Thinking | 4 May 2020

Investment funds: key points for credit or lending funds to consider when assessing the security of your book

By Katherine Payne, John Hutchinson, Mark Inston, Vince Battaglia and Harry New

The economic impact of the COVID-19 pandemic is likely to continue long after the health risk passes, with a significant economic downturn forecast by the Reserve Bank of Australia. This is likely to have a substantial impact on investment funds involved with lending, where an investment book may be exposed to several businesses simultaneously facing financial difficulties.

Now is the time for funds to 'stress test' the loan securities held under their investment book, and to formulate a well-structured strategy to respond. This article raises 10 key matters which ought to be considered when assessing loan investments secured over business assets and property.

  • Know your duties. In formulating strategy, officers of credit or lending funds must be conscious of their obligations and duties as trustees under Australian financial services licences, the Corporations Act, the general law and more broadly the fund constituent documents. These include an obligation to act in the best interests of the fund's investors. During this period, there is likely to be a heightened focus on the conduct of directors, related party dealings, and whether directors are complying with their obligations.
  • Revise the fund's cash flow analysis regularly. Market conditions are changing quickly, and it is important that directors of corporate trustees make decisions based on up-to-date information.
  • Categorise your book. High risk, medium risk and low risk investments will all require ongoing monitoring, but the fund's approach is likely to differ between categories. Act now to undertake that assessment and to develop the appropriate strategies for each category, so the fund can move swiftly when required.
  • Up-to-date valuations are important. Market conditions have impacted the value of both land and non-land assets. Strategies based on old asset values risk being out-of-date and may not provide accurate estimates of potential returns and recoveries on default. Ensure that you are satisfied with current valuations of secured assets and that there is a proper foundation for them, especially where the fund's exposure may be significant. This will also be important in relation to making decisions on suspending redemptions and issues of units in a fund.
  • Up-to-date financials and projections are equally important. For significant investments, you may request that the entities who have given the fund security provide an up-to-date cash flow analysis, both actual and forecast. You should also obtain information about their COVID-19 recovery plans. You may need more information than the periodic reporting required by your loan or other agreement with the entity. Usually, these documents allow for reasonable further information to be given upon request. This information should be assessed so that you can be satisfied that the businesses who have given securities to the fund have ongoing viability.
  • Know the fund's rights if the security provider defaults. Have you confirmed that the fund has the enforcement rights that you believe it has? What are the fund's obligations in undertaking enforcement action (eg notices, timeframes, investor communications)? What disclosures have you provided to investors in information memoranda about lending and debt collection practices, and does this need to be updated? You may need to reserve your rights if you agree to waive a default; in some cases, you may have waived your rights unknowingly. What is the best enforcement strategy for each type of security? These matters ought to be subject to ongoing consideration, not only when the fund is facing a potential default.
  • Review security registration and debt collection strategies. As part of this review:
    • Ensure that the fund's securities are valid and properly registered on the PPSR or other register, such as a land registry. It is not uncommon for a small inadvertent error in a PPS registration to entirely invalidate a security, leading a secured creditor to lose their rights. Now is a good time to ensure the fund is properly protected.
    • Make sure that you know the priority of the fund's security and your rights against more senior lenders. If the fund has taken second or third ranking securities, this may lead to a different strategy than if the fund has first ranking securities.
    • Consider whether lending and debt collection policies should be updated, and whether this will require follow-up disclosures to investors.
  • Consider the timing of when to act if there is a default. In this market, asset values may erode quickly. Delaying consideration of the available enforcement action may have the result of reducing the fund's potential recoveries. Equally, enforcing too quickly may not recover the true value of an asset.
  • Don't become a shadow director. Be careful that you do not inadvertently become a shadow director if you are giving direction to an entity in which you have invested.
  • Have a game plan for investor defaults. What will you do in the event of investor default? While investor defaults are traditionally rare, current market conditions may impact some investors' ability, or willingness, to meet their previously agreed obligations under the terms of issue of interests in the fund. Ensure that you know the fund's rights in the event of any such defaults. This includes the funds' rights and obligations in enforcement against the defaulting investor, and whether the fund is entitled to call for additional funds from the remaining investors to meet the shortfall.
  • Review your fund's disclosure document and other disclosures. You are likely to have made statements and representations to investors in your disclosure documents about your investment objectives and strategy, expected returns and distribution frequencies. You may also be required by law to give updated disclosures of any material changes. Under current market conditions, some of these representations may be adversely impacted by events and need to be reassessed or updated. In most cases, the potential for such impacts will have been contemplated as a risk in the disclosure documents, but this has to be assessed.
  • Communicate with your investors. In times like these, investors will be keen to understand the impacts on their investment and understand the fund's strategy going forward. For example, investors will want to know about whether loan investments have been impaired and whether such impairments affect the value of the fund's assets, forecast distributions and the current value of the fund's unit prices. Communication with investors generally and individually will allow you to manage their expectations, avoid investor complaints and mitigate the risk of any investor activism.

A strong plan can have a significant impact on an investment fund's ability to recover its investments. It is important that senior management actively monitor the fund's exposure and act quickly and strategically when required.

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