Unveiling new Terrain - AIFMD II's Impact on Alternative Investment Fund Managers and the Future of Loan Origination

Josef Bergt

2024

Introduction

In the ever-evolving landscape of European Union financial regulation, the publication on the Alternative Investment Fund Managers Directive and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010 (AIFMD II) marks a pivotal moment, culminating years of negotiation and anticipation. With its roots stretching back to the original AIFMD, which significantly altered the regulatory framework for alternative investment funds, AIFMD II emerges not as a radical overhaul but as a nuanced refinement of its predecessor. This article delves into the details of AIFMD II, shedding light its implications for fund managers and the broader contours of the alternative investment fund industry, with a keen focus on loan origination funds.

A Synthesis of AIFMD II's Provisions: The Core Enhancements

At the heart of AIFMD II lies the introduction of a pan-European regime tailored for loan origination funds (LOFs), alongside pivotal modifications affecting fund managers across the spectrum of alternative investment activities. Notably, the directive casts a spotlight on "loan origination," distinguishing it as a permissible investment activity for European Alternative Investment Fund Managers (AIFMs), thus providing much-needed clarity and a regulatory framework for funds engaged in direct lending. The directive delineates comprehensive requirements at both the AIFM and LOF levels, emphasizing risk retention, leverage limits, and the management of liquidity risks, thereby addressing systemic concerns and investor protection.

Expansion of Permissible Ancillary Services

Another cornerstone of adjustments under AIFMD II is the broadening of permissible ancillary services by AIFMs, notably including the management of benchmark values and the provision of credit services (Art. 6 para. 4 AIFMD II). This pivotal change not only enhances the operational scope for AIFMs but also aligns the directive more closely with the dynamic needs of the investment landscape, enabling AIFMs to embrace a broader spectrum of financial services while maintaining stringent regulatory compliance.

Loan Origination under AIFMD II: A New Paradigm

A pivotal aspect of AIFMD II is its stringent approach to loan origination, encapsulating a series of new obligations aimed at ensuring market stability and protecting investors. These include:

• Risk Retention and Syndication Limitations: AIFMD II mandates that AIFs retain a minimum of the notional value of originated loans, marking a significant shift from previous practices and aiming to align the interests of loan originators with those of investors.
• Leverage and Risk Management: The directive imposes leverage caps on loan originating AIFs, setting thresholds at 175% for open-ended funds and 300% for closed-ended funds, thereby curtailing excessive risk-taking and promoting financial stability.
• Operational and Compliance Adjustments: AIFMs are required to establish robust policies, procedures, and processes for loan origination, ensuring effective risk assessment, portfolio monitoring, and annual reviews, thus enhancing the governance and operational resilience of loan-originating activities.

The Preferential Treatment of Closed-Ended Structures and the ESMA's Role

AIFMD II exhibits a clear preference for closed-ended structures in loan origination as outlined above (with exceptions pursuant to Article 16 para 2a AIFMD II). This preference underscores the directive's risk management ethos, aiming to mitigate liquidity risks inherent in open-ended funds engaging in loan origination. Furthermore, the European Securities and Markets Authority (ESMA) is tasked with developing regulatory technical standards to further refine the requirements for open-ended loan originating AIFs, signaling an ongoing regulatory focus on liquidity management and investor protection.

Broader Implications for the Alternative Investment Fund Industry

Beyond loan origination, AIFMD II introduces several key changes impacting the alternative investment fund industry at large. These include modifications to delegation rules, depositary requirements, fund naming conventions, and enhanced reporting obligations. Notably, the directive's approach to delegation preserves the ability of European AIFMs to delegate portfolio management to third-country managers, while introducing more detailed reporting requirements, thus balancing regulatory oversight with operational flexibility. 

This narrative began in November 2023, when, after years of meticulous negotiations and deliberations, the Council of the European Union unveiled the detailed compromise text for AIFMD II, setting the stage for a series of regulatory updates aimed at refining the governance, transparency, and operational standards for Alternative Investment Fund Managers (AIFMs) and the funds under their management. On February 7, 2024, the European Parliament adopted changes proposed under AIFMD II.

Stringent Requirements for Credit Provision

AIFMD II sets forth stringent conditions for AIFs providing credit, notably prohibiting the extension of credit beyond 20% of the AIF's capital to any single AIF, UCITS fund, or financial institution (Art. 1 para. 4a AIFMD II). This limitation is a strategic move to mitigate concentration risk and promote diversification within AIF portfolios. 

