AIFMD II Enters into Force: Key Changes to EU Fund Regime

After several years of negotiations between the European Commission, European Council, and European Parliament following the publication of the initial draft proposal in November 2021, AIFMD II was published in the Official Journal of the EU on 26 March and entered into force on 15 April. This LawFlash provides an overview of some of the most significant features of AIFMD II that fund managers should know.

While Directive (EU) 2024/927 (AIFMD II) entered into force on 15 April 2024, member states of the European Economic Area (EEA) have until 16 April 2026 to implement its rules, subject to certain measures that member states must implement from 16 April 2027. There are also certain grandfathering measures, which are detailed below.

The changes under AIFMD II apply to all EEA full-scope alternative investment fund managers (AIFMs), but do not apply to sub-threshold AIFMs and the new loan origination provisions mainly apply only in relation to alternative investment funds (AIFs) engaged in loan origination. AIFMD II does not apply directly to UK-authorised AIFMs, but the UK Financial Conduct Authority has indicated that it will consult on amending the UK regime later in 2024. While AIFMD II does not directly apply to non-EEA AIFMs, many of its provisions are relevant to non-EEA AIFMs marketing AIFs in the EEA under national private placement regimes and non-EEA managers acting as delegates of EEA AIFMs.

Accordingly, EEA full-scope AIFMs (and non-EEA AIFMs marketing in the EEA and non-EEA managers acting as delegate of EEA full-scope AIFMs) should start considering what changes may be required to their practices, policies, or procedures.

AIFMD II introduces several significant changes to the existing regulatory regime, most notably in relation to loan origination activity by AIFs, but arguably stops short of being the wholesale transformation of the EU Alternative Investment Fund Managers Directive 2011/61/EU (AIFMD) that many had feared. Set out below is an overview of certain key changes relating to: (1) loan origination and liquidity management; (2) substance and delegation; (3) depositaries; (4) disclosure and reporting; (5) national private placement regimes; and (6) third-party AIFMs.

1. LOAN ORIGINATION & LIQUIDITY MANAGEMENT

AIFMD II introduces a new regulatory regime for AIFs originating loans, which should be of particular interest to private credit-fund managers. It brings some welcome clarity on the rules permitting loan origination by AIFs across the EEA but does not prevent individual EEA member states adopting national product frameworks with more restrictive rules and even prohibiting loan origination by AIFs to consumers in their territory.

AIFMD II differentiates between

• an AIF engaged in loan origination activity; and
• a “loan originating AIF” (i.e., an AIF “whose investment strategy is mainly to originate loans; or where the notional value of the AIF's originated loans represents at least 50% of its net asset value").

For this purpose, AIFMD II defines “loan origination” as the “granting of a loan: (i) directly by an AIF as the original lender; or (ii) indirectly through a third party or special purpose vehicle, which originates a loan for or on behalf of the AIF, or for or on behalf of AIFM in respect of the AIF, where the AIFM or AIF is involved in structuring the loan, or defining or pre-agreeing its characteristics, prior to gaining exposure to the loan.”

This means that AIFMD II covers indirect loan origination through other entities. However, a “loan” is not defined, leaving this open to a number of interpretative questions.

Requirements and Restrictions on AIFs Engaged in Loan Origination

Concentration Limits

AIFMD II prohibits AIFs from granting loans the notional value of which in aggregate is more than 20% of the AIF's total capital to a single borrower that is (i) another AIF, (ii) an undertaking for the collective investment in transferable securities (UCITS), or (iii) a financial undertaking within the meaning of Directive 2009/138/EC (Solvency II), subject to certain exemptions, such as where the AIF is selling assets to meet redemptions or as part of the AIF’s liquidation.

Restrictions on Lending

AIFMD II prohibits AIFs from granting loans to (i) the AIFM or its staff, (ii) the depositary or its delegates, (iii) the AIFM’s delegate or its staff, or (iv) an affiliate of the AIFM, unless that affiliate is a financial undertaking that exclusively finances borrowers not falling within the aforementioned categories.

Risk Retention

To disincentivise the quick re-sale of loans on secondary markets and to ensure AIFMs retain an active stake in the underlying loans (i.e., “skin in the game”), AIFs must retain 5% of the notional value of each loan that they originate and subsequently transfer to third parties. AIFMs must hold this percentage (i) until maturity in the case of loans whose maturity is less than eight years or granted to consumers regardless of their maturity, or (ii) at least eight years in the case of loans whose maturity is more than eight years.

Certain exceptions apply, including where the loan sale is necessary for the AIFM to implement the AIF’s investment strategy in the AIF's investors’ best interests.

Originate to Distribute

Similarly, AIFMs will be prohibited from managing AIFs whose investment strategy (or part of its investment strategy) is to originate loans with the sole purpose of transferring those loans or exposures to third parties.

Effective Policies for Risk Management

For loan-originating activities, AIFMs will need to (i) implement effective policies, procedures, and processes for the granting of credit, assessing the credit risk and for administering and monitoring their credit portfolio, (ii) keep those policies, procedures and processes up to date and effective, and (iii) review them regularly and at least once a year.

Additional Requirements and Restrictions on ‘Loan Originating AIFs’:

Leverage Limits

AIFMD II establishes maximum leverage limits for loan originating AIFs (i.e., 175% for open-ended AIFs and 300% for closed-ended AIFs, calculated as the ratio between the AIF’s exposure using the commitment method and net asset value). Subscription facilities and other borrowing arrangements fully covered by investor capital commitments will be excluded from the calculation and the leverage limits will not apply to a loan originating AIF whose loan origination activity consists solely of shareholder loans that do not exceed 150% of the AIF’s capital.

