MHC Financial Services Sector Update - In Brief - Q1 2024

Financial Services Sector Update In Brief Q1 2024

Financial Services Sector Update - In Brief

Welcome

Welcome to the latest edition of our Financial Services Sector Update - In Brief series. In this interactive magazine, we feature our most popular insights from the past month. We hope you find it informative.

First up, in the above video, Financial Services Sector lead partner, Liam Flynn discusses the key legal trends impacting stakeholders and policy makers in 2024. In particular, Liam talks about:

• New opportunities for financial institutions, including the expansion of private credit through loan origination funds

• The significant challenges that insurers are encountering due to climate change • The need for financial institutions to enhance their customer experiences and outcomes as a result of regulatory pressures

Key Contacts Liam Flynn Partner, Financial Services Lead lflynn@mhc.ie

Contact our Financial Services team

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Neil Campbell Partner, Head of Banking & Financial Services ncampbell@mhc.ie

Financial Services Sector Update - In Brief

Investing in Space

Can Ireland unlock its potential?

Julie-Ann Sherry Partner, Aviation & Asset Finance jsherry@mhc.ie

David McGovern Partner, Head of Aviation & Asset Finance dmcgovern@mhc.ie

The space industry is rapidly evolving from one dominated by the public sector to a model where private enterprise plays a significant role.

As the space economy expands so does the variety of investment opportunities. The industry encompasses a diverse range of commercial players, such as providers of satellite broadband internet, space tourism and launch services.

• Recognition of the critical role space has in the

Ireland has the capability and expertise to capture a larger portion of the global space industry.

Morgan Stanley estimates that the global space industry could generate revenue of more than $1 trillion or more in 2040, up from $350 billion in 2020.

Evolution of the space industry The term “New Space” or “Space 4.0” has been coined to describe the shift in the global space industry. Previously, it was regarded as a predominantly government-funded public sector model. More recently, it can be described as an era characterised by increasing private investment and interaction between governments, the private sector, society and politics.

Several factors have ignited the interest of private investors in the global space sector, including:

• The deregulation of satellite communications and the opening of domestic markets which enable new entrants to the satellite telecommunications industries.

• Technology has improved, reducing launch

global economy via (1) satellite communications and connectivity, (2) earth observation, and (3) navigation systems. Investment in space is likely to impact several industries beyond aerospace & defence, such as the IT hardware and communication, energy and agriculture sectors to name a few.

There are three stages of the space value chain attracting investment:

• Upstream: Spacecraft manufacturing and launch vehicles

• Midstream: Spacecraft operations and in-orbit management

• Downstream: Spacecraft-derived data application and services

Ireland and space Ireland manages its investment in space primarily through the Department of Enterprise, Trade and Employment (DETE) and Enterprise Ireland. In 2019, Ireland’s National Space Strategy was unveiled.

In 2023, the Irish Space Association (ISA) was launched to bring together various stakeholders in the Irish space industry.

costs and lowering barriers to accessing space.

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Financial Services Sector Update - In Brief

Since Ireland joined the European Space Agency (ESA) in 1975, Irish industry and research groups have demonstrated the ability to provide innovative technologies for use in the European space programme. The aim of both the space strategy and the ISA is to showcase these abilities at an international level and capture a larger portion of the global space sector.

2023 saw notable achievements by the Irish space industry. Ireland’s first satellite, Eirsat-1 was launched successfully into space. Now in orbit, the satellite goes around the earth once every 100 minutes. The satellite has been picked up by ground stations around the world.

Dublin-based artificial intelligence innovator, Ubotica Technologies was awarded a NASA Group Achievement Award for being part of the ISS autonomy and instrument processing team on the Spaceborne Computing 2 on the International Space Station.

What next for Ireland’s space industry?

It’s an exciting time for Ireland’s growing space industry. Ireland has the expertise to be at the forefront of space innovation and technology.

To date, the Irish space industry has excelled in upstream business. There is a desire by Irish stakeholders to develop downstream business, particularly earth observation, satellite communications and connectivity and navigation.

Similar to Ireland’s world-leading aircraft finance industry, Ireland can offer an attractive business ecosystem for satellite leasing firms, space sector companies and investors alike. The appeal of doing business in Ireland is well documented:

• Ireland’s attractive tax position with a low rate of

corporate tax and an excellent double tax treaty network.

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• Ireland’s common law legal system. The

types of transactions involved in financing space ventures vary. Equity finance secured and unsecured lending, and project finance structures have been utilised to raise capital. The legal environment in which these transactions take place is a major factor in ensuring that these transactions can be structured in a manner that reduces costs and risks.

