Fears of gold-plating in loan origination regs

It is critical that any European Union (EU) regulation or harmonisation of laws towards loan origination funds does not impede their development, or result in individual member states gold-plating the rules.

Gold-plating has become common under UCITS and the Alternative Investment Fund Managers Directive (AIFMD).
The dearth in corporate financing to small to medium sized enterprises (SMEs) in Europe comes as a number of banks face mounting capital requirements and balance sheet constraints under Basel III. The dependence by SMEs on bank financing in Europe is high, and many European regulators are tacitly encouraging alternative sources of financing such as loan origination funds to plug the gap as banks retreat.

This has occurred in Ireland, Germany and France, for example. The Central Bank of Ireland (CBI) has pushed for loan origination vehicles in the form of Qualifying Investor Alternative Investment Funds or “QIAIFs”. BaFIN in Germany has scrapped requirements that domestic funds restructuring or issuing loans hold a credit license in what should also boost interest. Novo funds, which are fund platforms that invest in SME French companies have also been given the green light. There is speculation as to whether EU-wide rules will be imposed on loan origination funds.

“Loan origination funds provide financing to SMEs which has a stimulating impact on the economy, and helps reduce the reliance of SMEs on banks. Such diversification in financing is welcome. The introduction of a credit fund or loan passport would theoretically make distribution easier but as we have seen with AIFMD and UCITS, national regulators do have a habit of introducing barriers and gold plating on distribution. This needs to be avoided if a pan-EU loan origination passport is being seriously considered,” commented Christopher Stuart-Sinclair, director of regulatory consulting at Deloitte in Luxembourg, speaking at the Fund Marketing and Distribution Conference in London.

Barriers to entry for UCITS and AIFMs across EU member states include additional registration fees, extra reporting obligations, enhanced tax transparency requirements, and documentation translation costs. While improvements were made under UCITS IV with some barriers being removed, managers complain individual member states still continue to gold plate in contravention of the Directive.

Should the regulatory environment be welcoming to loan origination vehicles however, such products could enjoy significant growth. The Alternative Investment Management Association (AIMA), the hedge fund industry group, predicts private debt funds could see their role in SME financing increase dramatically over the next five years. Such developments would also bring Europe into line with the US where about 80% of corporate financing is carried out in capital markets through bond and equity issuances.

The current regulatory environment in the EU is quite positive. Industry professionals speak warmly about the Capital Markets Union (CMU) project even if it is somewhat ambitious. The launch of European Long Term Investment Funds (ELTIFs) in December 2015 is also an interesting move although there are concerns it could fail to attract meaningful assets just as its predecessors (EUVECAs and EUSEFs) did.

ELTIFs are structured as AIFMs but can be marketed to retail and may invest in infrastructure, real estate and loans. Most believe their core target audience should be mid-sized insurers and pension schemes lacking the resources or sophistication to invest directly into infrastructure. “Regulators have eased the capital requirements for insurers investing into ELTIFs under Solvency II, and it is hoped this will help boost investment. However, for there to be meaningful investment into loan origination products, a similar reduction in capital requirements ought to be extended under Solvency II,” commented Stuart-Sinclair. One challenge facing loan origination products is that there are a number of similar investment vehicles being pushed to market simultaneously including ELTIFs, EUVECAs and EUSEFs. This could result in a degree of cannibalisation or even investor confusion.

Perhaps the biggest issue facing some loan origination funds is corporate debt. Speakers at the Association of Luxembourg Funds Industry (ALFI) European Alternative Investment Fund Conference said corporate debt was unsustainable with one expert comparing it to mortgage backed securities. As such, some believe loan origination funds are just a bull market phenomenon and could go sour in the event of the high yield corporate debt market crashing.
Another interesting issue raised during the Fund Distribution and Marketing conference surrounded AIFMD’s third country equivalence process. The European Securities and Markets Authority (ESMA) said it believes Guernsey, Jersey or Switzerland meet AIFMD regulatory equivalence and can take advantage of the pan-EU marketing passport. Nonetheless, the European Commission (EC) has yet to pass a Delegated Act officially sanctioning this.

Other countries are awaiting approval or require further analysis by ESMA such as the US, Singapore and Hong Kong. Stuart-Sinclair said the decision not to grant equivalence to Hong Kong and Singapore sent a terrible message to the regulatory authorities in those jurisdictions, given that they are the biggest non-EU buyers of UCITS. There are several APAC initiatives designed to create a regional funds passport. The recent snub by ESMA could result in those passport schemes taking off sooner than anticipated.