The Road Ahead: DFSA Seeks Market Feedback on the DIFC Credit Fund Regime

The Dubai Financial Services Authority (DFSA) has issued a consultation paper (CP 158) relating to proposed amendments to its Collective Investment Rules (CIR), which includes one proposed change in relation to credit funds, and has separately issued a Call for Evidence seeking market feedback more generally on nearly all aspects of its rules relating to credit funds, including the overarching question of whether Dubai International Financial Centre (DIFC) fund activity involving private credit should attract special requirements—as compared to other private funds—in the first place.

This LawFlash discusses the key proposed changes in relation to DIFC credit funds contemplated by CP 158 and the Call for Evidence.

Private credit as an investment strategy has significantly increased in popularity in recent years. In recognition of that, the DFSA implemented a specific regime for credit funds in June 2022. This regime imposed a number of special requirements on credit funds,[1] including the following:

1. Only professional clients (as defined in the DFSA rules) may invest in credit funds
2. Credit as an asset class is only available to those DIFC funds which invest almost exclusively (at least 90%) in credit[2]
3. Certain credit instruments are prohibited, including letters of credit, financial guarantees, and cross-border trade finance activities
4. Leverage is limited to 10% of the net asset value of a DIFC credit fund’s property
5. DIFC credit funds may only take a close-ended form
6. DFSA-authorised fund managers are not permitted to act as fund managers of a non-DIFC credit fund[3]
7. DIFC credit funds must have a clear strategy which aims, within a specified period not exceeding three years from the date the fund is established, to achieve a diversified portfolio of loans that limits exposure to any one person or group to a maximum of 25% of net assets
8. DIFC credit funds are prohibited from providing loans to certain related parties

The only foregoing requirement currently proposed to be changed is item six above, with the DFSA proposing to remove this restriction and permit the appointment of DFSA-licensed fund managers as fund manager of a non-DIFC credit fund. Based on the information available in the public register to date, the DFSA has only once approved the appointment of a DFSA-licensed fund manager as fund manager of a non-DIFC fund, so this proposed change may be a reflection of an increased number of relevant inquiries by industry participants and could indicate a new willingness of the DFSA to approve cross-border fund arrangements. Our experience is that, in practice, a DFSA-licensed entity will, assuming it has the appropriate “Managing Assets” financial services permission, generally seek to be appointed as the “investment manager” rather than “fund manager” of non-DIFC funds. The availability of this option remains unchanged by the current proposals.

Of the other requirements, items one through five (inclusive) are specifically identified in the DFSA’s call for evidence, although the DFSA is additionally seeking any other comments in relation to their credit fund regime.

In our view, a relaxation or removal of certain of the special requirements attached to DIFC credit funds would be welcomed by the market, as this would reduce or remove the regulatory arbitrage that currently exists as between the DIFC and other jurisdictions. This includes the other financial free zone in the UAE, the Abu Dhabi Global Market (ADGM).[4] In particular:

• we see demand for investment funds offering a combination of debt and equity investments, so we consider a reduction in the 90% threshold would be advantageous for sponsors, as it would enable them to offer funds deploying capital as both debt and equity;
• we are also seeing strong demand for credit funds to participate in cross border trade finance activities and consider that the robust stress testing requirements of the DIFC Credit Fund rules together with the diversification limits should be sufficient to mitigate the risks associated with the complexities of these financing activities—in fact, the treatment of trade finance funds as credit funds may ensure that the industry is better streamlined in terms of its regulatory treatment and the ability of fund managers to exercise broader discretion in selecting appropriate debt instruments to invest in;
• because credit funds have a more flexible approach to leverage and in general tend to utilize fund level leverage at higher levels than equity strategies, increasing the 10% limit to 100% may cause the DFSA rules to align with market practice and the rules of the ADGM (noting that under AIFMD II the leverage limit for credit funds is 300%[5]); and
• open-ended credit funds have enjoyed success in other jurisdictions, and we expect this flexibility would be welcome in the UAE, which has large pools of patient capital.

We note the DFSA’s query in relation to making credit funds available to retail investors. Whilst the financial free zones in the UAE, including the DIFC, have historically catered to institutional clients, it is expected that the UAE’s retail market will grow, and we are seeing demand for financial free-zone (both DIFC and ADGM) investment funds that can be marketed to UAE onshore retail investors through the intra-UAE marketing passport. This is because since 1 April this year, only funds that are domiciled in UAE onshore, or in either of the UAE’s financial free zones and which utilise the intra-UAE marketing passport, may be offered to UAE onshore retail investors.

That being said, we note that private credit has developed as an institutional asset class and the sophistication of its investors has driven the general practice of limited regulatory requirements, high levels of leverage, and so on. It may therefore be prudent to maintain some of the DFSA’s current special requirements in the context of DIFC credit funds offered to retail investors, whilst relaxing them as described above for those credit funds limited to “Professional Clients.”

Finally, whilst this particular requirement has not been specifically highlighted by the DFSA in its Call for Evidence, the prohibition on DIFC credit funds from making loans to certain “Related Parties of the Fund Manager” has, in our experience, posed some unexpected business constraints. It is not uncommon for large asset managers (of the type the UAE wishes to encourage to establish operations and launch products in and from the UAE) to operate debt, equity, and hybrid investing products, which may co-invest alongside each other.

We are also seeing a trend of established operating businesses in the UAE being willing to form asset management arms to offer third parties the opportunity to invest, via fund structures, in certain aspects of their businesses, which would be beneficial to the UAE’s broader economy in encouraging private investment.

Finally, it is unclear from the rules whether 5%+ investors are considered Related Parties for the purposes of this limitation—they are described as “Related Parties of the Fund” in the DFSA’s Glossary and the DFSA’s Credit Fund rules refer to “Related Parties of the Fund Manager,” so a reasonable interpretation is that these large investors are not considered Related Parties for these purposes. Given the prevalence of anchor investors in the UAE and broader Middle East funds market, clarification on this aspect of the rules would be beneficial.

In our view, in the context of professional investor funds and subject to fulsome disclosure in a fund’s offering materials, these sorts of related party transactions should be permitted. Sophisticated investors also generally negotiate investor consent requirements and other investor protections in relation to these mechanics, which is why the disclosures in the offering materials are important—they enable these investor discussions and document negotiations. The DFSA rules already require that offering documents contain all the material information that a person would reasonably require to make an informed investment decision, and that, in our view, should capture such related party transactions.

The Call for Evidence shows the DFSA continues to closely monitor the evolution of the private funds market and focus on ensuring that its rules encourage growth of the asset management sector in the DIFC whilst maintaining international best practices and appropriate investor and systemic protections.

Morgan Lewis is proud to participate in the market feedback process and our team looks forward to engaging with the DFSA on any proposed revisions to the DFSA Credit Fund Rules in due course.

View the table >>