What’s changing for debt fund managers?
The declared objective of the AIFMD is to regulate fund managers (the AIFMs), not the funds (the AIFs) themselves. The introduction of special rules (including investment restrictions) for private debt and their application to all AIFs that originate loans is a major departure from the general approach of the Directive. AIFMD II targets loan-originating AIFs, defined as AIFs whose strategy is mainly to originate loans or those whose loans represent at least 50% of their net asset value (NAV). Loan origination includes direct and indirect lending by AIFs, whether through third parties or special purpose vehicles. However, certain rules apply to all AIF-originating loans, even if they do not meet the definitional loan-originating AIF.
Shareholder loans are exempted from certain restrictions if they do not exceed certain thresholds.
Activities not considered as loan origination include secondary loan acquisitions where AIFs are not involved in structuring the loan and the acquisition of debt securities. Shareholder loans are exempted from certain restrictions if they do not exceed certain thresholds. This is particularly relevant for managers of private equity or real estate funds who provide shareholder loans alongside equity.
What is the impact for Luxembourg and the private debt fund sector?
Over the past decade, private debt has been one of the most successful alternative asset classes, with Luxembourg being the European jurisdiction of choice for private debt funds due to its favourable legal framework offering a variety of vehicles for structuring private debt funds, including supervised specialized investment funds (SIFs) as well as reserved alternative investment funds (RAIFs) and limited partnerships not under direct supervision.
The CSSF has developed a robust supervisory framework where Luxembourg AIFMs managing AIFs pursuing debt fund strategies must be approved by the CSSF to do so. The CSSF will in that context verify that AIFMs have proper organisational and governance structures, the necessary expertise/experience with appropriate technical and human resources as well as policies regarding assets and investors.
Currently, Luxembourg debt funds are not subject to specific “product rules,” but this will change with AIFMD II. While some may view the new regime as restrictive, it may potentially offer opportunities, if implemented so as to allow AIFMD-compliant AIFs to conduct loan origination on a cross-border basis across the EU – which is not the case for the time being because of strict banking monopoly rules in certain Member States.
Two key requirements applicable solely to loan-originating AIFs
· Leverage limits: The rules concerning leverage were subject to many discussions where the involved stakeholders maintained sometimes opposing positions. Ultimately, a consensus was found that establishes differentiation to assign distinct leverage restrictions to open-ended and closed-ended AIFs: AIFMD II introduces a leverage cap of 175% for open-ended funds and 300% for closed-ended funds. The leverage limit is to be expressed as the ratio between the AIF’s exposure calculated according to the commitment method and its NAV.
· Restrictions for open-ended AIFs: The EU Commission’s initial proposal was to require that AIFs must be closed ended if the notional value of all loans originated is greater than 60% of their NAV. Luckily, this was later changed. AIFs may adopt an open-ended structure if the AIFM can demonstrate to its competent authority that its liquidity risk management system aligns with their investment strategy and redemption policy. The European Securities and Markets Authority (ESMA) will develop technical regulatory standards by April 16, 2025, for liquidity management and stress-testing for open-ended loan-originating AIFs.
· Grandfathering: AIFs existing as of 15 April 2024, are exempt from the new rules if they do not raise new capital after that date. If they raise new capital, they are grandfathered until 16 April 2029, but must adhere the newly introduced leverage limits or where their leverage is higher than the applicable limit, their existing leverage levels as of 15 April 2024.
What requirements will apply to any AIF that originates loans?
· Five percent risk retention: AIFs must retain 5% of the notional value of any loan they transfer to third parties. This rule aims at preventing moral hazard and maintain the general credit quality of loans originated by AIFs. The retention period varies depending on the loan’s maturity: for loans up to eight years and all consumer loans, retention applies until maturity. For loans with longer maturities, retention is required for at least eight years. Certain exemptions will apply.
· Prohibited activities: AIFs cannot issue loans to related entities, including the AIFM and its staff, as well as depositaries and their delegates. AIFs are also prohibited from engaging in “originate-to-distribute” investment strategies.
· Loan policies and credit risk management: AIFs originating loans must establish, maintain and regularly update robust policies, procedures, and processes for loan granting and credit risk management.
· Grandfathering: The new rules above do not apply to loans originated by AIFs before 15 April 2024 and will apply as from the implementation date in the home Member State of the relevant AIFM to all loans originated after 15 April 2024.
· Twenty percent concentration limits: AIFs must limit their exposure to certain types of borrowers, such as banks and insurance companies, to 20% of the AIF’s capital. Compliance with the cap must be achieved within 24 months of the first subscription in the AIF unless a one-year extension is granted by the competent authority.
· Grandfathering: AIFs existing as of April 15, 2024, do not need to comply with the 20% concentration limits if they do not raise new capital after that date. If they raise additional capital, AIFs will be grandfathered until April 16, 2029.
The new regime will apply in all Member States and should not jeopardise Luxembourg’s position as the leading EU domicile for private debt funds.
The new requirements and restrictions for debt funds and loan origination, while being somewhat burdensome, are generally not expected to hinder the growth of private debt as an asset class in Europe in general and in Luxembourg in particular. The new regime will apply in all Member States and should not jeopardise Luxembourg’s position as the leading EU domicile for private debt funds. In other words, AIFMD II is more of a speed bump than a roadblock for the Luxembourg private debt fund sector.