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Loan origination funds: What next?

Loan origination funds: What next?

Loan origination funds are finally gaining traction within the European Union (EU). A host of countries have introduced legislation designed implicitly to boost lending to small to medium sized enterprises (SMEs) that have been cut off from conventional credit markets. France has witnessed the creation of Novo funds, private placement fund platforms that invest in mid-sized French companies although these vehicles are prohibited from industries associated with financial services, leveraged buy-outs and real estate. In Germany, BaFIN gave the green light to domestic funds being able to issue or restructure loans without needing to possess a credit license. The Central Bank of Ireland (CBI) authorised Qualifying Investor Alternative Investment Funds (QIAIFs), which too engage and participate in loan origination.

The reasons for the growth in such fund products is simple. Basel III capital requirements have applied serious pressure on the balance sheets of banks. Many banks are reluctant to provide financing to SMEs out of balance sheet considerations. Given the dependence of European SMEs on bank financing, this will have massive implications. It is hoped the renewed emphasis on non-bank financing will enable Europe to replicate corporate lending practises in the US, where 80% of corporate financing is conducted via the capital markets through issuances of equity and bonds. In Europe, about 80% of corporate lending is derived from banks. As such, the push towards loan origination is being driven by regulators’ recognition that European SMEs need to diversify their sources of financing.

Fund managers have taken note. Preqin, a data provider, estimates there is approximately $440 billion invested in private debt funds. The Alternative Investment Management Association (AIMA) is confident private debt funds could provide up to 20% of the funding to European SMEs in the next five years, compared with 6% at present. The AIMA study - “Financing the economy: The role of alternative asset managers in the non-bank lending environment” – said private debt funds were supporting a diverse range of sectors including shipbuilding, social housing, health and renewable energy. It added these funds rarely deploy leverage and have structured their businesses like private equity (i.e. longer lock-ins) so as to reduce maturity and liquidity transformation risks.

That a number of regulatory authorities have endorsed loan origination funds raises the question as to whether there needs to be some sort of EU framework governing it. The rules in Germany, France and Ireland are not necessarily consistent despite broadly having the same objective. The argument against regulation is that it could stifle and hamstring loan origination funds at an embryonic stage of their development. Conversely, arguments for regulation suggest it may result in the emergence of harmonised rules and a credit fund passport similar to what is available to managers regulated under UCITS and the Alternative Investment Fund Managers Directive (AIFMD). As with UCITS and AIFMD, the big fear is that national regulators could introduce their own barriers to marketing and restrictions through gold-plating which could make pan-EU distribution of credit funds challenging.

The mood, however, is reasonably optimistic in the context of the Capital Markets Union (CMU). Many believe regulators will introduce some sort of harmonisation which ought to facilitate the growth of loan origination funds. The European Commission – through the creation of the European Long Term Investment Funds (ELTIFs) last year – has sought to reduce the role of bank financing in the real economy. ELTIFs are allowed to invest in loans alongside infrastructure and real estate, while Solvency II capital requirements for ELTIFs have been eased to encourage greater investment into the asset class by insurers. Such sensible policies should bode well for any potential regulation of loan origination funds.

Loan origination funds could be an exciting opportunity for investors, while the creation of pan-EU standards governing them must be done in a sensible way that does not impede their development, either in lending to SMEs or soliciting capital from EU investors.