June 01, 2022
The Dubai Financial Services Authority (DFSA) has put in place a new regime for credit funds, which will come into effect on June 1, 2022. The new regulations mainly affect credit fund managers domiciled in the DIFC, but there are some implications for non-DIFC Credit Funds. The new regulations result in increased regulation of DIFC credit funds and their managers (compared to other DIFC funds and their managers) and, in practice, will likely operate as a new licensing category, with higher fees and additional compliance obligations.
It remains to be seen whether the DFSA’s approach will encourage or discourage the formation of credit funds in the DIFC, but the new rules provide welcome clarity on the DFSA’s approach to one more asset class. more popular.
DIFC Credit Fund
A DIFC fund is a “credit fund” if its investment objective is to use at least 90% of its assets to “provide credit”, including by acquiring loans, which means buying, taking transfer, take the credit risk or part of the credit. risk associated with the loan or take other risks on it. “Providing credit” means providing a credit facility to any natural or legal person in their capacity as a borrower or potential borrower. A “credit facility” means any facility that includes any arrangement or agreement that extends monetary credit, whether funded or unfunded, to a person, including, but not limited to, any loan or syndicated loan, mortgage , overdraft, leasing, letter of credit, financial guarantee, trade finance, transaction finance, project finance, asset finance or invoice financing, discounting or factoring.
Under the new DFSA regime, a DIFC credit fund is limited in terms of the credit instruments it can use, and the borrowers and counterparties to whom those credit instruments can be extended. Especially:
- a DIFC loan fund can not provide the following types of credit facility: (a) letters of credit, (b) financial guarantees, or (c) cross-border trade finance (trade finance for trade in goods or services that takes place entirely within one country is authorized on the that it is less operationally complex and entails a lower degree of risk); and
- a DIFC credit fund may not provide credit facilities to the following borrowers: (a) a natural person; (b) the Fund Manager, a Party Related to the Fund Manager or any other person acting for or on behalf of the Fund Manager; (c) another fund or fund manager; (d) a financial institution or a person related to a financial institution; (e) a person who intends to use the credit for the purpose of trading investments, commodities or crypto-assets; or (f) a person who intends to use the Credit for the purpose of providing Credit.
DIFC loan funds are subject to a number of additional rules and restrictions, as follows:
- Management:Generally, a non-DIFC fund manager (external fund manager) can manage a DIFC fund, but this is not permitted for a DIFC credit fund, which must be managed by a DFSA-regulated fund manager.
- Structure: A DIFC credit fund must be an investment company or investment partnership (not a trust).
- Business customers only: A DIFC credit fund must be either an exempt fund or an accredited investor fund, which means that a DIFC credit fund can only be opened to professional clients (as defined in the DFSA rules) .
- Term: A DIFC loan fund must be established for a fixed period not exceeding 10 years. DFSA rules require that any redemption or distribution before the end of the Credit Fund’s term requires majority approval in the interests of investors.
- Strategy: In addition to the limits on the types of credit facilities and the types of borrowers with which a DIFC credit fund may engage (as set out above), the fund manager of a DIFC credit fund must:
- have a clear strategy which aims, within a specified period not exceeding three years from the date of creation of the Fund, to achieve a portfolio of loans that limits exposure to any one person or group of companies to a maximum of 25% of net assets (the “Risk Diversification Limit”),
- not borrow in excess of 10% of the net asset value of the DIFC Credit Fund at any time,
- have strong and well-defined criteria for granting credit and acquiring loans and, to this end, the process for approving, modifying, renewing and refinancing credit and acquiring loans must be clearly established,
- have in place internal methodologies to assess the credit risk of exposures to individual obligors, securities or securitization positions and credit risk at the portfolio level, which are not based solely or mechanistically on external credit ratings ,
- provide ongoing monitoring and administration of the various credit risk positions and exposures in the portfolio, including to identify and manage problem credits and to make appropriate valuation adjustments and provisions, and
- have a comprehensive stress testing program performed at least annually (or, if requested by the DFSA, more frequently).
