Shadow Banking by Investment Funds
The scope and volume of credit and credit intermediation services being provided by banks and banking institutions has been going through a period of stress and contraction while the need for such services continues to exist and, in many markets, grow. Opportunities exist, and will continue to expand, for non-banks – particularly private, unregulated funds and fund like entities – to achieve favourable returns by providing credit and credit intermediation services to borrowers and issuers of various types across many product and regional markets in the world financial community.
Non-bank banking activity, referred to as "shadow banking", may be described generally as credit intermediation involving entities and activities outside the regular banking system. While shadow banking has existed for many years, the volume of “shadow banking” globally grew in the early 2000’s and appears to be poised to grow again. Aggregate global volume grew from approximately $27 trillion in 2002 to more than double that volume in 2007, dropped in 2008 and then re-grew in 2010 to 2007 levels, of which the US portion was approximately $24 trillion. In 2010, the largest proportions of the total were by investment funds (29%) and securitization vehicles (9%).*
Banks currently face a combination of obstacles that will impede or prevent the making of many types of loans that had been made by banks in the past. Compliance with risk-based capital rules is becoming more burdensome and expensive. Banks have been going through high general levels of de-risking, deteriorated asset quality, greater market concerns with bank counterparty risk, new restrictions on permissible banking business, and departure of experienced human resources. Further, large banking institutions are increasingly challenged by a plethora of new or expected regulations, legal uncertainties and increased regulatory scrutiny generally, together with the fact that certain funding mechanisms like the securitization markets have been reduced or closed.
Meanwhile, the need for credit and liquidity has increased across credit-stressed and liquidity-challenged borrowers. This is most apparent in the need for commercial real estate financing and refinancing, but extends to corporate lending needed for strategic transactions, infrastructure and other illiquid asset financings. Sovereign and bank credit stresses in Europe exacerbate these pressures.
The role of non-banks in “shadow banking” has the potential to grow significantly through investment funds. Capital and liquidity are in abundant supply at large, well-established investment funds. Investment funds have expertise in many relevant sectors. Private equity funds (and, to an extent, hedge funds) may avoid certain of the liquidity (and related mark-tomarket) pressures faced by deposit-taking banking institutions or by broker-dealers supported by repos and other short-term funding sources. An investment fund can use its familiarity with a business as an equity investor to facilitate underwriting credit risk to that business. Funds, moreover, boast relationships with potential borrowers, may provide favourable financing terms, and can be quick to react.
Financing tools exist to support the lending activity of private equity funds, hedge funds, money-market funds and other types of private investment vehicles. Funds are capable of bank style lending, capital markets financings, securitization term financing takeouts, short-term funding through repos, CP conduits and derivatives, as well as innovations in structuring permanent capital with efficient term financing. Developmental challenges exist that private funds engaging in shadow banking will need to address, such as direct or indirect systemic risks, potential for increased regulation, credit underwriting and surveillance systems development and fund investor acceptance. Nevertheless, credit intermediation activities for funds may potentially include new loan originations, both commercial and consumer, distressed loan acquisitions/restructurings, warehouse financings and sponsoring of securitizations, as well as generally advising on, arranging, syndicating and servicing loan assets.
Key Issues for Funds
An investment fund seeking to engage in shadow banking will need to address various issues and considerations. An existing fund undertaking a lending business must consider and reconcile its business plan with its structural limitations while a new fund will seek to have a structure that accommodates a lending business. Depending upon whether the fund is open-ended or closed-ended and its overall structure, the fund's capital may be locked in over a fixed term or drawn down as needed and returned upon realization or the fund may need to provide ongoing liquidity for investors, possibly subject to lock-ups. Incentive fee structures for the fund manager may influence the fund's planning as well. In origination of consumer loans, the existence of direct lender/borrower relationships typically necessitates regulatory licensing requirements. Loan origination activity generally poses U.S. taxable “trade or business” activity considerations and necessitates information barriers/walls to separate securities trading activities from borrower lending activities. Investment funds are challenged to develop the kinds of market access and broad reach historically enjoyed by large banks.
From a funding perspective, funds have to consider that, in the absence of deposit-taking, there are fund-raising needs and issues of timing – capital call notice periods, hedging, match funding, maturity mismatch risks (e.g. short-term funding for long-term assets); and counterparty risk for borrowers. In a number of areas, such as in real estate finance, investment funds must consider the availability and ease of securitization. Transaction-specific lending structures may vary widely and can include revolving credit facilities, repurchase agreements, term loans, securitizations and other kinds of structured and asset-based financings.
From a portfolio management perspective, an investment fund must consider investment advisor registration questions and potential statutory investment advisor duties, as well as conflicts of interest issues that may stem from multi-tranche investing or different channels of access to borrower information. Business relationship conflicts could arise as well. An investment fund's obligation to its equity investors must be evaluated on a number of levels, such as return of capital timing, needs for liquidity, avoiding mark-to-market risks, and accommodating excuse needs/requests. Special measures may be necessary to enable pledging of capital commitments. Obligations to provide ongoing disclosure to investors must be considered in light of obligations of confidentiality.
Regulatory changes, actual and pending, must be considered across many areas and in different jurisdictions. A very large fund could become subject to certain requirements due to being deemed systemically important. The new U.S. rules that will curtail or limit equity investments by banks in funds may lead to market shifts in how funds themselves are capitalized.
U.S. tax law requirements scheduled to take effect under FATCA will affect structures as well. Operational systems will need to enable a fund to perform borrower AML and suitability reviews, have reliable cash management systems, and carry out ongoing reporting. Additional considerations arise in managing credit-impaired and distressed loan assets.
Private investment funds are well-positioned to fill an existing and growing funding gap borne of changes in the traditional banking industry occurring around the world. Adapting to meet this opportunity is bringing structural and operational changes to funds and giving rise to new fund structures designed to meet the needs of borrowers and other customers while addressing the needs of fund investors. Broadly-focused planning and structuring will best position an existing or contemplated investment fund to explore new opportunities in shadow banking.
Steven T. Kolyer is a partner of Clifford Chance US at the firm's New York City office. Mr. Kolyer has extensive experience in structured financings and other credit transactions through the securities and finance markets and in investment fund formations and investments. Over the years Mr. Kolyer's experience has been highlighted by transactions involving innovation and structured solutions in the capital markets. In this regard, he played a lead role in the development of a number of securitization products dating back to the origins of that market, in the U.S. and off-shore, including first-time structures with real estate loan and other financial assets in various types of actively-managed fund and specialty finance products. He has headed the Firm's U.S. Structured Capital Markets Group and is recognized as a leading lawyer by Chambers, Legal 500 and NY Super Lawyers. Mr. Kolyer may be contacted on +1 212 878 8473 or by email at firstname.lastname@example.org.
* See "Shadow Banking: Strengthening Oversight and Regulation", Recommendations of the Financial StabilityBoard, October 27, 2011.