AIFMD II: The Next Phase Of EU Alternative Investment Fund Regulation - Fund Management/ REITs

On 10 November 2023, the text of an Amending Directive that will make amendments to the EU Alternative Investment Fund Managers Directive (EU AIFMD) was published. This set of changes is referred to as "AIFMD II".

The proposals are likely to come into effect in 2026. Precisely when, however, depends on the timing of when formal approval by the European Parliament and the Council of the European Union takes effect. Both are expected to consider them in the first quarter of 2024 - the Parliament is currently forecasted to consider the text in its plenary session starting on 5 February 2024. Assuming that the Amending Directive is adopted promptly and published in the Official Journal without delay that means that most of the changes will come into effect in 2026 (subject to the grandfathering period for certain of the loan origination provisions and certain Annex IV disclosure requirements which will come into effect a year later).

We set out an overview of the main changes introduced under AIFMD II below. The final unofficial agreed text is available here but there may be some further minor changes as part of tidying up the drafting. (The Amending Directive will also make a similar set of amendments to the UCITS Directive but these are not covered in this briefing.)

The impact of the provisions will, in many respects, depend on the strategies employed by the AIFM. In particular, credit fund managers should focus on the provisions for "Loan Originating AIFs" and "AIFs Which Originate Loans" as a priority. PE fund managers should pay careful attention to the provisions around shareholder loans and the likely need to ensure that loans are stapled to the equity in order to meet the definition of shareholder loan.

Introduction

The final agreement follows months of negotiations and EU Alternative Investment Fund Managers (EU AIFMs) will no doubt be relieved to have the final rules even if they are not necessarily exactly what they would have wanted. In many respects, outside the provisions relating to loan origination, the changes are relatively limited in scope; this is not a full overhaul of the entirety of EU AIFMD but rather a series of targeted amendments.

Key changes include:

New requirements and restrictions for AIFs which originate loans.
Leverage limits for AIFs with significant loan origination activity.
Potential lending passport for EU AIFMs.
Application of delegation requirements to non-EU distributors.
Additional disclosure and reporting requirements.
New rules on liquidity management for open-ended funds.

Most of the changes apply to all EU full-scope AIFMs (the changes will not be relevant for EU sub-threshold AIFMs). However, the large number of loan origination provisions will only apply where the AIF managed by an EU full-scope AIFM is engaged in the activity of loan origination, (with a few, specific requirements reserved only for those AIFs materially involved in loan origination and considered to be "Loan Originating AIFs" – discussed below).

The new requirements regarding Article 23 disclosures and Annex IV reporting will also be relevant for non-EU AIFMs marketing AIFs under National Private Placement Regimes (NPPRs).

EU AIFMs should start therefore familiarising themselves with the measures and considering what changes to their business practices or policies and procedures may be required. The changes will not apply to firms authorised in the UK under the UK version of AIFMD and there is currently no indication that the UK is planning to make similar changes although the FCA has suggested that there will be a consultation on UK AIFMD during the course of 2024 to implement certain simplification measures.

Changes relevant to EU AIFMs engaging in loan origination

Loan origination provisions are new in EU AIFMD and were heavily negotiated with an imperfect compromise reached.

Very broadly, most loan origination provisions apply to all AIFs when originating loans (AIFs Which Originate Loans) with a few loan origination provisions only applying to AIFs which originate loans on a significant basis – called Loan Originating AIFs. There are also some exemptions in the case of "shareholder loans".

For these purposes, an AIF will be considered to engage in loan origination activity (and therefore be an AIF Which Originates Loans) where:

it grants a loan directly as original lender; or
it grants a loan indirectly through a third party or SPV which originates a loan for or on behalf of the AIF (or EU AIFM) where the AIF (or EU AIFM) is involved in structuring the loan or defining or pre-agreeing its characteristics prior to gaining exposure to the loan.

