Private Credit Funds: An alternate to traditional lending?
Financial Services Focus
Historically, banks and finance companies have been the traditional source of credit for businesses.
Law Update: Issue 365 - Financial Services Focus
Ashish Banga Senior Consultant,Banking & Finance
Marianna MargaritidouAssociate,Banking & Finance
Historically, banks and finance companies have been the traditional source of credit for businesses. Accessing credit from traditional sources has faced challenges during exogenous events like the Global Financial Crisis of 2008 and the more recent Covid-19 pandemic. Where gaps in the credit market have occurred, these gaps have been filled in by the rise in alternative funding sources, such as credit from private investors instead of equity, noting that the private credit business is a US$1.5 trillion as of 31st March 2023.[1] Initially concentrated in developed markets like the United States, United Kingdom, and certain parts of Europe, the ‘private credit’ trend is now expanding into emerging markets like the United Arab Emirates (UAE).
The regulatory framework in the UAE has adapted to acknowledge private credit as a burgeoning asset class. In June 2022, the Dubai Financial Services Authority, which oversees the financial services sector in the Dubai International Financial Centre, introduced its credit funds regime. This regime recognizes credit funds as a specialized category of funds, allowing them to offer credit services. Likewise, in May 2023, the Financial Services Regulatory Authority, governing the financial services sector in the Abu Dhabi Global Market, expanded its regulatory framework to authorize private credit funds as a specialized class of funds, enabling them to invest in credit facilities, recognizing that historically, the provision of credit facilities was restricted to entities holding licenses to provide credit (like banks).
Private credit involves the extension of credit beyond the confines of traditional banking systems and publicly issued debt. This form of credit is typically provided by institutional investors like hedge funds, sovereign wealth funds, and specialized private credit funds. These entities increasingly offer financing to business facing challenges in accessing conventional bank loans or seeking alternative funding avenues with bespoke credit structures that banks cannot provide.
As a result, collective investment funds with the primary objective of deploying all or a substantial portion of their assets for credit provision—whether through origination, purchase, or participation—are categorized as credit funds.
Although these funds offer borrowers a chance to pursue a more adaptable financing method compared to traditional lending institutions, and provide investors with an opportunity to invest in a high-yield asset class, they can introduce risk to the overall financial system when lacking regulatory standards typically applied to banks and traditional lending institutions.
Accordingly, depending on the regulatory framework in place, funds may be subject to certain constraints. These limitations can include restrictions on the types of facilities they can extend and the categories of borrowers they can serve.
For instance, both the funds’ regimes of the Abu Dhabi Global Market (ADGM) and the Dubai International Financial Centre (DIFC) exclude credit provision by these funds to certain borrower segments. These exclusions encompass natural persons, other funds, credit providers, and those intending to utilize credit proceeds for speculative purposes.
In the past, lending within the ADGM and DIFC was restricted to persons possessing the necessary license to provide credit within their respective jurisdictions. However, the recent revisions to the fund regimes in both jurisdictions have granted non-banking actors the ability to extend credit, thereby affording borrowers the opportunity to access financing from a DIFC/ADGM licensed credit fund.
Whether credit funds serve as an alternative to traditional lending in ADGM and/or the DIFC depends on various factors that need to be taken into account. These include:
to whom the borrowing is intended to – as noted above, both of these fund regimes impose limitations on fund managers regarding who the credit can be extended to or for the benefit of. These restrictions include prohibiting credit provision to natural persons, the fund manager, and affiliated parties, as well as other funds, individuals intending to use financing for speculative investments, or those planning to use credit for further credit provision.
the nature of the borrowing – while the ADGM credit funds face no restrictions on the types of credit facilities they may extend, DIFC fund managers must ensure that the credit funds they oversee do not provide facilities such as letters of credit, financial guarantees, or trade finance, unless such finance is intended for the trade of goods or services conducted entirely within the UAE or another country.
tenure of the facilities – considering operational and other risks, regulators may opt to restrict the duration of the fund and consequently the term of facilities. For instance, DIFC credit funds, unlike those in the ADGM, must be set up for a fixed period of 10 years and therefore, facilities originating from need to be structured with this in mind
exposure limitations – credit funds operating in the ADGM and DIFC are subject to restrictions on the maximum exposure they can have to a single borrower or a group of connected borrowers. This implies that the lending capacity of a fund may not match that of a traditional lending institution. In the ADGM, private credit funds must limit their exposure to 25% of their committed capital, a requirement similar to that in the DIFC, where fund exposure to a single borrower is capped at 25% of the net asset value of the fund.
leverage limitations – credit funds operating in the ADGM and DIFC are also governed by restrictions on borrowing and leverage. Such that: (a) DIFC funds are limited to borrowing no more than 10% of the net asset value of the fund; and (b) ADGM funds are restricted from borrowing more than 100% of their committed capital. These limitations suggest that these funds may have limited capacity to meet the credit needs of large corporations but could potentially accommodate those of small and medium enterprises.
These points are not exhaustive, and there could be additional factors that are pertinent in deciding between traditional funding options (bank credit, public debt, etc.) and alternative funding. These factors may include the size of the deal, the intended use of the loan, the structure and location of collateral, borrower characteristics, credit quality, and plans for the secondary market.
The credit fund regimes in the ADGM and DIFC are relatively recent and a positive development to their regulatory frameworks. They offer a new avenue through which business, within the region can access credit, becoming part of and benefiting from the US$1.5 trillion industry. The revisions to these frameworks lay the foundation for business expansion in the region and provide a platform for broader fund management activities within the respective jurisdictions.
[1] PitchBook
For further information,please contact Ashish Banga and Marianna Margaritidou.
Published in February 2024
