As interest in the debt markets in Asia continues to intensify, with covid-19 only heightening demand for distressed debt and special situations opportunities, regulators continue to sharpen their focus on the activities of credit funds.
With many fund managers moving to diversify their portfolios into new asset classes or strategies – with private equity funds turning to trading debt, for example, and hedge fund managers exploring less liquid strategies including unlisted debt – the regulatory landscape is constantly changing to keep up.
Viola Lui, an investment funds partner at Clifford Chance in Hong Kong, says: “Areas such as risk management, particularly with respect to liquidity risks and operational risks, and conflicts of interest, particularly with respect to fees and expenses, continue to be at the forefront of the regulatory and enforcement agenda of regulators in Asia.” She says suitability and transparency, personal accountability, and anti-money laundering and counter-terrorism financing rules are also high on the agenda.
With covid reshaping day-to-day operations, cyber is another focus. “With the increased use of technology and remote office arrangements, regulators are requiring licensed managers to assess their operational capabilities and implement appropriate measures to manage the cybersecurity risks associated with such use,” Lui adds.
Anne-Marie Godfrey, a funds partner with law firm Akin Gump Strauss Hauer & Feld, says: “The Hong Kong Securities & Futures Commission [SFC] is super-focused on cybersecurity and has published lots of guidelines on that. They see it as a really big risk, which it is, and they are really trying to stay on top of it.
“It is an issue that comes up again and again in inspections, and every licensed manager has to have a manager in charge responsible for the IT department who has personal accountability to the SFC for what happens in the IT department.”
Internet trading and the mitigation of hacking and ransomware risks are also priorities in the spotlight.
The challenge for managers in the region is not only that the asset class is growing in complexity, but that there are so many jurisdictions to understand across Asia-Pacific. Godfrey says: “The problem with Asia is that, unlike the EU – where some countries are more developed than others, but they are all required to implement the same rules – here there is no level playing field and things are very fragmented. No matter how many passporting initiatives there are, there is always going to be this fragmentation from a regulatory perspective, and there is, of course, rivalry between Hong Kong and Singapore to be Asia’s leading financial centre.”
“Credit risk management will also be front and centre for likely regulatory review”
She adds: “You have got some fairly sophisticated jurisdictions, including Japan and Korea, but then there are places like Cambodia, Laos and Vietnam where the regulatory infrastructure is underdeveloped. As a debt fund lending to borrowers in places like the Philippines, Vietnam or Thailand, you want to be sure you can enforce loan agreements and security documents and that whatever security you have taken is also enforceable. You need to be comfortable that the local courts will be receptive to any applications that you need to make.”
The level of knowledge required on the downstream side is much higher than it is in other regions, with challenges extending beyond market access to require much more understanding of diverse legal systems. GPs need to be constantly monitoring changes in local laws and regulations, particularly in relation to non-performing loans, insolvency and restructuring.
Justin Dolling, an investment funds partner in the Hong Kong office of Kirkland & Ellis, says: “While Asia encompasses many jurisdictions and there are country-specific issues, many Asia jurisdictions do not have specific laws or regulations directed at the private credit industry. This creates its own challenges, but also generally means that on issues such as know-your-customer [KYC] and anti-bribery, larger sponsors generally look to adopt global best practices as a starting point, which are then tailored as necessary for different jurisdictions.
“Similarly, many local regulators do not have the resources or expertise to effectively regulate these sectors and so will generally look to established regulators such as the US Securities and Exchange Commission for direction. Even if not directly subject to US regulation, often Asia GPs will be conscious of the SEC’s areas of focus.”
Hong Kong-based Karen Man, partner and global head of the financial services regulatory practice at Baker McKenzie, says: “In the event that they require one or more licences to operate, funds in Asia will need to continue to focus on compliance processes that adequately and appropriately deal with anti-money laundering and ‘know your customer’ requirements. Credit risk management will also be front and centre for likely regulatory review. Conduct and suitability have been the subject of numerous thematic reviews in Hong Kong and Singapore, and these regimes also continue to see enhancement and increased enforcement activity.
