On November 25, 2021, the European Commission put forward the long-awaited proposal for amendments to the Alternative Investment Fund Managers Directive ("AIFMD" - Directive 2011/61/EU), and to the relevant extent, to the Directive relating to undertakings for collective investment in transferable securities (“UCITSD” – Directive 2009/65/EC). In addition to these proposed amendments to the AIFMD, the European Commission also presented, on the same date, a proposal to amend the Regulation on European Long-term Investment Funds (“ELTIFR” – Regulation (EU) 2015/760).
Such proposed amendments (collectively, the “Proposal”), focusing, inter alia, on delegation arrangements, liquidity risk management, supervisory reporting, provision of depositary/custody services, and loan origination tactics, will now be subject to the EU legislative review process before they are agreed and published in the Official Journal of the European Union.
Article 69 of the AIFMD required the European Commission to have a review of the AIFMD by 22 July 2017 and, once such review was finalised, to have submitted a report to the European Parliament and the Council, including any proposed amendments to the AIFM (the “Report”). To prepare this Report, the European Commission instructed KPMG to provide an assessment of the AIFMD which was eventually published on 10 June 2020, together with a Commission Staff Working Document which complemented the Report.
Later on 18 August 2020, ESMA issued a letter to the European Commission identifying “many areas of the existing AIFMD framework that could be improved”, setting out 19 areas for improvement on both legislative framework and reporting issues. In response, on 22 October 2020, the European Commission rolled out a public consultation on the AIFMD, containing more than 100 questions spanning investor protection, international relations, private equity provisions, sustainability and interaction with the UCITS framework, which eventually closed on 29 January 2021. Responses were used by the European Commission to inform its decision on the text of the current Proposal.
Assessing all the facts before it, the European Commission had identified several pitfalls in the overall AIFMD and UCITSD framework, such as fragmented rules on and availability of liquidity management tools, differing local rules for loan originating funds as well as different regulatory treatment of custodians.
Additionally, in specific reference to the COVID-19 pandemic and the market trend developments, the European Commission noted that loan-originating funds can also serve as shock absorber when market liquidity is constrained, by continuing to provide loan financing when more traditional lenders have pulled back from the market. Lastly, how permissive the delegation provisions under the AIFMD and UCITSD has been a point of discussion for some time now, especially in a post-Brexit context, where EU policymakers and regulators were increasingly concerned about the prospect of UK-based managers relying on the delegation model to enjoy the benefits of passporting while continuing to conduct the lion’s share of their business from the UK.
Key provisions of the Proposal re AIFMD
i. Loan origination funds
The European Commission, recognising the importance and value that loan originating funds have on the wider economy, proposed the establishment of common rules for loan-originating AIFs to ensure that the European Union has a uniform level of investor protection. AIFMs are now expressly permitted to manage loan origination funds under certain conditions which should therefore allow AIFs to grant loans in all EU borrower jurisdictions. This development goes into the right direction as it brings legal security in light of the current situation where the conditions may vary greatly between EU jurisdictions. It would also be useful in the legislative process to have clarification that AIFs are authorized to grant loans not only directly but also indirectly via subsidiaries. The conditions set out in the Proposal are as follows:
- An AIF that issues loans more than 60% of its net asset value must be closed-ended;
- AIFMs managing loan origination funds must put in place effective policies and procedures for granting such loans: they must assess credit risk, administer and monitor their credit portfolios;
- AIFs will be required to retain an economic interest of 5% of the notional value of any loans they grant prior selling-off;
- Lending to a single borrower that is a financial institution is limited to 20% of the fund’s capital so as to reduce systemic risk;
- AIFMs and their employees should not receive loans from loan originating funds that they manage.
- AIFs will also be required to report to investors the portfolio composition of originated loans.
Of particular attention are (i) the requirement for AIFs to be closed-ended for being able to engage in loan origination above 60% of their net asset value which will have an impact on existing open-ended funds; and (ii) the requirement of imposing a new risk retention requirement for AIFs that originate with a view to subsequently selling loans which will have an impact on strategies of AIFs for avoiding to be subject to such risk retention risk.
ii. Delegation arrangements
While the European Commission explored the introduction of additional qualitative or quantitative qualifications on delegation during its AIFMD review, no such caps have ultimately been proposed and the Proposal does not set out any fundamental change to the existing AIFMD delegation regime as expected. The changes in the context of delegation largely amount to increased data collection by the EU regulators.
The Proposal introduces a new requirement for EU regulators to notify ESMA where an AIFM delegates more portfolio management or risk management functions to entities located in third countries than the AIFM retains.
ESMA will develop regulatory technical standards to specify the content, form and procedures to standardize the notification process of AIFMs’ delegation arrangements. This form will indicate the activities that make up the risk and portfolio management functions to determine whether an AIFM has delegated more functions than it has retained (“letter box test”).