• Ireland’s ability to support these transactions

is demonstrated in the success of its global aviation industry. Our Aviation & International Asset Finance team advises on the financing, leasing and structuring of platforms for the aviation and shipping industries. Our expertise can similarly support domestic and international clients in the space industry on a range of matters from international asset financing and cross-border leasing, to regulation and alternative funding.

• Ireland’s membership of the EU, political stability and depth of talent in space innovation also demonstrate the appeal of doing business in Ireland for the space industry.

The Irish space sector is committed to growth. The National Space Strategy’s ambitious targets of doubling space-related revenue and employment in space companies by 2025 illustrates the Irish industry is in a new era of its own, one which recognises the potential it has to offer the global space economy.

For more information and expert advice on anticipated transactions in this sector, contact a member of our Aviation & International Asset Finance team.

Financial Services Sector Update - In Brief

The Irish CRE Market Can it survive to 2025?

Irene Nic Chárthaigh Partner, Financial Services iniccharthaigh@mhc.ie

As 2023 came to a close the European Central Bank (ECB) predicted that the euro zone’s sinking commercial property sector could struggle for years to come, posing a threat to the banks and investors that financed it. We consider the causes and symptoms of the distress in the Irish commercial real estate (CRE) market, the lessons that can be learnt from the US and UK, and whether a further repricing of the market is likely. We will also examine the potential catalysts in bringing about a market correction and the investment opportunities that will result.

Neil Campbell Partner, Head of Financial Services ncampbell@mhc.ie

Current state of the Irish CRE market Rising funding costs, tightening credit standards and a deterioration in sentiment amongst market participants have caused investment activity in the Irish CRE sector to decrease. This slow down stood at nearly 60% by the end of the third quarter of 2023 compared to the same period in 2022.

This has been accompanied by a sharp decline in property capital values, down 14% year-on-year according to 2023 Q3 data from the Central Bank of Ireland, bringing the cumulative fall to over 20% since late 2019. As of the time of writing, the Central 5

Financial Services Sector Update - In Brief

As 2023 came to a close the European Central Bank (ECB) predicted that the euro zone’s sinking commercial property sector could struggle for years to come, posing a threat to the banks and investors that financed it. We consider the causes and symptoms of the distress in the Irish commercial real estate (CRE) market, the lessons that can be learnt from the US and UK, and whether a further repricing of the market is likely. We will also examine the potential catalysts in bringing about a market correction and the investment opportunities that will result.

Current state of the Irish CRE market Rising funding costs, tightening credit standards and a deterioration in sentiment amongst market participants have caused investment activity in the Irish CRE sector to decrease. This slow down stood at nearly 60% by the end of the third quarter of 2023 compared to the same period in 2022.

This has been accompanied by a sharp decline in property capital values, down 14% year-on-year according to 2023 Q3 data from the Central Bank of Ireland, bringing the cumulative fall to over 20% since late 2019. As of the time of writing, the Central Bank of Ireland has not yet published its year end data, but it is predicted the CRE investment activity in 2023 will be significantly below the 10-year average.

The office sector is currently the worst performing, with the largest price declines for lower quality, older and less energy efficient units. While rising interest rates have put downward pressure on prices in the Irish CRE market, waning tenant demand due to remote working policies and a change in Irish tech firms’ office requirements, has also played a significant role. CBRE report that the vacancy rate across all stock in the Dublin office market is now close to 15%, this is the highest point since 2014.

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On the finance side, lenders are reporting sizeable movement of CRE loans to stage 2 arrears. This is defined under accounting standards as a significant increase in credit risk. One bank’s half year results reported an increase of stage 2 loans from €2.3 billion to €3.7 billion in its property and construction portfolio, excluding residential mortgages. €1.6 billion of this was made up of commercial investment exposures, most of which were commercial investment office loans. For context, the bank cited potential interest cover breaches and an unlikelihood of these borrowers being able to meet refinance terms as causes of this movement.

On a more positive note, the Central Bank has recently reported that Irish banks’ CRE exposures are a much smaller portion of total lending than in the past. They had declined significantly since the 2008 financial crisis from just over 30% to under 10%. CRE borrowers now have loan-to-value (LTV) ratios that will allow for substantial price declines before losses are experienced, with the estimated weighted average current LTV of banks’ CRE investment exposures currently around 50%.

However, the Central Bank now warns that LTV positions are subject to elevated risks relating to market liquidity when trying to realise collateral values in a stressed market.

Comparisons with the US and UK CRE markets Distress in the commercial real estate market is not unique to Ireland. Globally, commercial property investment is at an all-time low. This is largely driven by the same factors: high interest rates and waning demand for office space. Despite this, there has not yet been a significant repricing of the CRE market. Sources indicate that in the 12 months up to the end of March 2023, US-listed real estate prices decreased by 14%, compared to 22% in the UK for the same period and 13% in Europe.