A “shareholder loan” is defined for this purpose as “a loan which is granted by an AIF to an undertaking in which it 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.”

Liquidity Risk Management

A loan originating AIF can only be open-ended under AIFMD II if its AIFM can demonstrate that the AIF’s liquidity risk management system is compatible with its investment strategy and redemption policy.

More generally, AIFMs that manage open-ended AIFs are subject to enhanced liquidity risk management requirements under AIFMD II, including the requirement to select at least two additional liquidity management tools from a specified list. AIFMs are required to implement detailed policies and procedures for the use of the selected liquidity management tools and, in the event these tools are used or subsequently not used, must notify the relevant regulator and, in certain cases, investors.

Grandfathering

The leverage limits, concentration limits and liquidity management requirements (for open-ended funds) set out above do not apply to preexisting AIFs until 16 April 2029, or at all if those AIFs raise no further capital after AIFMD II takes effect. However, where a preexisting AIF is already in breach of the leverage or concentration limits when AIFMD II takes effect, it must not increase its leverage or lending until 16 April 2029.

Further, some of the requirements relating to loan origination could apply to loans originated from 15 April 2024 if they are still in place by 16 April 2026.

2. SUBSTANCE AND DELEGATION

AIFMD II introduces further rules around substance and delegation.

Of particular note, (i) AIFMD II has clarified that AIFMs should have appropriate technical and human resources envisaged when applying for an AIFM authorisation and (ii) AIFMD II requires that the two (natural) persons who effectively conduct the business of the AIFM must be (a) either employed fulltime by the AIFM or be an executive member or members of the governing body of the AIFM who are committed full-time to conduct the business of the AIFM, and (b) domiciled in the EU (to address concerns around “letter-box” entities).

AIFMs that delegate portfolio management or risk management functions will be subject to enhanced reporting obligations and must provide substantial information to their regulator as part of their regular reporting, including detailed information on the delegates, the manner of delegation (including quantitative information) and the measures employed for the ongoing monitoring of the delegated activity. The European Securities and Markets Authority is required to produce regulatory technical standards on the frequency and timing that AIFMs will need to report by 16 April 2027.

Further, AIFMs will be required to ensure that the performance of delegated functions and/or services complies with the requirements under the AIFMD (although marketing by distributors acting on their own behalf and under the EU Markets in Financial Instruments Directive (MiFID) or EU Insurance Distribution Directive will not be subject to the AIFMD delegation requirements).

3. DEPOSITARIES

Under AIFMD II, AIFMs may use a depositary based in an EEA member state other than the AIF’s home member state, which is not currently the case under the AIFMD. However, to appoint a depositary outside the AIF’s home member state, the AIFM must make a request to its regulator and demonstrate the lack of relevant depositary services in the AIF’s home member state.

The regulator will then carry out a case-by-case assessment. These changes, while welcomed by depositaries and AIFMs, fall short of providing for a full cross-border passport for depositaries that many had hoped for.

4. DISCLOSURE AND REPORTING

The existing pre-contractual disclosure obligations under Article 23 of the AIFMD have been updated under AIFMD II to require

• the AIF’s name;
• in case of open-ended AIFs, a description of the possibility and conditions under which an AIFM might use liquidity management tools; and
• a detailed list of all fees, charges and expenses borne by the AIFM in connection with the AIF’s operation that will be directly or indirectly allocated to the AIF.

The ongoing disclosure obligations have been updated under AIFMD II so that AIFMs will also be required to periodically report

• the composition of any originated loan portfolio;
• on an annual basis, all fees, charges, and expenses that were directly or indirectly borne by investors; and
• on an annual basis, any parent company, subsidiary, or special purpose entity utilised in relation to the AIF’s investments by or on behalf of the AIFM.

The regular reporting obligations under Article 24 of the AIFMD have also been updated under AIFMD II. In addition to the new requirements concerning delegation (discussed above), an AIFM is required to report

• on all markets, instruments, and exposures and assets of each AIF that it manages (as opposed to only the principal markets and main instruments currently required to be reported on under the AIFMD); and
• for each AIF it manages or markets in the EEA, (i) the EEA member states in which the AIF is marketed, and (ii) the total amount of leverage the AIF employs.

5. NATIONAL PRIVATE PLACEMENT REGIMES

A non-EEA AIFM will not be able to market an AIF, and a non-EEA AIF will not be able to be marketed, into an EEA member state under AIFMD II if the non-EEA AIFM or non-EEA AIF is established in a jurisdiction that (i) is identified as high risk under the Fourth EU Anti-Money Laundering Directive, (ii) has not signed with the EEA member state an agreement that fully complies with the standards under Article 26 of the OECD Model Tax Convention on Income and on Capital and ensures an effective exchange of information in tax matters, or (iii) is on the EU list of non-cooperative tax jurisdictions.

6. THIRD-PARTY AIFMS

AIFMD II also provides additional rules for third-party AIFMs. Where an AIFM manages or intends to manage an AIF at the initiative of a third party (i.e., a third-party AIFM or “hosted AIFM”), it will be required to submit to its home member state regulator detailed explanations and evidence of its compliance with the conflict-of-interest requirements under the AIFMD.

The AIFM will need to specify what reasonable steps it has taken to prevent conflicts of interest or, when they cannot be prevented, how it identifies, manages, monitors, and discloses those conflicts of interest to prevent them from adversely affecting the AIF and its investors.