It has been almost three years since the pan-European financial regulator, the European Securities and Markets Authority, penned its opinion on how to regulate fund loan origination (or private debt) but little has changed.
While slow movement on regulation can have its upsides, as it allows the industry to continue to develop unimpeded by potentially stifling new rules, there is a place for sensible regulation and this is particularly the case in a large and developed (but inconsistent) market for financial services like the European Union.
In April 2016, ESMA outlined plans to examine differences in regulatory regimes pertaining to how investment funds originate loans in the hope it could create a more consistent environment that would increase cross-border activity by private debt vehicles.
ESMA said: “[We are] of the view that a common approach at EU level would contribute to a level playing field for stakeholders, as well as reducing the potential for regulatory arbitrage. This could in turn facilitate the take-up of loan origination by investment funds, in line with the objectives of the Capital Markets Union.”
The Alternative Credit Council published its own thoughts on how regulators should approach the asset class at the end of February this year and recommended harmonisation of rules across the bloc.
It appears that both ESMA and the private debt industry are closely aligned in their thoughts on the future regulation of non-bank lending and the major challenges facing the industry today. The ACC has outlined what it believes are the most pressing issues that must be resolved in order to ease cross-border activity in Europe and create a more harmonised regime. These are the country-by-country issues identified:
France: Defying free movement
Private credit’s biggest obstacle to doing business in France is that loans must be originated from a French-domiciled alternative investment fund. This means any pan-European lender that wants to originate loans in the country would need to establish a fund purely for that jurisdiction, adding a significant cost and administrative burden that is simply not economical for many alternative lenders.
The ACC argues these rules are inconsistent with the free movement of capital within the EU and with the Alternative Investment Fund Managers Directive. Furthermore, it believes the rules are bad for France’s economy: “This both undermines the commercial case for investing in France and ultimately increases the cost of finance for French businesses seeking finance.”
France has a number of other problematic rules for non-bank lenders. Banking secrecy laws can make it difficult to share information on loans with the fund’s investors, while its insolvency and credit protection regime can create excessive risks for funds in the event of default or bankruptcy of a borrower.
Germany: Uncertainty around new regime
Compared with France, the German market is more open, allowing AIFs based in other jurisdictions to make loans. This follows some relatively recent changes to the German Investment Code and there remains some uncertainty over how the new regime will affect loan funds in practice.
Germany places other burdens on loan funds, requiring them to establish detailed procedures for loan origination, processing, workout and restructuring. Other aspects of the rules are often not suitable for private credit managers as they mimic banking models. The result is that most of the activity conducted in Germany is done via special purpose vehicles owned by AIFs domiciled elsewhere in the EU.
However, these SPVs are not expressly covered under a German Banking Act exemption which allows approved AIFs or AIFMs to make loans without additional authorisation. While the German regulator BaFin has taken a view that SPVs are merely an extension of an AIF, the ACC believes the exemption should be clarified to specifically cover activities by SPVs.
Ireland: falling behind Luxembourg
While Ireland has become an important fund domicile in recent years, the Central Bank of Ireland places restrictions on Qualifying Investor AIFs undertaking loan origination, which prevent them from acquiring investments and instruments other than loans. This has reduced the attractiveness of Irish fund structures relative to Luxembourg. The rules have recently been replaced to allow some AIFs to make investments in unrelated debt instruments but are still restricted on equities.
The Central Bank’s AIF Rulebook also contains provisions that make it more difficult for typical loan funds to operate, the ACC says. For example, it imposes an inability to tranche and requires investors in the same class are treated equally and requires general partners to be separately regulated.
The Irish government is also looking at proposals to extend the existing regime for credit servicing firms to all owners of Irish loans. “These proposals risk reducing the appetite of private credit managers to invest in Irish loans and the securitisation of Irish loan portfolios,” the ACC says. “Asset managers who purchase Irish NPLs are already subject to regulatory authorisation requirements such as the AIFMD or the ELTIF Regulation.”
The ACC warns these moves may be incompatible with existing authorisation under AIFMD and may also be inconsistent with legislation governing the free movement of capital within the EU.
Italy: hampered by the 10% limit
Private credit funds remain a small part of the Italian lending market, having only been allowed to carry out loan origination since 2016. However, the country is of growing interest to alternative lenders due to its many high quality SMEs.
One of the main barriers for private credit funds is an exposure limit, which means funds cannot lend more than 10 percent of their total to a single portfolio company. The ACC says this is too low and should be brought into line with other European jurisdictions.
The market is also hampered by a requirement for EU AIFs seeking to originate loans in Italy to prove they meet “equivalent” requirements to Italy’s regime. However, the ACC said it is not always easy to verify such equivalence and ultimately leads to EU AIFs avoiding Italy due to a need to file an application with the Bank of Italy to have its home-state rules declared equivalent, which can be costly in legal fees.
Creating a more consistent regulatory environment across Europe, which fully recognises the EU’s commitment to enabling cross-border capital flows and investment, should be the main focus for European legislators in the medium-term, the ACC believes.
It points out that private credit managers already spend significant resources on underwriting and are predominantly serving institutional investors and not retail depositors, which makes them very different to banks and would make a bank-style approach to regulation unsuitable for the industry.
The ACC notes that many jurisdictions have already trended towards making incremental improvements to their rules regarding non-bank lending and have been responding to market feedback. It adds that maintaining dialogue between industry, policymakers and regulatory supervisors will be essential to ensuring Europe adopts a sensible regulatory approach.
“The focus of this dialogue should now be on how to; (i) remove the barriers to finance flowing from the capital markets to European businesses, (ii) facilitate knowledge sharing between stakeholders on non-bank lending in Europe; and (iii) ensure non-bank lending benefits borrowers and enhances the financing of innovation throughout Europe. This will catalyse the growth of non-bank lending and support economic growth,” the ACC says.