ADGM Private Credit Funds: How to Design a Defensible Credit, Diversification and Stress Testing Framework

By CRYPTOVERSE Legal Consultancy

A private credit fund can look strong at launch. Its first borrowers are familiar to the investment team, its projected returns are attractive, and its prospectus promises careful underwriting.

The harder test comes later.

A borrower misses a payment. Another asks to extend its facility. Several loans turn out to depend on the same sector. At the same time, interest rates rise and investors want to know what the portfolio is worth.

For an ADGM Private Credit Fund, these are not problems to solve for the first time when they arise. The Financial Services Regulatory Authority (FSRA) expects the fund manager to establish documented credit, concentration and stress testing controls as part of its operating model.

A defensible framework should answer three questions:

Why was this credit approved? How is the portfolio being monitored? What will the manager do if its assumptions fail?

This article explains how to turn the requirements in FUNDS chapter 13A and the FSRA’s Supplementary Guidance – Private Credit Funds into a practical framework.

Start with the fund’s risk appetite

The first document to design is a fund risk appetite statement. Under FUNDS Rule 13A.2.1(a), the manager’s documented systems and controls must ensure that such a statement is developed and incorporated into the investment process.

It should define the credit risk the fund is prepared to take. Depending on the strategy, that may include:

• Target borrowers and sectors;
• Permitted types of Credit Facilities;
• Desired security and collateral;
• Acceptable borrower leverage and repayment capacity;
• Currency and geographic exposure;
• Maximum transaction size;
• Expectations for loan maturity and liquidity; and
• Circumstances in which the manager will decline or escalate an investment.

The FSRA’s guidance explains that the risk appetite should inform the investment policy described in the fund’s prospectus and constitution, allowing investors to understand the facilities and borrower risk profile the manager intends to pursue. Supplementary Guidance, paragraph 4.1. (assets.adgm.com)

A statement such as “the fund will seek attractive risk-adjusted returns” does little work on its own. A useful risk appetite gives the investment committee limits it can apply to an actual proposed loan.

Build borrower eligibility into the first screen

Before analysing whether a loan is profitable, the manager should establish whether the fund may provide it.

FUNDS Rule 13A.3.1 prohibits credit being provided to, or for the benefit of, natural persons, Affected Persons, Collective Investment Funds, persons intending to use financing for speculative investment, and Banks or Lenders. The FSRA’s guidance also draws attention to these borrower restrictions. (assets.adgm.com)

An initial screening record should therefore identify:

1. The legal borrower;
2. The person or business that will ultimately benefit from the financing;
3. The proposed use of proceeds;
4. Relevant relationships with the fund, manager, investors and service providers; and
5. Any intermediaries involved in the transaction.

A transaction that fails this screen should not proceed to credit approval merely because it offers strong collateral or a high yield. Where the structure is complex, the manager should resolve the legal eligibility question before committing capital.

Create a credit assessment and pricing methodology

Under FUNDS Rule 13A.2.1(b), the manager’s documented controls must ensure that credit is provided only following a sound assessment and pricing methodology. The FSRA does not prescribe one universal lending formula. Its guidance recognises that managers may use different methods, but expects them to demonstrate defined lending criteria and show how those criteria operate in practice. (assets.adgm.com)

A transaction file should allow a reviewer to follow the decision from evidence to conclusion. It might address:

These are practical design considerations, rather than a separate FSRA checklist. Their purpose is to give substance to the required assessment and pricing methodology.

The credit paper should also identify exceptions to policy. If a deal exceeds an internal sector limit or relies heavily on refinancing, the approval record should show who considered that risk, what mitigants were accepted and why the investment remained within the fund’s mandate.

Separate approval from ongoing monitoring

Approval is the start of a credit exposure, not the end of the manager’s responsibility.

FUNDS Rule 13A.2.1(c) requires controls for ongoing monitoring of granted credit, including policies for renewals and refinancing. The same rule requires controls for credit and concentration risk, collateral, bad debts, impairments and valuation.

The FSRA’s guidance expects managers to be able to identify changes in each borrower’s credit risk profile throughout the life of the Credit Facility. (assets.adgm.com)

A workable monitoring process should specify:

• What information borrowers must deliver and when;
• Who reviews financial performance and covenant compliance;
• Which events trigger closer supervision;
• How changes in collateral value are assessed;
• When a facility enters a watchlist;
• Who can approve waivers, extensions or restructurings; and
• When the manager reassesses valuation or impairment.

For example, a late financial report may be a minor administrative issue in one case and an early warning sign in another. The framework should require someone to make and record that judgment.

Design diversification for the whole portfolio

Private credit concentration is not always obvious from a list of borrower names. Several companies may share an owner, operate in the same sector, rely on the same customer, or be vulnerable to the same currency or interest rate shock.

