The Central Bank of Ireland ("Central Bank") has announced that with effect from October 1, 2014 it will accept applications for authorisation of Irish domiciled qualifying investor alternative investment funds ("QIAIFs") which can engage in direct loan origination. Readers will be aware that earlier this year the Central Bank issued a Consultation Paper (CP 85) indicating its intention to allow the establishment of such funds.
That consultation closed on August 25. The Central Bank has now issued its Feedback Statement and has simultaneously issued its revised AIF Rulebook incorporating the final rules for loan originating QIAIFs. The relevant section from the AIF Rulebook is repeated in the Appendix to this briefing paper.
Ireland now has a new product offering, within a regulated structure, designed to address market needs and at the same time systemic risk concerns of regulators. This is to be welcomed.
Application forms for this new product will be published on the Central Bank website in advance of October 1, 2014 and its key features are explained further below.
The key features of Irish loan originating QIAIFs are as follows:
(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.
We think it likely that QIAIF type investment companies or ICAVs (and not unit trusts, CCFs or ILPs) will be the vehicles predominately used for establishment as loan originating funds.
A loan originating QIAIF must limit its operations to the "business of issuing loans, participating in loans, participations in lending and to operations directly arising therefrom, including handling assets which are realised security, to the exclusion of all other commercial business."
This represents an improvement over what was previously proposed. In response to quite an amount of comment on the previously proposed text, the Central Bank explained that it was never intended to prohibit investment by loan originating QIAIFs in syndications or in loan participations purchased on the secondary market. The Central Bank also made it clear that the handing of assets which are realised security for loans is acceptable and it also clarified that treasury management and the use of derivatives for hedging purposes fall within "operations directly arising therefrom".
Readers need to note, however, that loan originating QIAIFs cannot invest in other funds. The Central Bank feels that that could confuse the supervisory approach and that investment in other funds could be used to circumvent the requirements applied to the loan originating QIAIF.
In addition, loan originating QIAIFs cannot invest in other asset classes such as equities, debt securities, etc. In its Feedback Statement, the Central Bank has said that if a loan originating QIAIF wishes to invest in other assets, the solution is to set up an umbrella structure with a loan originating QIAIF sub-fund and a separate sub-fund for non-loan strategies.
The new rules also apply where a loan originating QIAIF engages in loan origination as part of a syndication or club deal
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 the case where there is a bona fide treasury management purpose which is ancillary to primary objective of the loan originating QIAIF); nor to persons intending to invest in equities or other traded investments or commodities.
(v)Acquiring loans from credit institutions
The 5% "skin in the game" requirement for bank vendors remains but has been tempered somewhat as the Central Bank has taken on board comments received during the consultation process. As explained in its Feedback Statement, it has now "modified the rule to apply it only where the loan acquired from a credit institution is a bilateral arrangement. Accordingly the retention rule does not apply if the loan purchased has been offered to multiple parties and is acquired on an arm's length open market basis".
Otherwise, a loan originating QIAIF shall not "acquire a loan" from a credit institution under arrangements which involve:
- the retention by the credit institution or a member of its group of an exposure correlated with the performance of the loan;
- the provision of an administration, credit assessment or credit monitoring service in relation to the loan whether on an individual or portfolio basis, by the credit institution or a member of its group,
unless the loan originating QIAIF is satisfied that it has in place and implements particular policies and procedures (including as to valuation, performance, monitoring, stress testing, etc.) and has received from the vendor warranties that:
- the vendor (or, where within scope of banking consolidated supervision, an entity within its group) will retain, on an on-going basis, a material net economic interest of at least 5% of the nominal value of the loan as measured at origination;
- the exposure will not be subject to any credit risk mitigation techniques; and
- the loan originating QIAIF will have readily available access to all materially relevant data on the credit quality and performance of the underlying exposures and on cash flows relating to and collateral supporting the exposures so as to be able to conduct comprehensive and well informed stress tests on the cash flows and collateral values supporting the exposures.
Exposure to any one issuer or group cannot exceed 25% of net assets. The QIAIF has to set out its risk diversification strategy in its prospectus, designed to achieve a portfolio of loans which is diversified and which will limit exposure to any one issuer or group to 25% of net assets within a specified time-frame. The loan originating QIAIF must not intentionally breach its risk diversification strategy and, in the event that it is not able to achieve that strategy within the timeframe set out in its prospectus, it must seek investor approval to continue with the actual level of diversification.
Diversification limits will not apply to a loan originating QIAIF which has reached its end of life phase and is closing out positions. Otherwise, the normal QIAIF rules regarding breaches of investment limits will apply - if the limits are exceeded for reasons beyond the control of the QIAIF, the QIAIF must record such matters and adopt as a priority objective the remedying of that situation, taking due account of the interests of its investors.
The Central Bank has decided to retain its leverage limit for loan originating QIAIFs, albeit described slightly differently. The limit is that the loan originating QIAIF must not have gross assets of more than 200% of net asset value (or such other limit as may be set by the Central Bank from time to time for loan originating QIAIFs or for one or more classes of loan originating QIAIFs). In other words, the ratio of debt to equity is still set at 1:1.
If the limit is breached, the QIAIF is required within 30 days (or such longer period as the Central Bank may specify) to obtain approval for a formal plan to bring it back into compliance with the leverage ratio.
(viii)Liquidity and Distributions
Having taken on board several of the comments received during the consultation process, the Central Bank's position in relation to liquidity and distributions for loan originating QIAIFs is now that loan originating funds must be closed-ended and must be established for a finite period. However, they can have discretion to invite, at dates determined at the authorisation date or such other dates as may be approved by the Board of the AIFM / Investment Company / Management Company / General Partner, without commitment and on a non-preferred basis, requests for redemption of holdings from investors. Distributions to or redemptions of investors holdings can only be effected during the life of the loan originating QIAIF to extent that there is unencumbered cash or liquid assets available for such purposes and will not endanger regulatory compliance or liquidity regulated obligations of the QIAIF.
In addition, unless the assets can be valued by reference to prevailing market prices, a redemption cannot be made without the approval of the investors in accordance with the approval process set out in the QIAIF's constitutional document on each occasion.
(ix)Credit Granting, Monitoring and Management
Loan originating QIAIFs must establish and implement a variety of documented and regularly updated procedures, policies and processes 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 policy;
- concentration risk management policy;
- valuation, including collateral valuation and impairment;
- credit monitoring;
- identification of problem debt management;
- delegated authority;
- documentation and security.
The new Chapter to the AIF Rulebook sets out a variety of additional controls and restrictions around the credit granting, renewal and refinancing processes; the credit risk assessment process; and processes for value adjustments and provisions (including the requirement for effective systems) and adequacy of credit position diversification (See the Appendix to this briefing paper). Loan originating QIAIFs will also be subject to the Central Bank's Code of Conduct for Business Lending to Small and Medium Enterprises when lending to Irish SMEs.
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