the acceptance and use of the new regime) will depend on whether the requirements which will be adopted end up to be reasonable and sufficiently consider the fact that AIFMs of Loan-Originating Funds are not comparable to credit institutions: they do not take deposits of retail clients (nor do the AIFs they manage) but they simply engage in investment management activities (typically for AIFs with only for institutional investors) just like other AIFs which are managed by AIFM subject to the AIFMD.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.