While certain changes under AIFMD 2.0 are of limited impact for the fund management industry in Luxembourg thanks for a large part to the high regulatory standards set by the Luxembourg regulator (the CSSF), others like the new framework for loan origination activities and the recognition of the delegation model are of particular interest for the industry.
Loan origination: a significant change for the Luxembourg financial sector
The changes to be introduced regarding loan origination activities will impact what has clearly become a key alternative strategy in Luxembourg. Indeed, according to the latest ALFI-KPMG, Private debt fund survey, in 2022 the total assets under management of debt funds reached EUR 267.8 billion with an annual average growth of 45.4%.
The changes to be introduced regarding loan origination activities will impact what has clearly become a key alternative strategy in Luxembourg.
AIFMD 2.0 aims at introducing an EU framework the purpose of which is to (i) set a minimum playing field for loan origination activities and (ii) set forth certain additional requirements applicable only to the so-called “loan-originating AIFs” (Loan-originating AIFs), which are defined as (a) AIFs whose investment strategy is mainly to originate loans; or (b) where the notional value of the loans originated by such AIFs represents at least 50% of their net asset value (NAV).
Loan origination activities: raising the bar of the minimum playing field
The main rules applicable to any AIF carrying out a loan origination activity may be summarized as follows:
· Prohibition of “originate to distribute” strategies: EU AIFMs are prohibited from managing AIFs whose investment strategy (or part of it) is to originate loans with the sole purpose of transferring those loans or exposures to third parties.
· Risk retention requirement: Any AIF engaged in loan origination must retain 5% of the notional value of each loan it originated and subsequently transferred to third parties. This percentage must be retained for a period ending at the earliest of the maturity of the loan or 8 years, except for loans granted to consumers, where the retention period must match the maturity of the loan irrespective of its duration.
However, AIFMD 2.0 provides for certain exemptions, in particular when (i) the AIFM starts to sell assets of the AIF in order to redeem units or shares as part of the liquidation of the AIF, (ii) the sale is necessary to enable the AIFM to implement the investment strategy of the AIF it manages, in the best interests of the AIF’s investors, and (iii) the sale of the loan is due to a deterioration in the risk associated with the loan and the purchaser is informed of that deterioration when buying the loan.
· Lending limit: As a principle the notional value of the loan originated by any AIF to a single borrower shall not exceed in aggregate 20% of such AIF’s capital (amounts contributed plus uncalled commitments) where the borrower is a financial undertaking, an AIF or a UCITS. Such limit shall apply by the date specified in the AIF documents, which shall not be later than 24 months from the date of the first subscription in the AIF.
New strict product rules applicable to “Loan-originating AIFs”
AIFMD 2.0 introduces specific limitations and restrictions applicable to a newly created category of AIFs, namely the Loan-originating AIFs:
· Closed-ended vs. open-ended: Loan-originating AIFs shall as a principle be closed-ended; however open-ended Loan-originating AIFs are authorized to the extent that they implement adequate liquidity risk management tools as approved by the AIFM national competent authority (NCA).
· Leverage limit: The ratio between the exposure (calculated according to the commitment method) of the Loan-originating AIFs and its NAV shall be capped at 175% for open-ended Loan-originating AIFs and 300% for closed-end Loan-originating AIFs. Any unintentional breach of those limits shall be remedied within an appropriate period of time, taking due account of the interests of the investors.
For the purpose of the calculation of these limits, AIFMD 2.0 expressly specifies that shareholder loans shall be excluded to the extent their notional value does not exceed in aggregate 150% of that AIF’s capital. Shareholder loans are defined under AIFMD 2.0 as those granted to an undertaking in which the AIF holds directly or indirectly at least 5% of the capital or voting rights, and which cannot be sold to third parties independently of the capital instruments held by the AIF in the same undertaking.
Grandfathering clause and transitional period: AIFMD 2.0 expressly provides that AIFs that do not raise capital after its entry into force are grandfathered. Other preexisting AIFs have a period of 5 years from such effective date to comply with the provisions of AIFMD 2.0, with the exception of leverage and lending limitations, which shall be crystallized and not be increased as from the date of its entry into force.
