Direct Lending Funds: Proposal for European regulation

The European Securities and Markets Association (ESMA) has published its views of how loan origination – or “direct lending” – by investment funds should be regulated in the European Union. ESMA has provided its opinion to support the EU Commission’s planned consultation on loan origination.

ESMA’s proposal, if adopted, would be a mixed blessing at best. While it could facilitate loan origination in some jurisdictions if it replaces existing national legislation, it could also present new restrictions, timing issues and costs for direct lending funds. Accordingly, while the opinion has no immediate legal effect and there is no timetable for implementation of any new regulation, sponsors of direct lending funds should now start to take ESMA’s proposals into account when considering new fund structures and strategies. Sponsors should also consider participating in the EU Commission’s forthcoming consultation on the regulation of loan origination funds.

Background

Investment funds with direct lending strategies have become an important source of funding for European corporates over recent years. While the managers of alternative investment funds (AIFs) are currently regulated in Europe under the Alternative Investment Fund Managers Directive, any loan origination activities of those funds are subject to inconsistent regulation by EU member states on a national basis. The result is that while most EU member states currently permit loan origination by AIFs, to some degree at least, there are specific restrictions in countries including Germany, Ireland, Spain, Italy and Malta. France has also recently proposed new regulation on direct lending funds. In ESMA’s view, it would be preferable for these activities to be regulated on a consistent basis across the EU, and it has set out the key principles that it believes would be appropriate for a new European regulatory framework for loan origination funds.

What you need to know

• The scope, form and impact of the planned regulation is not yet clear.
• The regulation may facilitate loan origination in some EU jurisdictions, but it may also present new restrictions for direct lending funds.
• The regulation could eventually require direct lending funds to be closed-ended, require specific authorisations and impose additional risk management requirements on direct lending funds.

Scope and purpose

ESMA considers that specific regulation of direct lending funds is necessary to ensure any systemic risk presented by such funds is mitigated and, in any event, is no higher than that presented by bank lending. ESMA also believes that consistent EU regulation would contribute to a more level playing field between EU jurisdictions, reduce regulatory arbitrage and ultimately facilitate loan origination activities across Europe.

ESMA’s proposal only covers investment funds which act as a sole or a primary lender, and not those funds which gain exposure to loans through secondary market participation. It also focuses specifically on AIFs (as UCITS funds are generally prohibited from originating loans), and does not consider those particular types of AIF for which direct lending is already regulated; i.e. AIFs which qualify as European Venture Capital Funds (EuVECAs), European Social Entrepreneurship Funds (EuSEFs) and ELTIFs.

Key issues

ESMA identifies a number of key issues that it believes the EU Commission should consider as part of its consultation, and makes proposals for how some of those issues should be handled under eventual regulation:

• Authorisation: ESMA suggests that the Commission assesses whether direct lending AIFs and their managers should be subject to specific authorisation, and suggests that this may be desirable. It is not clear how this would affect managers based outside the EU.
• Type of AIFs: ESMA believes that direct lending AIFs should generally be closed-ended vehicles, given the illiquid nature of their loans, but suggests that some limited redemption rights could still be offered to investors. ESMA notes that the consultation will need to consider whether direct lending funds should be permitted to carry on other activities, but gives no opinion on that.
• Matching maturity: Direct lending AIFs should be prohibited from providing loans with a longer maturity than the AIF’s own expected lifespan.
• Type of investors: ESMA questions whether direct lending AIFs should be available to retail investors at all. However, if they are made available to retail investors, then ESMA proposes that specific protections should be put in place, consistent with those under the European Long Term Investment Funds (ELTIF) Regulation.
• Risk management: ESMA proposes that AIFMs which manage direct lending AIFs should be required to have additional procedures in place addressing specific issues related to loan origination, such as the assessment and monitoring of credit, valuation, risk and collateral management.
• Leverage: ESMA believes it may be appropriate to impose a leverage limit for direct lending AIFs, especially if they are available to retail investors.
• Stress testing: Direct lending funds should be subject to regular stress testing, and specific liquidity management and additional reporting may be needed.
• Eligible investments: ESMA proposes that short-selling or securities financing transactions should be not be allowed for direct lending AIFs, and that the use of derivatives should only be allowed for hedging purposes.
• Eligible debtors: Loans should not be: (i) granted to individuals, financial institutions, collective investment schemes or the fund’s own AIFM and its related parties (e.g. depositary, general partner or delegates); and/or (ii) used for the financing of a financial institution.

What's next?

Once the Commission’s consultation paper on direct lending funds is published, the fund sponsors should consider participating in the consultation. In the meanwhile, the market participants should already take ESMA’s proposals into account when structuring new funds or planning new investment strategies.

_{This article is part of our latest edition of Credit Funds INSIGHT. To download a PDF of the full publication, please click here.}