Financial Services Sector Update - In Brief

Some of the reasons for this are:

• Assets being refinanced rather than repriced and sold, and

• Lack of willingness from sellers to accept low

offers, particularly in London where purchasers are seeking to pay over a quarter below the asking price

• As with the UK and US markets, there remains

unrealistic pricing in the Irish CRE sector. There needs to be a cyclical pricing correction in weaker CRE assets to bring liquidity back to the market.

Opportunities and solutions While it is clear the Irish CRE market is in need of further repricing, we must look to the potential solutions in making that happen, and whether they are likely to be borrower-led or lender-led.

The price gap between sellers and purchasers can, at least in part, be explained by timing of loan maturities and the “pretend and extend” phenomenon. The Central Bank reported in its most recent Quarterly Financial Stability Review that most commercial real estate loans owed to banks need to be repaid or refinanced by 2027, with a quarter due by the end of 2024.

Despite this, the prevalent attitude among market participants is “survive to 2025”. We should expect to see extensions, modifications and a variety of other tactics as lenders and borrowers “hold-on” in the hope of “waiting- out” the high interest rates and for market conditions to improve. In the current market, enforcement makes little sense to lenders who will be hard-pressed to get more out of these assets than the current owners. However, if lenders are unwilling or unable to extend new credit or refinance the existing loans, owners will be forced to align their pricing to make assets more attractive.

of the difference in attitude between senior banks and non-bank lenders regarding appetite for risk.

In terms of lending for office projects, 50% of senior banks said that they would lend at an LTV ratio of up to 59%, while 50% would lend at an LTV ratio of up to 69%. When non-bank lenders were asked the same question, a third said they would lend at an LTV ratio of up to 69% and 44% said they would lend at an LTV ratio of up to 79%.

The conservative approach of the traditional banks will require borrower-led resolutions. These might include:

• An injection of additional sponsor equity • Putting in place hedging agreements to

safeguard against interest rate rises, and

• Consensual sales This kind of creative capital structuring may plug the gap until interest rates start to level out.

The ECB restrictions on the traditional banks have resulted in a widening of the debt-funding gap. It is defined as the gap to be bridged between the original debt amount due at loan maturity and new debt available to repay the original debt. The debt-funding gap presents an opportunity for lender-led resolutions in the form of investment by alternative lenders, as demand for alternative financing grows. Alternative financing solutions include additional sponsor equity, mezzanine and junior debt insertions and preferred equity lending, or a combination of these. Indeed, we are aware of private equity credit funds being set up for this purpose.

As the traditional banks look to keep their LTV and Non-Performing Exposure (NPE) ratios in line with ECB requirements, many CRE loans will be unable to refinance without creative solutions from borrowers and alternative lenders. KPMG’s recent Irish Real Estate Lending Survey paints a picture

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Financial Services Sector Update - In Brief

If refinancing is not achievable, and owners do not elect to put their properties back on the market, an orderly sale of loans on a consensual basis with sponsors is the most likely course of action for banks as they look to protect their balance sheets.

This approach is prevalent in the US market at the moment. This presents another opportunity for investors to purchase portfolios of non-performing loans or loans experiencing stress at a discount.

Alternatively, investors experienced in asset restructurings may adopt a loan-to-own strategy and acquire discounted, non-performing debt to lead a restructuring, becoming the equity owner of a property at a discounted valuation.

Receivership is an important tool for lenders if a borrower enters repayment difficulty. The Beckett Building formerly occupied by Meta is a recent high-profile example of a Dublin office put into receivership. Bought by Korea-based Kookmin Bank for €104 million, it was put back on the market at a significantly reduced price of €80 million. Even at €80 million, the owners were unable to find traction for a sale and, reportedly, the lender was in a position to accept an offer as low as €60 million.

The repossession and potential sale of CRE assets by lenders has the potential to exacerbate price declines. Receivership numbers remain low. From the stock of outstanding balances owed by Irish CRE borrowers in June 2023, just 0.1 per cent of these balances are associated with a receivership initiation in 2023. This is broadly in line with an average of 0.2 per cent for the years 2020 to 2022, which suggests this trend is set to continue in the near term at least.

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Conclusion Despite economists predicting cuts by Q2 2024, ECB interest rates remain stubbornly high and with Eurozone inflation rising again in December 2023, the economic outlook remains uncertain.

If we do not see interest rates tapering off from Q2 2024 onwards, traditional lenders may be forced to take more aggressive action against borrowers in an effort to protect their balance sheets. This may come in the form of loan portfolio sales. Of course, these sales will offer an alternative entry point for investors and will also open the door to loan-toown strategies. We may also see increased levels of receiver sales if lenders decide to enforce.