FUNDS Rule 13A.3.2 requires the fund’s investment strategy to achieve its stated diversification and concentration requirements within a suitable, stated timeframe. Rule 13A.3.3 requires the strategy to limit maximum exposure to a single borrower or group of connected borrowers to 25% of the fund’s Committed Capital.

If a fund has USD 100 million in Committed Capital, that rule requires its investment strategy to respect a USD 25 million maximum exposure to one borrower or connected borrower group. The calculation should be applied to the actual relationship between exposures, not just to separate names in the portfolio system.

The FSRA’s guidance expects a clear diversification policy that is realistically achievable after launch. Where the fund does not meet, or is unlikely to meet, that policy, the guidance expects the manager to notify unitholders and provide options for resolution. Supplementary Guidance, paragraph 3.2. (assets.adgm.com)

A concentration dashboard can track the regulatory borrower limit alongside the fund’s own limits by sector, geography, currency, collateral type and maturity. Those additional limits are strategy-specific management choices, not fixed percentages prescribed by Rule 13A.3.3.

Make stress testing a decision tool

Stress testing should tell the manager what its portfolio could look like when several assumptions fail at once.

FUNDS Rule 13A.7.1 requires a comprehensive stress testing and scenario analysis programme. It must, among other things:

• Identify adverse events or economic changes that could affect credit exposures;
• Assess the fund’s ability to withstand them;
• Compare stressed outcomes with the fund’s internal risk limits;
• Consider both individual transactions and aggregate exposures;
• Conduct exposure stress testing of principal market risk factors at least semi-annually; and
• Undertake scenario analysis at least annually.

The rule specifically refers to market risk factors such as interest rates, foreign exchange and credit spreads. Testing must be performed by qualified personnel who are not involved in the fund’s investment management process. The FSRA may direct more frequent testing, and results must be reported without undue delay to the manager’s governing body. FUNDS Rules 13A.7.1–13A.7.3.

A manager might, for example, test a scenario in which:

• Borrower revenues fall across a key sector;
• Interest costs rise;
• Several facilities seek maturity extensions;
• Collateral values decline; and
• The fund cannot refinance its own borrowing on expected terms.

The exercise becomes useful when it identifies which borrowers need action, which limits may be breached, whether valuations need reassessment and whether the fund retains enough capacity to meet its obligations.

The FSRA’s guidance expects managers to demonstrate both their ability to test adverse conditions and a strategy for mitigating the risks those tests reveal. (assets.adgm.com)

Connect stress results to governance

A report marked “stress test complete” is weak evidence of effective oversight if nobody decides what to do with it.

A stronger process records:

1. The scenario and assumptions used;
2. The portfolio and transaction-level results;
3. Any internal limit breaches or emerging concentrations;
4. Management’s proposed response;
5. The governing body’s review; and
6. The action owner and follow-up date.

That approach supports the requirement to report stress testing results to the manager’s governing body under FUNDS Rule 13A.7.3. It also allows the manager to demonstrate how risk information influences investment, monitoring and portfolio decisions.

Align valuation, disclosures and investor reporting

A credit framework will be difficult to defend if different documents tell different stories.

The risk appetite, credit approval policy, valuation methodology and prospectus should describe a consistent strategy. FUNDS Rule 13A.5.1 requires a prominent prospectus warning addressing the particular risks of credit investing, including possible losses and illiquidity. It also requires information on the loan origination strategy’s risks, intended concentrations and the fund’s credit assessment and monitoring process.

After launch, FUNDS Rule 13A.6.1 requires additional information in periodic reports, including matters such as undrawn Credit Facilities, loan-to-value information, non-performing exposures, forbearance activity, recent stress testing results and material changes to credit assessment or monitoring.

Those reporting requirements should influence the operating model before the first loan closes. If a manager cannot capture the necessary data from its borrowers and service providers, it will struggle to produce reliable investor reporting later.

What would a defensible framework look like in practice?

The test is whether a knowledgeable person outside the investment team can follow a credit decision and understand how it will be supervised.

For each facility, the manager should be able to produce a coherent record showing:

Borrower eligibility → credit assessment → pricing → approval → concentration check → facility monitoring → valuation and impairment review → stress testing → escalation and reporting.

Each stage needs an owner, a decision standard and retained evidence. The exact process will vary with the fund’s size, strategy and complexity, but the link between stages should be visible.

That is particularly important when a loan deteriorates. A manager should be able to explain when it first identified the problem, what its policies required, what it decided and why.

The central lesson

The FSRA permits ADGM Private Credit Funds to pursue lending and loan investment strategies, but expects managers to control the risks those strategies create. The framework is not satisfied by a persuasive prospectus or a credit policy kept on a shelf.

A credible manager can demonstrate that borrower selection, pricing, diversification and stress testing affect actual transactions and that warning signs reach decision-makers in time to act.

CRYPTOVERSE Legal Consultancy assists sponsors and fund managers with ADGM Private Credit Fund structuring, FSRA licensing, fund documentation and the design of credit and risk governance frameworks.

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