“The licensing regimes within Hong Kong and many other Asia Pacific markets are product- and service-specific, which can present challenges when operating on a cross-border basis. Depending on its proposed operating model, a debt fund operating in Hong Kong may need to consider money-lending, asset management and/or money broker licensing requirements.”
With many funds in Asia set up in offshore jurisdictions, particularly the Cayman Islands, the focus over the last few years has often been on the regulatory changes there in areas such as anti-money laundering, economic substance and, most recently, the registration of private funds. In October, Cayman was removed from the EU’s blacklist of non-co-operative tax jurisdictions.
Hong Kong continues to position itself as the funds hub for the region, most recently introducing new limited partnership fund legislation that came into effect on 31 August. A new law, known as the Unified Fund Exemption Regime, was also introduced last year to exempt funds from Hong Kong profits tax on qualifying transactions. There is now talk of carried interest concessions to encourage funds into the market.
“The new unified fund exemption regime, carried interest concessions that are still in consultation and the Hong Kong limited partnership law are all viewed as positive developments to encourage the investment funds and alternative asset industry in Hong Kong,” says Dolling. “This will be particularly relevant to GPs that have, or intend to establish, a significant presence in Hong Kong, although it is certainly not expected that the HK Limited Partnership will replace the Cayman Exemption Limited Partnership as the investment vehicle of choice globally.
“The rules are still new, and the carry concessions are still in consultation, so the impact is yet to be confirmed.”
Lui says: “We are seeing an initial increase in fund establishments in Hong Kong, especially by Chinese managers. In the short- to mid-term, with the business opportunities inherent to the Greater Bay Area, this is where we expect the greatest potential for growth in Hong Kong’s asset management industry to be.
“An increase in global enforcement activity and co-ordination between international regulators means that Asia GPs and their LPs are increasingly attuned to potential reputational and legal risk that may arise from investments”
Kirkland & Ellis
“In the future, investor preferences may lead Asian managers to reassess the possibility of ‘onshoring’ at least some of their operations and fund vehicles, so they may want to focus more on licensing requirements and conduct of business rules in their respective jurisdictions.”
Pure credit investments may not be considered qualifying transactions for UFER and carry concessions, so credit funds and sponsors may not benefit. Dolling says there is continued lobbying on that point, but if it does not change, the new rules will do nothing to encourage credit sponsors, or multi-strategy sponsors, to establish or expand their presences in Hong Kong.
Another area where new rules are being developed is on environmental, social and governance investing.
“ESG is a real buzzword at the moment,” says Godfrey. “The SFC launched a strategic framework for green finance in September 2018 and following on from that did a survey of asset managers in Hong Kong. They now intend to deliver a new set of expectations of asset managers in the near term, covering areas such as governance and oversight, risk and disclosure with a focus on environmental risks, which credit managers will also be subject to.”
That legislation could make an impact at the asset level, the fund level and the manager level, and shows Asian regulators are in line with themes being focused on elsewhere.
Cori Lable, another partner with Kirkland & Ellis, concludes: “An increase in global enforcement activity and co-ordination between international regulators means that Asia GPs and their LPs are increasingly attuned to potential reputational and legal risk that may arise from investments, and many have enhanced the anti-bribery and corruption, KYC and ESG diligence they are conducting on contemplated investments.”
With so many jurisdictions to navigate, the patchwork of regulation in Asia-Pacific means legal and regulatory issues must be front of mind for debt funds moving in.
A sense of upheaval
The ongoing trade tensions between the US and China and the upheavals caused by covid-19 continue to push debt funds into new areas.
Clifford Chance’s Viola Lui says: “The US-China trade tensions may affect where credit investors are looking for opportunities, namely in sectors that are likely to be affected by the tensions. There is a possibility of existing debt in such sectors becoming distressed or at least of businesses in these sectors requiring credit when traditional lenders are not able or willing to lend.
“The covid-19 pandemic is, of course, another major factor and credit investors have certainly been assessing dislocations in the markets that have resulted and whether these present attractive buying opportunities.”