- Strategies: The fund manager must ensure that the DIFC credit fund maintains and adheres to appropriate written policies and procedures regarding:
- assessing, pricing, granting, managing and acquiring credit, in accordance with a defined risk appetite statement;
- credit monitoring, renewal and financing;
- criteria, governance and decision-making structures for (a) and (b);
- Warranty management;
- concentration risk management;
- valuation, including valuation and impairment of guarantees;
- identification and management of problematic debts;
- Delegated Authority; and
- documentation and security.
- Investor reports: The annual report and interim report of a DIFC credit fund should include the following information on credit granted and loans acquired:
- a breakdown between senior secured debt, junior debt and mezzanine debt;
- a breakdown between loans with decreasing maturities and loans with bullet repayment;
- a breakdown of the loan-to-value ratio for each loan;
- information on non-performing exposures and aggregate information on exposures subject to forbearance activities; and
- any material changes to the credit reporting and monitoring process.
- Content of the Prospectus: In addition to the standard disclosures for DIFC funds, a DIFC credit fund prospectus must include risk warnings and statements regarding compliance with the aforementioned regulatory requirements, such as risk diversification strategy and borrowing limits.
- Fees and base capital requirements: The license application fee for the fund manager of a DIFC credit fund is $10,000 (generally the fee when the fund is a QIF is $5,000), and the basic annual fee is 10 $000 (generally the annual fee when the fund is a QIF is $5,000) . The capital base required for a manager of a DIFC credit fund is $140,000, which is the same as for retail funds (the capital base required for fund managers of other professional client funds is $70,000).
- Regulatory reports: The fund manager of a DIFC credit fund is required to make additional reports to the DFSA compared to fund managers of other DIFC funds, and must submit the following forms on a quarterly basis: large exposure, arrears and provision , credit activity and trade Financial activity.
Foreign credit funds
A foreign fund is a credit fund if its investment objective is, or includes, the granting of credit, including by acquiring loans. Note that this definition does not include the 90% threshold of a DIFC credit fund. Morgan Lewis is not yet aware of any guidance, through public announcement or precedent, from the DFSA as to the amount of credit investment activity that would cause a foreign fund be treated as a credit fund for purposes of the DFSA rules, noting that many private equity and venture capital funds allow debt as an investment activity.
That said, the impact of the DFSA rules on foreign funds is currently limited to the following two issues:
- Management: Generally, a DIFC (i.e. DFSA regulated) fund manager can manage a foreign fund, but this is not permitted for a foreign credit fund. This means that the role of a DFSA-regulated entity with respect to a foreign credit fund is likely to be limited to that of investment adviser to the manager of the foreign fund (if the DFSA-regulated entity has the appropriate category 4 advisory license), or managing investment adviser (if the DFSA-regulated entity has the appropriate category 3C asset management licence).
- Marketing: There are three statutory provisions under which foreign funds may be marketed in the DIFC: Sections 54(1) (a), (b) and (c) of the DIFC Collective Investments Act. When marketing under 54(1)(a), the Foreign Fund must either be a Designated Fund (as defined in the DFSA Rules) or meet the criteria specified by the DFSA. Under the new regulations, a foreign credit fund must meet the following requirements:
(i) it is a Closed Ended Fund;
(ii) it satisfies the conditions which would be necessary for it to be an Exempt Fund or a Qualified Investor Fund if it were a Domestic Fund;
(iii) it has appropriate policies and procedures in place to assess, price, grant, manage and acquire credit;
(iv) it has an appropriate stress testing program in place; and
(v) it is subject to regulatory requirements that provide an equivalent level of protection to that provided by the DFSA rules (including prospectus disclosure requirements and various limitations on duration, structure, strategy and requirements policies and procedures described above).
However, Article 54(1)(c) of the Collective Investment Schemes Act, which is the basis on which many foreign private investment funds are promoted, has not been amended. It only requires that the Foreign Fund be offered by way of private placement only to Professional Clients with an initial subscription of at least $50,000.
If you have any questions or would like more information about the advice discussed in this LawFlash, please contact one of the following Morgan Lewis attorneys:
Ayman A. Khaleq
William L. Nash