Furthermore, AIFMD II stipulates that loan-originating AIFs predominantly assume a closed-fund structure, with specific provisions allowing for exceptions under rigorous liquidity risk management systems as already outlined before (Art. 16 para. 2a AIFMD II). The directive also caps leverage for credit-providing AIFs at 175% for open funds and 300% for closed funds, employing the commitment method and net asset value for threshold calculations (Art. 15 para. 4b AIFMD II), thus ensuring a balanced approach towards leveraging while safeguarding financial stability.

Prohibitions and Retention Requirements

Significantly, AIFMD II delineates clear prohibitions on credit provision to certain entities, including AIFM staff, the depositary, or any outsourcing service provider (Art. 15 para. 4e AIFMD II), ensuring the integrity of credit transactions and preventing conflicts of interest. Moreover, for each credit extended, AIFs are required to retain 5% of the credit sum, a measure designed to align the interests of AIFs with risk-bearing and to promote prudent lending practices (Art. 15 para. 4i AIFMD II).

Refinement of Licensing Conditions

The directive introduces an elaborative description of the personnel managing AIFM affairs, alongside a detailed account of any outsourced service providers (Art. 7 para. 2 AIFMD II). This ensures a more transparent and accountable framework for AIFM operations, mandating that at least two directors of an AIFM are resident within the EU (Art. 7 para. 8 AIFMD II). Such provisions aim to enhance the governance and oversight mechanisms within AIFMs, fostering a robust regulatory environment conducive to investor protection and market stability.

Implications and Strategic Adaptations for AIFMs

The ratification of AIFMD II necessitates a strategic recalibration for AIFMs within the European Union. The directive's nuanced changes present both challenges and opportunities, compelling AIFMs to revisit their operational, compliance, and strategic frameworks in alignment with the new regulatory mandates. Specifically, the expansion of ancillary services opens new avenues for AIFMs to diversify their service offerings, while the stringent requirements for credit provision underscore the need for robust risk management and due diligence processes. This updated directive introduces a refined regulatory framework designed to significantly enhance transparency, bolster investor protection, and improve operational efficiency for Alternative Investment Fund Managers (AIFMs). It stands to fundamentally transform the dynamics of the European alternative investment sector. 

EU member states have to initiate the process of integrating the Alternative Investment Fund Managers Directive II (AIFMD II) into their respective national legislations within the mandated 24-month period. However, the transposition of these directives into national law is contingent upon the directive's formal adoption, which requires the approval of the Council of the European Union, which is still pending as of now. 

Sources: Proposal for AIFMD II, COM/2021/721 final; European Parliament vote on February 07, 2024 on “8.4. Amendments to the Alternative Investment Fund Managers Directive (AIFMD) and to the Directive relating to undertakings for collective investment in transferable securities (UCITSD)”.

Executive Summary:

• The Alternative Investment Fund Managers Directive II (AIFMD II) represents a significant milestone in the European Union's regulatory evolution, offering a refined framework that balances the facilitation of loan origination as an investment activity with the imperative of safeguarding financial stability and protecting investors. 
• The directive's nuanced approach to loan origination, emphasizing risk retention, leverage limits, and operational rigor.
• Expansion of Permissible Ancillary Services (Art. 6 para. 4): Broadens AIFMs' operational scope to include management of benchmark values and provision of credit services, enhancing service diversity while maintaining regulatory compliance.
• The preference for closed-ended structures in loan origination, coupled with the ESMA's forthcoming technical standards, underscores a strategic move towards enhanced liquidity risk management.
• AIFMD II's broader implications for the alternative investment fund industry highlight the directive's comprehensive reach, affecting delegation, depositary functions, fund naming, and reporting obligations. 
• Refinement of Licensing Conditions (Art. 7 para. 2 AIFMD II & Art. 7 para. 8 AIFMD II): Mandates detailed descriptions of AIFM personnel and outsourced service providers, aiming to improve transparency and governance, thereby fostering a robust regulatory environment conducive to investor protection and market stability.
• Stringent Requirements for Credit Provision (Art. 1 para. 4a AIFMD II & Art. 16 para. 2a AIFMD II): Introduces limits on the extension of credit and prescribes closed-fund structures for loan-originating AIFs to mitigate concentration risk and ensure financial stability, with leverage caps set at 175% for open funds and 300% for closed funds, calculated using the commitment method and net asset value (Art. 15 para. 4b AIFMD II).
• Prohibitions and Retention Requirements (Art. 15 para. 4e AIFMD II & Art. 15 para. 4i AIFMD II): Establishes prohibitions on credit provision to specific entities like AIFM staff and the depositary and mandates a 5% credit sum retention by AIFs to align interests and promote responsible lending practices.

The AIFMD II aims to enhance transparency, investor protection, and operational efficiency in Europe's alternative investment sector, with EU member states required to integrate it into national law within 24 months, pending EU Council approval for formal adoption.