Loan Origination Funds Have a Lot of Wood to Chop Before Aifmd II Kicks In
Following a review of the AIFMD, the Commission, in a draft amending directive published in 2021, noted that common rules should be laid down to establish an efficient internal market for loan originating funds, to ensure a uniform level of investor protection in the European Union. However, diverging national regulatory approaches have been hindering the establishment of an internal loan originating fund market (allowing regulatory arbitrage).
In July 2023, the Council of Europe announced that it had reached a long-awaited political agreement with the European Parliament (“EP”) on the proposed reforms to the AIFMD framework (“Proposal”).
The Proposal imposes new restrictions and obligations on loan originating funds (with a particular focus on open-ended funds), including a requirement to retain 5% of the notional value of the loans originated by the fund as well as imposition of new leverage limits. It is currently anticipated that, once adopted, Member States will have around 18-24 months to transpose the AIFMD II into national law and during this time AIFMs will be busy updating their processes (including with respect to liquidity management systems) and disclosure documents.
The political agreement, however, is provisional and the final amending directive has not been published yet (and the delegated acts, setting out the operative details of the directive, will be drafted at a later stage).
Accordingly, the below is a summary of key areas likely to be affected by the proposed reforms, based on market intelligence and the latest publications from the Council and the EP.
So, what is likely to change?
Loan Origination Defined
A new definition of “loan origination” is included in the Proposal and covers being “involved in structuring the loan, defining or pre-agreeing its characteristics prior to the purchase”. A “loan-originating AIF” is an AIF which has an investment strategy which is mainly to originate loans and which has originated loans the notional value of which represents at least 50% of its NAV.
K&S Comment: This definition is generally in line with market expectations and does not cover secondary market activity. It does not, however, make a distinction between loans originated with EU borrowers and non-EU borrowers (so all loan origination activity, regardless of the borrower’s jurisdiction, will be covered for the purposes of calculating the 50% threshold).
Policies and Procedures
Managers must implement effective policies, procedures, and processes (and review them regularly, at least once a year) for granting loans, assessing credit risks and administering and monitoring their credit portfolios.
K&S Comment: This provision reflects the current practices of many credit managers, however, care should be taken that all such policies and procedures are effectively documented.
Pursuant to the Proposal, an AIF has to retain at least 5% of the notional value of loans it has originated and subsequently sold on the secondary market.
Helpfully, however, various carve outs to this requirement will be applied.
K&S Comment: The Proposal will generally seek to put in place limitations with respect to “originate-to-distribute” strategies. While many private debt funds invest with the intention to hold loans to maturity, this requirement may still put European loan origination activities at a disadvantage versus the US. The risk retention rule somewhat resembles the risk retention requirements under the Securitisation Regulation, however, this seems disproportionately restrictive in light of the fact that the loan origination market does not currently face the same systemic concerns.
Once the Proposal has been finalised and published, it will be important to evaluate whether the rules have the effect of preventing private debt funds from entering into genuine portfolio rebalancing transactions or exiting distressed positions (which could otherwise be in the interest of investors).
The Proposal imposes leverage limits on loan origination funds, expressed as the ratio between the exposure of the AIF, calculated according to the AIFMD commitment method, and its NAV.
The limits are set at 175% for open-ended AIFs and 300% for closed-end AIFs.
Subscription line financing arrangements are helpfully excluded from the calculation.
K&S Comment: The leverage limitations seem to be consistent with the measures adopted by the ELTIF Regulation.
Market intelligence suggests that shareholder loans that do not exceed 150% of the AIF’s capital are excluded for such purposes (but real estate shareholder loans will not be covered by this carveout).
Closed Ended Structure
The Proposal requires that a loan originating AIF has to be structured as closed-ended unless the AIFM can demonstrate the robustness of its liquidity policies.
K&S Comment: It is likely that grandfathering provisions will apply with respect to this requirement and that ESMA will adopt regulatory technical standards setting out criteria for this assessment.
Where Do We Go From Here?
As far as the UK is concerned, so far the government has not given much indication that it intends to make corresponding changes to the UK Alternative Investment Fund Managers Regulations. If this is the case, UK AIFMs would continue to be subject to the current version of the AIFMD (as onshored under the European Union (Withdrawal) Act).
Once the agreed text of AIFMD II is issued and formally adopted by the EP and the Council, local transposition by the Member States will follow.