"Loan" is not a defined term in AIFMD II and can capture a range of activities. There is a question over whether it is intended to include lending in the form of transferable debt securities such as bonds and notes. We expect that there will be a push for it to be interpreted as narrowly as possible.

A "Loan Originating AIF" is defined as "an AIF: (i) whose investment strategy is mainly to originate loans; or (ii) where the notional value of the AIF's originated loans represents at least 50% of its net asset value". This definition is narrower than had originally been feared and is aimed at AIFs which have loan origination as a principal activity rather than those which grant loans incidentally or on a very minor basis.

Requirements applicable to all loan origination activity by AIFs Which Originate Loans

Many of the loan origination provisions apply to all loan origination activity by AIFs Which Originate Loans.

Concentration limits: AIFs Which Originate Loans must not make loans in excess of 20% of the AIF's capital (including those made through an SPV) to other AIFs, UCITS and financial undertakings (a broad term which covers a wide range of financial services firms).
The 20% limit does not apply where the AIF is selling assets to meet redemptions or as part of the liquidation of the AIF and may also be temporarily suspended for up to 12 months where the capital of the AIF is increased or reduced.
Restrictions on lending: AIFs Which Originate Loans must also not make loans to the EU AIFM (or its staff), the EU AIFM's delegate (or its staff); or the depositary or its delegate. Lending to entities in the same group as the EU AIFM is only permitted where the entity is a financial undertaking which exclusively finances borrowers that are not any of the entities in the previous sentence. Member states will have the option to prohibit loan origination to consumers (i.e. natural persons acting outside their trade, business or profession).
Risk retention: Risk retention provisions also apply in order to reduce incentives for AIFMs to originate poor quality loans to be immediately sold off on the secondary market.
AIFs Which Originate Loans must retain 5% of each loan that they originate and subsequently transfer to third parties as follows:
- Loans with a maturity of less than eight years: 5% of the notional value until maturity.
- Loans to consumers: 5% of the notional value until maturity.
- Loans with a maturity of more than eight years: 5% of the notional value for at least eight years.
As "loan" is not defined, it is currently unclear whether tranched loans would be required to be retained on a per-tranche basis or grouped together as a single "loan" (e.g. 5% of the value of the loan, but held through an outsize holding of the loan's most junior tranche).
There are also some potentially very helpful exemptions from this requirement including where:
- the EU AIFM sells assets of the AIF in order to redeem units or shares as part of the liquidation of the AIF;
- the disposal is necessary to comply with EU sanctions or product requirements;
- the sale of the loan is necessary to enable the EU AIFM to implement the investment strategy of the AIF, in the best interests of the AIF's investors; and/or
- the sale of the loan is due to a deterioration in the risk associated with the loan and the purchaser is informed of such deterioration when buying the loan.
Policies and procedures: EU AIFMs of AIFs Which Originate Loans will need to implement effective and up-to-date policies, procedures and processes for the granting of credit. Where an AIF Which Originates Loans is engaging in loan origination or purchasing loans from third parties, the EU AIFM must put in place effective policies, procedures and processes for assessing credit risk and administering and monitoring the credit portfolio. Such policies, procedures and processes also have to be kept up to date and reviewed regularly – at least once a year.
In the case of shareholder loans (i.e. loans made to an undertaking in which the AIF holds at least 5% of capital or voting rights, either directly or indirectly, and cannot be transferred independently of the AIF's holding in the undertaking), this requirement does not apply where the notional value of the loans is, in aggregate, below 150% of the capital of the AIF.
No originate to distribute: EU AIFMs are prohibited from managing AIFs Which Originate Loans whose investment strategy (or part of it) is to originate loans with the sole purpose of transferring those loans or exposures to third parties. This is expected to apply to loans originated directly by the AIF and also indirectly, for example, through an SPV.
Proceeds of loans: The proceeds of loans (less administration fees) must be attributed to the AIF Which Originates Loans in full with costs and expenses linked to the administration of loans being Article 23 disclosures.

