LOAN ORIGINATION IN AIFMD II
AIFMD II defines “loan-originating AIF” (LOF) as an AIF whose investment strategy is mainly to originate loans; or, when the value of an AIF’s originated loans represents at least 50% of its NAV.
EU AIFMs will now be able to originate loans across the EU under the passport regime, as AIFMD II adds this to the functions that an AIFM may perform while managing an AIF. In this way, AIFMD II aims to provide financing for the real economy and lay out common rules, which is critical for EU SMEs having trouble accessing traditional lending. It settles years of uncertainty on the possibility for actors other than banks to extend loans, and may be viewed as a recognition by the EU of the professionalism developed by AIFMs since AIFMD.
AIFMD II defines “loan-originating AIF” (LOF) as an AIF whose investment strategy is mainly to originate loans; or, when the value of an AIF’s originated loans represents at least 50% of its NAV. “Loan origination” means an AIF granting a loan directly, or indirectly through a third party or SPV on its behalf, or on behalf of the AIFM for the AIF. Although in principle LOFs must be closed-ended, it is possible for them to be open-ended if the AIFM demonstrates to the national authorities that the LOF’s liquidity risk management system is compatible with its investment strategy and redemption policy.
AIFM POLICIES AND ONGOING RULES
For loan-originating activities, regardless of whether AIFs meet the LOF definition, AIFMs must implement effective policies and procedures and review them at least once a year. They need to periodically report to investors on the composition of the originated loan portfolio. While this is new at the level of EU rules, this is not new for the Luxembourg funds and AIFMs, as the CSSF has implemented practices for the same purpose since the translation of the AIFMD into Luxembourg law. Luxembourg AIFMs are therefore prepared to play by the new rules.
What is new is that leverage provisions are now fixed by AIFMD II. One may wonder whether such rule might have been more helpfully allocated to national authorities or an EU supervisory authority, as the level and multiplication effect of leverage is linked to monetary policy and could have been a tool to foster economic growth. However, it has been decided to limit leverage of an LOF to 175% of its NAV if the LOF is open-ended, and 300% if the LOF is closed-ended, with some exemptions.
Another novelty is a diversification requirement, as there is a maximum concentration of 20% of the AIF’s capital applied to loans granted to a single borrower which is a financial undertaking, AIF or UCITS. Such limit applies as of 24 months after first subscription. Notably, this diversification requirement will generally not apply, as most credit is granted to other sorts of entities.
To ensure that AIFMs do not start a business of granting loans to sell them immediately, an AIFM must keep 5% of the notional value of loans granted and sold off to the secondary market, unless the AIFM sells the AIF’s assets in order to redeem units as part of its liquidation, if the disposal is necessary to comply with EU sanctions, if the sale is necessary for the AIFM to implement the investment strategy of the AIF, or if the sale is due to a deterioration in the loan’s risk associated, as detected by the AIFM’s due diligence and risk management process.
Finally, an AIF is not permitted to lend to its AIFM, depositary or delegates, or to the AIFM’s delegates and staff, unless it is a financial undertaking that exclusively finances borrowers other than connected entities.
LUXEMBOURG LEADING THE WAY
Unlike some Member States, Luxembourg AIFs have been able to originate loans prior to AIFMD II under the Luxembourg AIFM Law and product laws.
Luxembourg will hold its advantage in loan origination under AIFMD II, thanks to its existing debt fund expertise. Unlike some Member States, Luxembourg AIFs have been able to originate loans prior to AIFMD II under the Luxembourg AIFM Law and product laws.
Currently, the CSSF analyzes the AIFM’s or AIF’s considerations when originating loans on a case-by-case basis during its approval and supervisory process. Generally, AIFMs or AIFs are responsible for the “implementation of a robust and appropriate approach” and key principles include addressing the risks of the activity, using proper processes with a focus on credit and risk management, concentration and risk limitation, and policies regarding assets and investor disclosures.
Even though the “loan origination” definition under AIFMD II is not the same as the CSSF definition, as its scope is a bit wider, it is clear that these requirements are largely aligned with AIFMD II, which will help Luxembourg preserve its leading position in loan origination. As AIFMs and the CSSF are used to these policies and procedures to manage risk in loan origination, compliance with the AIFMD II will be greatly facilitated and costs reduced. In addition, Luxembourg will likely adopt AIFMD II without stricter requirements, in conformity with its general policy approach.
Luxembourg will thus lead the way to transpose AIFM II into national law by leveraging the similarities between its current debt fund framework and the compliance requirements under AIFMD II.