The German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, "BaFin") today announced changes to its administrative practice with regard to loan origination by investment funds (Reference number WA 41-Wp 2100 – 2015/0001). Loan origination, which for investment funds was deemed inadmissible in the past, shall in future generally be viewed as a permissible investment activity for certain investment funds with qualified investors. BaFin however, in light of upcoming legislatory changes to the German Capital Investment Act (Kapitalanlagegesetzbuch, "KAGB"), has made certain restrictive recommendations which should be adhered to today already.
I. Executive Summary
The new administrative practice can be summarized as follows:
- Loan origination (including restructuring of loans) by Spezial-AIFs (i.e. funds with only institutional investors) is permissible.
- It is insofar irrelevant whether the funds are managed by a fully licensed fund manager or by a "sub-threshold" fund manager registered pursuant to Section 44 KAGB.
- Leverage is permissible to a moderate extent.
- Loans may not be issued to consumers.
- The fund manager of the loan originating fund must meet certain risk management and organizational requirements.
- The loan origination must be free of conflicts of interest.
- The fund must maintain a liquidity reserve.
- In our view, loan origination by EU (and likely third-country) funds to German undertakings should be permissible under the same conditions.
II. Previous Administrative Practice
The origination of loans for the account of or by investment funds ("Funds") was, with few exceptions, generally not allowed (cf. Section 93 para. 4 KAGB). In Germany the origination of loans was only permissible with a respective banking license under the German Banking Act (Kreditwesengesetz, KWG).
III. Legal Situation in Europe
With reference to the European regulatory legal environment, BaFin has now changed its administrative practice and argues as follows:
- The AIFM Directive does not generally contradict the permissibility of loan origination by Funds, as the AIFM Directive essentially does not include any product rules.
- In recent European legislation however, i.e. in the EuVECA Regulation, the EuSEF Regulation as well as the draft of the ELTIF Regulation, the permissibility of loan origination for account of Funds is generally foreseen (Art. 3 (e) ii) of the EuVECA Regulation; Art. 3 (e) iv) of the EuSEF Regulation; Art. 9 of the draft of the ELTIF Regulation).
- The European supervisory authority, ESMA, therefore currently deems loan originating funds permissible.
- Whereas in some countries lending is generally possible without any restrictions, loan originating funds are permitted subject to meeting certain requirements in other countries. As these Funds can be generally marketed into Germany on a cross-border basis, BaFin is currently striving for a Europe-wide uniform regulation with regard to credit funds.
IV. The New Administrative Practice
1. Loan Origination
BaFin now understands loan origination as well as loan restructuring to be part of the collective asset management. Provided these activities are in compliance with KAGB product rules, they will generally be permissible.
As a result, the KAGB will henceforth supersede the KWG (cf. the field exemption Section 2 para. 1 no. 3b and para. 6 no. 5a KWG).
Restructuring of loans, i.e. changes to the conditions of a loan after its acquisition, which in the past was deemed as unauthorized loan origination, is now permissible (see below).
2. German Funds caught by the new administrative practice
Loan origination will however only be permissible for Funds which under the KAGB are subject to no or virtually no product rules. According to BaFin, this includes the following Funds:
- open-ended Special-AIF under Section 282 KAGB;
- closed-ended Special-AIF under Section 285 KAGB;
- all Special-AIFs and Public-AIFs which fall under Sections 2 para. 4, 4a and 4b KAGB, meaning those Funds which are managed by registered sub-threshold management companies. It needs to be noted that in this case provisions principally not applicable to "sub-threshold" fund managers will need to be complied with (cf. Sections 26, 28 and 29 KAGB).
- Private Equity Funds: Private Equity Funds issue shareholder loans. The origination of loans by such Funds was in the past viewed as generally permissible, so long as the loans were subject to a qualified subordination. In the Guidance Notice, BaFin notes that now fewer requirements apply to shareholder loans issued for the account of closed-ended Spezial-AIFs, provided certain requirements are met. Also in this respect legislatory amendments are to take place.
3. Impact on non-German Funds
BaFin only comments on German Funds. Non-German Funds are not subject to the rules of the KAGB. However, also these Funds in the past ran the risk that their granting of loans to German undertakings could be deemed as unauthorized banking business. This should however also change with the new administrative practice under discrimination aspects: EU (and most likely third country) Funds should henceforth be able to originate loans to German undertakings, provided they are subject to similar requirements as German Funds.
4. Recommendations by BaFin with respect to loan origination by Funds
Until the permissibility of loan origination for account of certain Funds has been implemented in the KAGB, BaFin advises all respective fund managers to already adhere to the following BaFin recommendations:
- Loan origination and loan restructuring may only be conducted by Special-AIF (see above).
- Loan origination is principally restricted to closed-ended Special-AIF.
- No financing of long term debt by short term borrowings.
- Loans may not be granted to consumers and, by reference to Section 26 para. 2 no. 3 KAGB, to such persons where the granting of such loans would lead to a conflict of interest (e.g. the fund manager, the depositary of the Fund or its outsourcing companies) and where the non-granting would have avoided such conflict. The wording is very broad, so that it will need to be evaluated on a case-by-case basis in how far there may be limitations, for example for Multi-Asset Managers. If – and this is what it looks like from a first glance – the main point is the avoidance of a potential conflict of interest with respect to the addressee of the loan, then this should not be a problem in practice. The requirements of Section 26 para.2 no. 3 KAGB now also apply to sub-threshold fund managers.
- The use of leverage is considered critical by BaFin; the use should be restricted to very limited cases. No simultaneous borrowing from the general public and granting of loans by the Fund is permissible, as this would otherwise be in conflict with the rules of the Capital Requirements Regulation (EU) Nr. 575/2013 (CRR).
- The fund manager must have in place an adequate business organization, which includes an appropriate risk management, Section 28 KAGB. It must in particular be ensured that the risks of the Fund arising out of the respective investment strategy are at all times caught, observed, controlled and monitored. For sub-threshold as well as fully licensed managers this means that the "Minimum Requirements for Risk Management" ("MaRisk") established by BaFin, insofar as they are transferable to the origination of loans, will need to be obeyed (e.g. requirements relating to credit business processes, granting of loans, further processing of loans, monitoring of loan processing, intensive support, management of non-performing loans, risk prevention, procedures for early detection etc. (BTO 1 Lending Business and BTR 1 Addressee Default Risk ).
- Risk diversification must be provided for.
- Liquidity reserve: This requirement is very critical. It makes absolutely no sense why a closed-ended Fund, whose loans are 100 % covered for by the capital commitments of its investors, would need to maintain a liquidity reserve. Such a requirement would only make sense with respect to open-ended Funds having to meet redemption right requests.
In conclusion, the new administrative practice is a milestone and highly welcomed. Certain of the recommendations could however in practice be problematic. Closed-ended loan origination funds, which need to maintain a liquidity reserve (for utterly implausible reasons) are not very attractive for investors. Also with regard to the MaRisk requirements it remains to be seen if the generally understandable requirements are applied using the principle of proportionality, taking into account that a fund is generally not active in the deposit business. Lastly, it will be of essential importance that Private Equity Funds, which grant shareholder loans, are not viewed as credit funds.
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