Requirements applicable to Loan Originating AIFs

The following requirements are applicable to Loan Originating AIFs:

Limits on leverage: The provisions on leverage were subject to extensive negotiation with the various parties holding strong views. A compromise was finally reached under which a distinction is made between open-ended and closed ended funds with different leverage limits for each.
Open-ended funds (which are perceived to pose a greater risk) are subject to a 175% limit on leverage and closed-ended funds are subject to a 300% limit on leverage. Leverage is to be measured on the commitment basis excluding subscription line financing and passive breaches of the leverage limit will need to be rectified within an appropriate period of time.
The leverage limits do not, however, apply to an Loan Originating AIF whose loan origination activity is limited to making shareholder loans provided that these loans do not exceed 150% of the AIF's capital.
Leverage for these purposes reflects the definition in the original text of AIFMD and therefore an AIF is considered to be leveraged if its exposures are increased by the AIFM by any means – including through borrowing of cash or securities or leverage in derivative positions. It is important to note that this is not limited to borrowing by the AIF but is a broad concept which includes a wide range of exposures such as those under derivatives, repos and securities lending agreements. Many AIFMs will be familiar with this but others may need to dust off their work from AIFMD I on leverage calculations.
Requirement to be closed-ended: Loan Originating AIFs are required to be closed-ended unless the EU AIFM can demonstrate that its liquidity risk management system is compatible with its investment strategy and redemption policy.

Grandfathering provisions

Grandfathering provisions apply in respect of the loan origination requirements with a distinction made between (i) leverage limits, concentration limits and the requirement to be closed-ended and (ii) other loan origination rules. By way of reminder, the leverage limits and requirement to be closed-ended apply to Loan Originating AIFs and the concentration limits and other loan origination rules apply to AIFs Which Originate Loans.

For the first five years after AIFMD II comes into force, the leverage limits, concentration limits and the requirement to be closed-ended do not apply to pre-existing AIFs (but the benefit of this is limited - as discussed in the next paragraph). These rules can be disapplied indefinitely if the AIF does not raise additional capital after AIFMD II comes into force. It is important to note that the grandfathering period runs from when AIFMD II comes into force and not when it starts to apply. Based on the current timetable, the five-year grandfathering period is likely to run from 2024 until 2029 and therefore only be effective in practice for around three years.

Crucially, although the leverage limits and concentration limits are expressed to be disapplied, this comes with significant exemptions which largely have the effect of reapplying the requirements for pre-existing AIFs. Pre-existing AIFs which are already in breach of the leverage and/or concentration limits at the time AIFMD II comes into force must not increase their leverage or lending to the relevant borrower during that five-year period. Pre-existing AIFs which are not in breach of the leverage and/or concentration limits may increase leverage or lending to the relevant borrower but only if the relevant limits would not be breached.

In addition, loans originated prior to AIFMD II coming into force will not need to comply with the prohibition on lending to certain types of persons, risk retention requirements, prohibition on "originate-to-distribute" strategies, requirement for policies, procedures and processes and requirements in respect of proceeds of loans.

Changes relevant to all EU AIFMs

Permitted activities for EU AIFMs

AIFMD II extends the scope of permitted activities for EU AIFMs to include benchmark administration under the EU Benchmarks Regulation and credit-servicing under the EU Credit Servicers Directive as additional "top-up permissions". However, EU AIFMs will not be able to administer benchmarks used in the AIFs they manage.

Originating loans and servicing securitisation SPVs are also included as permitted ancillary activities for EU AIFMs. This would allow for loan origination activities to be carried on in other member states on a cross-border basis – effectively allowing for some form of passport – although following recent statements from the European Commission it is unclear the extent to which this can be done independently from any management activity.

EU AIFMs will also be able to provide any other service that is already provided by the EU AIFM in respect of the AIFs it manages or related to its top-up permissions provided that any conflicts are appropriately managed. This appears to be intended to capture activities such as HR or IT services rather than regulated activities.