Movement in the CRE market may be triggered if traditional lenders lose confidence in the value of CRE loans and borrowers’ resilience wanes in the current market conditions. If borrowers cannot refinance with the traditional lenders, they may look to alternative lenders with strong balance sheets to offer equity top-ups and other forms of alternative financing to help bridge the debt funding gap.

While market participants have adopted the “survive to 2025” mantra, 2025 may seem a long way away for those borrowers due to refinance during 2024.

For more information and expert advice on navigating the issues impacting the CRE market in 2024, contact a member of our Financial Services team.

Financial Update - In-Brief FinancialServices ServicesSector Sector Update In Brief

A New Chapter for Crypto in 2024?

Rowena Fitzgerald Partner, Co-head of Financial Regulation rfitzgerald@mhc.ie

Sarah Cloonan Partner, Financial Regulation scloonan@mhc.ie

Since late 2022 the global crypto industry has been in turmoil. In the USA, the approach of state and federal regulators has been to vigorously pursue enforcement action against crypto firms in an attempt to eradicate bad practices. The downfall of FTX and its founder Sam Bankman-Fried has been well documented. Coupled with investigations into other big players in the crypto market, these developments have served to focus attention on the lack of oversight in the sector.

Nonetheless, there is reason for the crypto industry to be optimistic going into 2024. The imposition of increased regulatory oversight and clearer rules on players in the industry will allow for greater certainty for crypto providers and customers alike.

It is hoped that the recent penalties imposed on crypto operators, together with the introduction of stringent regulatory controls, will deter similar regulatory breaches in the future and increase consumer confidence in the market.

In the EU, the Markets in Crypto Assets Regulation (MiCAR) will finally introduce a harmonised regulatory framework for crypto-assets and is set to take effect in 2024. MiCAR will establish an authorisation regime for crypto-asset service providers, allowing them to passport their services across the EU.

Perhaps this recent regulatory action has contributed to the price of Bitcoin surging in recent months to reach a high of $42,000 in December 2023. In addition, in a significant boost for the crypto industry, the SEC has approved the first USlisted stock market funds to invest directly in Bitcoin.

This will offer investors exposure to Bitcoin without having to hold it directly.

We consider the outlook for the crypto industry in Ireland and further afield in 2024.

Recent enforcement action Globally, the number of investigations into crypto and fintech companies rose sharply in 2023. For the first time, this group was fined more for regulatory deficiencies than traditional financial institutions.

Recurring issues identified by regulators included inadequacies in anti-money laundering (AML) and sanctions compliance. Most notably, the world’s largest crypto exchange, Binance, entered into a settlement of $4 billion with the US Department of Justice relating to regulatory violations, which saw its founder, Changpeng Zhao, step down as CEO. 9

Financial Services Sector Update - In Brief

Developments at home

Comment

Under MiCAR, a grandfathering period is available for existing crypto asset service providers providing their services in accordance with national law for 18 months. However, the Department of Finance recently confirmed in a Feedback Statement that Ireland has opted to reduce this grandfathering period to a maximum of 12 months. In addition, it confirmed that Ireland will not exercise the discretion to offer existing virtual asset service providers (VASPs) a simplified authorisation process under MiCAR.

The lack of a clear regulatory framework in the US, coupled with the rigorous enforcement action there in recent months, means that it is currently a challenging environment for crypto exchanges to operate in.

Firms in Ireland with existing VASP registrations who intend to apply for authorisation under MiCAR are likely to have to reach a significantly higher regulatory threshold. For example, higher levels of substance and governance will certainly be expected of MiCAR entities.

We have extensive experience in advising crypto operators and are assisting firms who are interested in applying for authorisation under MiCAR. Please reach out to a member of our Financial Regulation or Fintech teams should you require advice and support in this area.

While the CBI is not mandated to foster innovation, in 2018 it established an Innovation Hub to enable fintech firms to engage with the CBI outside of its formal processes. In response to feedback received from crypto and payments firms via the Hub, the CBI announced its intention in a recent Consultation Paper to establish a Regulatory Sandbox in 2024. This will provide stakeholders with access to regulatory insight and support to help them understand the potential regulatory implications of their product or business model.

As it sets about implementing MiCAR, consistent with its stated intention to foster innovation in Ireland via the Hub, it is hoped that the CBI will engage in meaningful dialogue with potential applicants. It is also hoped that the CBI will apply proportionate and sensible expectations.

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Consequently, Ireland should be in a strong position to, subject to the Central Bank’s approach to implementation, attract firms who can apply for authorisation under MiCAR and passport their services across the EU.

Financial Services Sector Update - In Brief

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Financial Services Sector Update - In Brief

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The contents of this publication are to assist access to information and do not constitute legal or other advice. Readers should obtain their own legal and other advice as may be required. © Copyright 2024. Mason Hayes & Curran. February 2024.