Golden age for debt funds in Germany?

Until recently, debt funds in Germany needed a banking licence in order to lend money, a hurdle that perpetuated the dominance of banks. This practice changed when, in May 2015, Germany's federal financial supervisory authority BaFin decided to change its administrative practice regarding loan-originating alternative investment funds (AIF). With its new administrative practice, BaFin considers the origination, restructuring and prolongation of loans by AIFs to be activities that fall within the concept of collective management services. The German government followed this with a rule change that came into effect last month: debt funds managed by EU AIFMs can now operate in the country without a banking licence.

For Christian Schatz, a partner at King & Wood Mallesons who was involved in the lobbying team that worked on the law together with the German government, the change is an improvement: "Considering the current activity level of debt funds in Germany, it is a very positive development. It is the first time they can act in the country without brutal banking regulatory restrictions."

With respect to German domestic closed-ended debt funds, the new regulation comes with four main restrictions. First, the leverage the funds themselves can take on is restricted – retail AIFs are allowed to take on anything below 50%. "Those debt funds can take more leverage because they are more strictly regulated," says Schatz. Special AIFs on the other hand are only allowed to leverage 30%; they are less regulated and can invest in anything that can have its valuation determined. Those funds only target professional and semi-professional investors and have to have a minimum investment of €200,000 for LPs.

The second restriction has to do with diversification. Not more than 20% of the fund can be allocated per borrower. "The government wanted to make sure that debt funds do not put all their eggs in one basket," says Schatz. "However, most funds would impose those limits onto themselves regardless because it is expected by LPs." The diversification limit only refers to the loans, not the whole investment.

Exceptions to the rule
The 20% rule has an exception whereby it can increase to 50% for shareholder loans if they meet one of the following criteria: the borrower is a subsidiary of the fund; the fund is subordinate; the loan is no more than twice the amount of the equity stake held by the fund in the borrower. If the fund itself does not borrow more than 30% of fund commitments, there is no limit at all for subordinated shareholder loans.

The third and fourth restrictions are more straightforward: debt funds operating in Germany are not allowed to issue loans for consumers. Since debt funds tend not to do this anyway, the rule makes only for a side note. Lastly, fund managers need to comply with certain risk management and liquidity rules.

The new regulation is also good news for funds from overseas as the same rules apply to them and they are now permitted to issue debt in Germany – as long as they have submitted to the AIFMD.

The revised legislation is likely to encourage higher activity levels for alternative lenders in Germany, thereby enforcing a positive development in M&A and refinancing activity that already started in 2015, according to DLA Piper partner Wolfram Distler: "The market saw high liquidity in 2015, because banks were able to hand out cheap loans. The funds have also become more flexible in terms of pricing and were encouraged by the change of the administrative practice of German regulator BaFin as published in May 2015. So the rise in activity which we will continue to see will not only be impacted by the deregulation of debt funds in Germany, but also by banks, which are able to lend money cheaply thanks to the European Central Bank."

By opening up to debt funds, Germany moves closer toward the UK and other countries with a more liberal regulation. And it could mean that easier and more plentiful financing options encourage increased levels of private equity activity.

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