Recognition of the importance of the delegation model
Delegation is the possibility for AIFMs to delegate to third parties the task of carrying out AIFMs functions on their behalf within the limits of the no letterbox entity principle. Following intense discussions, AIFMD 2.0 finally recognizes the merits of such a model and acknowledges that it plays a key role in fund management organization.
If it is now clear that the delegation model will not be restricted, AIFMD 2.0 still intends to reinforce supervision of such delegation arrangements.
AIFMs will have to obtain the approval of their delegation and sub-delegation arrangements by their NCA in the context of their initial authorization as well as when such arrangements are contemplated, in particular when it comes to delegation of portfolio and/or risk management functions. Such authorizations will take into account the organizational structure of the AIFM, information on the delegate or sub-delegate and a description of the delegated functions for such specific AIF (in particular, whether there is a full or partial delegation).
Regular reporting to NCAs will also include further information on delegation arrangements and will especially have to include in case of a delegation of the portfolio management function, the amount and percentage of the AIF’s assets which are subject to such delegation (the quantitative reporting). In its recitals, AIFMD 2.0 expressly indicates that such a quantitative reporting should not in itself be viewed on its own as an evidential indicator for determining the adequacy of substance or risk management, or the effectiveness of oversight or control arrangements at the level of the manager.
If it is now clear that the delegation model will not be restricted, AIFMD 2.0 still intends to reinforce supervision of such delegation arrangements.
When it comes to the delegation of the marketing function, AIFMD 2.0 provides that if the marketing function is performed by one or several distributors which are acting on their own behalf (under MiFID II or the Insurance Distribution Directive), the provisions of the AIFMD regarding delegation should not apply, irrespective of any distribution agreement between the AIFM and the distributor. While one can welcome such a clarification, some uncertainties remain in case of marketing by non-EU entities acting on their own behalf for which the AIFMD delegation requirements would then apply.
Some other notable changes for AIFs and AIFMs
Extension of AIFM permitted activities: Additional top-up requirements for benchmark administration and credit servicing are now available to EU AIFMs.
Liquidity Management: EU AIFMs that manage open-ended AIFs must in principle select at least two additional liquidity management tools (LMTs) out of a list set out in a new Annex V which provides notably for the following LMTs: suspension of redemptions and subscriptions, redemption gates, notice periods and deferrals of payment.
Reporting: AIFMD 2.0 significantly extends AIFMs reporting obligations. AIFMs will not only be required to report on the principal markets and main instruments of the AIFs they manage but on all of them.
Depositaries: While the industry largely lobbied in favour of the creation of a passport allowing depositaries to provide their services freely across the EU, AIFMD 2.0 instead provides for the possibility to use the services of a depositary which is not established in the same Member State as the AIF but only to the extent certain criteria are met such as the lack of the relevant depositary services in the home Member State of the AIF.
Non-EU AIFMs/AIFs marketing: These entities will be subject to enhanced AML and tax compliance requirements.
Expected timing for adoption
AIFMD 2.0 provides for a period of 2 years for Member States to implement its provisions following its entry into force.
One can expect AIFMD 2.0 to be adopted in the course of H1 2024 with an implementation by Member States in the course of H1 2026.
Global assessment
Overall if the review of the AIFMD delivers a satisfactory result, some uncertainties remain and further guidance will be required on specific points. Indeed, for numerous provisions of AIFMD 2.0, ESMA is tasked with providing essential operative details and reports. It will be crucial to see how this institution will exercise its authority through delegated acts.
There are, however, certain missed opportunities such as the depositary passport or the democratisation of private markets. Regarding the latter, AIFMD 2.0 no longer envisages widening the investor-base accessible through the marketing passport to investors investing a minimum EUR 100,000 and confirming in writing awareness of the risks. However, the Retail Investment Strategy (RIS) package and, in particular, the revision of MiFID 2, contemplates an expansion of the definition of “professional investor” through additional criteria allowing a larger base of investors to elect for the possibility to opt up for the professional client status.
Further improvements of the alternative investment regulatory framework may therefore be expected and should be closely monitored.
ALFI-KPMG, Private debt fund survey 2022