Finally, portfolio management will no longer be a mandatory top-up permission. This will allow firms to hold top-up permissions for the other top-up activities, such as advising, without having to also be authorised for portfolio management.

Delegation

AIFM delegation arrangements have been a key focus of AIFMD II. Although "letter-box entities" are already prohibited, the authorities have been concerned about the scope of many delegation arrangements.

The AIFMD delegation requirements have been explicitly extended to cover delegations of Article 6(4) "top-up services" such as segregated portfolio management services and also to apply "irrespective of the regulatory status or location of any delegate or sub-delegate" clarifying that non-EU delegates will also need to comply with AIFMD (if they were not doing do already).

There is also a new additional requirement for EU AIFMs managing AIFs on behalf of a third-party to provide additional information on their management of conflicts of interest to their competent authority. This may result in the third-party AIFM model being put under some pressure.

EU AIFMs will have to provide additional information to regulators on delegations including:

details of the delegates;
information on the delegation;
a detailed description of the human and technical resources to be used by the EU AIFM for day-to-day portfolio and risk management and for monitoring the delegated activity; and
a description of the periodic due diligence measures used to monitor the delegated activity.

Rules on distributors

Marketing carried on by distributors who are acting on their own behalf and marketing under the EU Markets in Financial Instruments Directive (MiFID II) or the EU Insurance Distribution Directive (IDD) are not subject to the EU AIFMD delegation requirements. This applies irrespective of any distribution agreement between the EU AIFM and the distributor.

On the face of it, therefore, marketing by non-EU entities, which would not generally be marketing under MiFID II or the IDD, would not be able to benefit from this provision. Taken further, this may also mean that non-EU distributors would need to be treated as delegates of the EU AIFM even where they are acting on their own behalf and have no relationship with the EU AIFM.

Authorisation and organisational requirements

Reflecting ongoing concerns about the level of EU-based substance within AIFM arrangements, the business of the EU AIFM needs to be conducted by at least two natural persons, domiciled in the EU, who are either employed full-time by that EU AIFM or who are executive members of the governing body of the EU AIFM who are committed full-time to conduct the business of that EU AIFM. It is unclear whether this applies retrospectively but, if member states interpret this as applying to existing EU AIFMs, then this may require some EU AIFMs to re-examine their management structures.

EU AIFMs also have to provide to the relevant competent authorities additional information at the time of authorisation, including, for the persons effectively conducting the business of the EU AIFM, a description of their reporting lines and an overview of their time allocated to each responsibility and a description of the technical and human resources that support the EU AIFM's activities.

Liquidity management – open-ended AIFs

The existing liquidity management provisions in EU AIFMD have been extended, with new obligations and powers for EU AIFMs that manage open-ended AIFs.

EU AIFMs that manage open-ended AIFs are required to select at least two additional liquidity management tools (LMTs) from a specified list set out in a new Annex V:

redemption gate;
extension of notice periods;
redemption fees;
swing pricing or dual pricing;
anti-dilution levy; and
redemptions in kind.

EU AIFMs which manage money-market funds are only required to select one LMT. The selected LMTs must be appropriate to the investment strategy, liquidity profile and redemption policy of the AIF.

EU AIFMs must implement detailed policies and procedures for the activation and deactivation of the selected LMTs and the operational and administrative arrangements for the use of the LMTs. They must notify competent authorities of the selected LMTs and the associated policies and procedures as well as any activation or deactivation of certain LMTs. Certain information on LMTs must also be provided to investors.

EU AIFMs managing open-ended AIFs are also permitted temporarily, in the interests of investors, to suspend the repurchase or redemption of the AIF units or shares, activate or deactivate their selected LMTs or activate side pockets. Suspensions and side pockets may only be used in exceptional cases, where this is necessary in the circumstances and justified in the interests of the AIF investors.

