Debt Funds as an alternative financing option in the Coronavirus crisis: a ray of hope for young FinTechs?

in the US and Luxembourg), until 2016 there was no legal framework for German AIFs to grant loans by AIF. Rather, this was only allowed for banks as lending business (Kreditgeschäft) and subject to a licence under the German Banking Act (Kreditwesengesetz – “KWG“). Therefore, for a long time, AIFs had to cooperate with a fronting bank which granted loans using its existing licence from the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht – “BaFin“) and subsequently assigned the claims arising from the granted loans to the AIF.

By mid-2015, BaFin had already abandoned its previous administrative practice, according to which loan origination by AIFs was generally prohibited. The legal framework followed somewhat later. With the implementation of Directive 2014/91/EU (UCITS Directive), the German legislator made it possible under the German Capital Investment Code (Kapitalanlagegesetzbuch – “KAGB“) in 2016, for certain AIFs to grant loans directly to companies, without the need for a banking licence. This regulatory shift was largely based on the fact that AIFs can play an important role, especially in times of a crisis, in the financing of companies that for various reasons (including a lack of profits or lack of collateral) are ineligible to receive regular bank loans…. almost as if Covid-19 had been foreseen.

Regulatory requirements for debt funds

Lending by debt funds is not completely unregulated. The KAGB imposes certain requirements on each of the AIF, its investors, its management company (Kapitalverwaltungsgesellschaft – “KVG” or “AIFM“) and on the loans to be granted.

Requirements for AIF / its investors

In principle, loans may only be granted by Special AIF (respectively via its AIFM for the AIF’s account), i.e. AIFs in which only

• professional investors (for example, banks, insurance companies or stock exchange traders) and/or
• semi-professional investors (including retail investors who invest at least EUR 200,000 and submit a so-called “declaration of competence” in which they declare that they are aware of the risks of the investment and which the AIFM must confirm after verification)

Requirements for AIFM

AIFM managing special AIF and granting loans on the AIF’s account must comply with further requirements. This is the case irrespective of whether the AIFM is “full-scope”, holding a licence with BaFin, or a “small” AIFM which are only registered with BaFin and in principle are subject to a very limited regulatory regime (De Minimis AIFM). The following requirements apply to De Minimis special AIFM only where they grant loans for the account of the special AIF they are managing:

• general rules of conduct – in particular:
  • acting in the exclusive interest of the investors / equal treatment of all investors;
  • measures to avoid conflicts of interest.
• liquidity and risk management:
  • liquidity management systems and procedures; documentation, review, adjustment; liquidity limits and stress tests;
  • structural and procedural organisation regarding credit processing (e.g. separation of functions and voting) and early recognition of risks;
• documentation and reporting obligations (including reporting of so called “million loans” to the German Federal Bank – Deutsche Bundesbank)

Requirements for loans

The regulatory requirements for the loans granted depend on whether they are to be granted to third parties (Dritte) or to companies in which the special AIF has invested (“Shareholder Loans“).

For loans to third parties:

• the special AIF itself may borrow only up to 30% of the equity available for investments (internal leverage);
• loans to individual borrowers may not exceed 20% of the equity available for investments;
• no consumer loans are permitted.

For shareholder Loans:

Insofar as Shareholder Loans are to be granted in addition to loans to third parties, the following shall apply:

• in principle, 50 % of the equity available to investments may be used for the granting of Shareholder Loans, provided that one of the following conditions is met:
  •  the borrower is a subsidiary (Tochtergesellschaft) of the AIF, or
  • the loan is a subordinated loan (Nachrangdarlehen), or
  • the amount of the Shareholder Loan does not exceed twice the acquisition costs of the respective investment;
• in the case of qualified subordinated loans (qualifiziertes Nachrangdarlehen), the 50% limit may be exceeded as long as AIF complies with the 30% limit for borrowings of the AIF

Advantages of debt funds over banks

In particular for De Minimis special AIFM, only certain organisational and documentation requirements must be complied with in addition to the otherwise straightforward regulation. Even if they are obliged to classify the risks associated with loans, they can also become active where banks might usually say “No, thanks.”.

The current crisis is a particular illustration of the importance of flexible financing outside the tight regulatory corset applicable to banks. However, even after the Coronavirus, debt funds are likely to become increasingly suitable for raising capital, in particular for young companies, as they do not lose voting rights to the AIF as the AIF does not hold an equity participation in them, but nevertheless receive (indirectly) capital from investors who are interested to support young companies.

It is not to be expected, however, that lending by banks will become completely obsolete. Banks can offer – in ordinary times – more favourable conditions, especially when it comes to established companies. Therefore, banks and debt funds will probably jointly satisfy capital needs in the future, although with quite different target groups.