Topaz Johnson | The new dynamics of alternative investment funds

The phenomenal growth of alternative investment funds, or AIF, internationally has ignited new economic analysis, debate and even litigation. The sector’s increasing prominence in Jamaica takes the topic beyond academic interest, locally.

Finding a universally accepted definition of AIF is difficult, but a variant of the European Parliament’s might suffice for this article: that is, any collective investment undertaking, including investment compartments thereof, which raises capital from a number of investors with a view to investing it in accordance with a defined investment policy for the benefit of those investors and which does not require authorisation pursuant to laws regulating collective investment schemes offered to the public.

The International Monetary Fund highlighted AIF and in particular corporate private credit, or CPC, in its April 2024 Global Financial Stability Report. The IMF’s definition of CPC is “nonbank corporate credit provided through bilateral agreements or small ‘club deals’ outside the realm of public securities or commercial banks”.

Increased interest in AIF is unsurprising given their growth since the global financial crisis which resulted in tighter bank regulation. The United States Securities and Exchange Commission, SEC, reported that assets under management of all private funds reported to it by advisers between October 1, 2017 and September 30, 2022 grew from US$15.75 trillion to over US$26.2 trillion. The European Parliament noted that the EU market for AIF reached €6.8 trillion in net asset value at the end of 2022, increasing by over 15 per cent between 2020 and 2022.

CPC has taken market share from bank lending and public markets. The IMF reports that CPC’s remit has expanded over the past five years growing at an average annual rate of 20 per cent during this period to US$1.6 trillion as at June 2023.

AIF has gained positive recognition. This February the European Parliament stated, “there is still room for the industry to grow by providing institutional investors with greater choice and enhancing the competitiveness of the capital markets union”. The IMF acknowledged that “private credit creates significant economic benefits by providing long-term financing to firms too large or risky for banks and too small for public markets”. Additionally, providers of CPC might offer a combination of greater flexibility, speed of execution and confidentiality than banks.

While recognising the valuable contribution of CPC the IMF has warned of potential risks. Also, regulatory authorities in the US and Europe have within the past five years made their own assessments and initiated legal and regulatory changes affecting AIF.

One risk the IMF identified relates to the competition between banks and CPC. The reasoning is that “as private credit assets under management grow rapidly and competition with investment banks on larger deals intensifies, supply-and-demand dynamics may shift, thereby lowering underwriting standards, raising the chance of credit losses in the asset class and rendering risk management models obsolete”.

Another IMF concern is that private credit vulnerabilities may become systemic if for instance borrowers’ weaknesses generate large, unexpected losses in a downturn. A fear of the unknown features in risk analysis. Data constraints make it challenging for supervisors to evaluate across segments of the financial sector and assess potential spillovers.

Both the IMF and US regulators are concerned by the increasing retail participation in private credit markets, particularly through insurance companies and pension funds.

The IMF identified some mitigants against CPC’s possible effect on financial stability, noting that risks “appear contained at present”. Mitigation includes the support of private equity sponsors and the relatively close and flexible relationship between lenders and borrowers. Collateralisation and greater use of covenants in agreements provide some protection for investors. These factors may lessen defaults in a short-lived downturn, it notes.

Analysts seem nervous though that CPC at a historically high level might amplify negative shocks to the economy in a longer downturn.

AIF regulation is not new. Regulation and supervision of private funds was strengthened significantly after the global financial crisis. Market-specific regulations have emerged. For instance, the EU crafted specific regulations for AIF, through the AIF Managers Directive, AIFMD, while some other jurisdictions regulate activities of entities involved in AIF using the same laws applicable to entities not involved.

Amidst the recent rapid growth in CPC, the IMF has encouraged countries to “undertake a further comprehensive review of the regulatory requirements and supervisory practices where the private credit market or exposures to private credit are becoming material.”

Efforts at such enhancement preceded the IMF’s pronouncements. The European Commission had by February 2024 concluded that amendments to its AIFMD were necessary to improve its functioning for integrating the EU market for AIF, ensuring a high level of investor protection and protecting financial stability.

However, regulators in the US met resistance. In 2023, the SEC adopted a rule to enhance the regulation of private fund advisers “designed to protect investors who invest in private funds and to prevent fraud, deception or manipulation by the investment advisers to those funds”, referred to as the Final Rule. On June 5, 2024, on a petition by private fund managers the US Court of Appeals for the Fifth Circuit held that the SEC had exceeded its statutory authority in adopting the Final Rule and set it aside. What of AIF in Jamaica? The exact number of firms involved in AIF is uncertain. The Caribbean Alternative Investment Association was incorporated in 2019 to promote the expansion of alternative investments in the Caribbean. Its membership of over 25 entities consists largely of Jamaican companies, but likely reflects only some Jamaican entities involved in AIF.

There is no single enabling or regulating statute applicable to all Jamaican companies involved in AIF. However, there are laws applicable to all such companies. Their applicability depends on the type of AIF and the individual transactions of AIF companies.

The Companies Act applies to all companies. The Securities Act’s requirements for investment advice businesses or dealing in securities apply to some transactions and AIF companies. The Microcredit Act applies to companies granting credit facilities or providing business advisory services to medium-sized enterprises if exemptions are inapplicable. For some foreign currency loans, the Bank of Jamaica Act is relevant. Pension regulations now allow for limited investments in equity and debt securities of private companies. The list of laws could continue.

Regulation of AIF companies now and in the future is in the context of the government’s indication that financial supervision will adopt a twin-peaks regime by 2026. This will ultimately make the BOJ the sole prudential supervisor of financial sector entities, while the FSC will focus on supervision of market conduct and consumer protection. The IMF sees the need for both aspects of supervision for CPC.

Various sectors within Jamaica including the government through the Development Bank of Jamaica have supported the development of AIF. This aligns with international recognition of AIF’s economic value. Still, AIF companies may desire more enabling laws. Regulators would assess safeguards within the context of growing participation.

The SEC case may demonstrate an extreme method of creating a balance between perspectives. A harmonious approach should be achievable given available lessons on how this sector is taking shape globally, with the possibility that Jamaica may again contribute insights beyond its shores and size.

Topaz Johnson is an attorney-at-law who specialises in banking and finance law.topaz.johnson@dunncox.com