Competent authorities also have the power, in exceptional circumstances and after consultation with the EU AIFM, to require EU AIFMs to suspend (or cease the suspension of) redemptions and subscriptions.

Article 23 disclosures to investors

Additional Article 23 investor pre-contractual disclosures also apply, including:

the name of the AIF (with ESMA to develop guidelines on unfair, unclear or misleading names);
a list of the fees, charges and expenses borne by the EU AIFM in connection with the operation of the AIF and directly or indirectly allocated to the AIF; and
for open-ended funds, information on the possibility and conditions for using liquidity management tools.

EU AIFMs are also required to report periodically the composition of any originated loan portfolio to investors as well as the following on an annual basis:

all fees, charges and expenses directly or indirectly borne by investors; and
any parent company, subsidiary or special purpose entity utilised in relation to the AIF's investments by or on behalf of the EU AIFM.

Annex IV regulatory reporting

The reporting obligations to competent authorities under Article 24 are also extended. Currently, an EU AIFM has to report on the principal markets and instruments in which it trades and provide information on the main instruments in which it is trading and on the principal exposures and most important concentrations of each of the AIFs it manages. However, in the future, an EU AIFM will be required to report on all markets, instruments and exposures and assets of each AIF that it manages. The relevant identifiers, such as Legal Entity Identifiers or LEIs, will also need to be included.

The total amount of leverage employed by the AIF will also need to be reported as well as relatively detailed information on delegation arrangements concerning portfolio management or risk management functions – this includes quantitative information on the delegated portfolio where portfolio management has been delegated.

EU AIFMs will also need to report on the member states in which the units or shares of the AIF are being marketed.

The Annex IV reporting requirements will apply one year after the rest of AIFMD II starts to apply (likely 2027).

Marketing requirements

Third-country entities accessing the EU single market will also be subject to enhanced AML and tax compliance requirements.

Non-EU AIFMs marketing into the EU under National Private Placement Regimes (NPPRs) and the AIF must not be established in jurisdictions identified as high risk under the Fourth Anti-Money Laundering Directive. Those jurisdictions would also need to have signed an agreement with each member state in which the fund is to be marketed which fully complies with the standards laid down in Article 26 of the OECD Model Tax Convention on Income and on Capital and ensures an effective exchange of information in tax matters, including any multilateral tax agreements. They must also not be on the EU list of non-cooperative tax jurisdictions.

Similarly, non-EU AIFs will only be able to be marketed in the EU if the non-EU AIF is established in a jurisdiction which is not identified as high risk under the Fourth Anti-Money Laundering Directive; has signed an agreement with the home member state of the EU AIFM and each member state in which the AIF is to be marketed complying with certain tax standards and allowing for tax information to be exchanged; and is not on the EU list of non-cooperative tax jurisdictions.

EU AIFMs are also able to market units or shares of an EU AIF which invests predominantly in the shares of a particular company to the employees of that company or its affiliates within the framework of employee savings or participation schemes, including on a cross-border basis. This follows requests for clarification from some industry bodies as this had been a point of uncertainty in some member states.

Depositaries

It will now no longer be necessary for a depositary to be established in the same Member State as the relevant EU AIF - acknowledging that there is a limited market in depositaries in certain member states. Therefore, where certain criteria are met, an EU AIFM will be able to make use of a depositary based in another member state. AIFMD II does not, however, provide for a depositary passport as some depositaries had hoped.

The criteria include that there are no appropriate depositary services in the home member state and a case-by-case assessment has been carried out by the relevant national competent authority.

Such depositaries will need to co-operate not just with their own competent authorities but also those of the AIF and (if different) the EU AIFM.

Where a third-country depositary is used, the use of depositaries in jurisdictions which are identified as high-risk under the Fourth Anti-Money Laundering Directive or on the EU list of non-co-operative tax jurisdictions is not permitted.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.