The Proposal also suggested applying the existing delegation rules to all the main (all services listed in Annex I of AIFMD) and ancillary activities (Article 6(4) of the AIFMD).
iii. Substance requirements
The Proposal includes provisions for AIFMs to employ at least two persons full-time or engage two persons who are not employed by the AIFM but nevertheless are committed to conduct that AIFM’s business on a full-time basis, and who would be resident in the European Union. This seems to permit to have conducting persons of AIFMs to be resident in another Member State than the home Member State of the AIFM.
The requirement of at least two persons to be employed or engaged by the AIFM is not a particularly onerous requirement and simply substantiates the existing AIFMD requirement to not delegate functions to such an extent that the AIFM becomes a letter-box entity. However, this is a minimum requirement and the regulators may expect a greater number of personnel in order to demonstrate appropriate human resources.
iv. Extension of ancillary services list
As a means to increase the efficiency of AIFM activities, the Proposal also provides for an extension of the ancillary services that can be provided to by the AIFMs so as to include benchmark administration and credit servicing.
v. Liquidity management tools
By way of background, the ESRB and ESMA had made recommendations for harmonisation of the rules on the use of liquidity management tools, which although they are widely used, are not currently explicitly referenced in AIFMD or UCITS.
In order to address this topic, the European Commission proposed that AIFMs that manage open-ended AIFs to choose at least one other appropriate liquidity management tool from a list, which they could activate if needed. Nevertheless, AIFMs shall notify their national competent authority "without delay" of the activation / de-activation of any liquidity management tool.
The Proposal also confirms that AIFMs managing open-ended AIFs may, in the interests of investors, be able to temporarily suspend the repurchase or redemption of the AIF's units in situations of market stress.
The current AIFMD requirement is that a depositary should be located in the same Member State as the appointing EU AIF. The Commission notes that in smaller, more concentrated markets, where there are fewer service providers, this requirement leads to a lack of competition, increased costs for fund managers and less efficient fund structures, impacting on investor returns. The Proposal contains an interim measure permitting depositary services to be sourced cross-border pending further review. Related to this, depositaries must cooperate, not only with their home state competent authorities but also with the competent authorities of the AIF’s and its AIFM’s home states. It is noted though that a depositary should not be established in a high-risk third country pursuant to Article 9(2) of the Directive on the prevention of the use of the financial system for the purposes of money laundering or terrorist financing (“AML Directive” - Directive (EU) 2015/849).
Additionally, the Proposal hinted that central securities depositaries (CSDs) will be deemed to be delegates of the depositary where they are providing custody services, bringing the AIFMD into line with the UCITS rules.
vii. Reporting requirements
The Proposal aims for the supervisory reporting template for AIFMs to change so as to avoid duplicative reporting requirements that exist under European Union and national legislation, in particular the European Market Infrastructure Regulation (EMIR - Regulation (EU) No 648/2012) and the European Central Bank’s regulations on statistical reporting.
The reporting scope could be broadened to include a full portfolio disclosure periodically, depending on how ESMA assesses this information’s relevance. ESMA will develop regulatory technical standards that set out the content, form and procedures to standardize the supervisory reporting process, which will replace the reporting template laid down in the (AIFM Delegated) Regulation with regard to exemptions, general operating conditions, depositaries, leverage, transparency and supervision (EU) 231/2013.
viii. Marketing of AIFs by non-EU AIFMs and marketing of non-EU AIFs by EU AIFMs
It is further proposed that, in the future, third country AIFs may only be marketed by non-EU AIFMs in the EU through the applicable national private placement regimes pursuant to Article 42 of the AIFMD if their home states are not on the EU list of non-cooperative jurisdictions for tax purposes. In practice, this means that a non-EU AIF that wishes to market into the European Union cannot be domiciled in either (a) a high-risk third country pursuant to Article 9(2) of the AML Directive or (b) a ‘non-cooperative jurisdiction’ as defined by the EU Council from a tax perspective.
The Proposal also laid down new requirements for EU AIFMs to market non-EU AIFs without a passport across the European Union pursuant Article 36 AIFMD, such rules being as follows: (i) the third country where the non-EU AIF is established is not listed on the EU list of non-cooperative jurisdictions for tax purposes, (ii) the third country has signed a qualifying agreement on the exchange of information in tax matters with the home Member State of the EU AIFM and with the Member States where the marketing takes place, and (iii) the third country is not identified as a high-risk country according to the AML Directive.
The novelty consists in the fact the references to the list of non-cooperative country and territory by the Financial Action Task Force will be replaced by the reference to the two equivalent lists established by the EU.
ix. Additional Investor Disclosure
Additional disclosures to investors under Article 23 AIFMD will be required, including (i) possibility and conditions for using liquidity management tools, (ii) fees and charges that will be borne by the AIFM or its affiliates, (iii) on a quarterly basis, all direct and indirect fees and charges that were directly or indirectly charged or allocated to the AIF or to any of its investments, (iv) the portfolio composition of originated loans and (v) any parent company, subsidiary or special purpose vehicle established in relation to the AIF’s investments by the AIFM, the AIFM’s staff or the AIFM’s direct or indirect affiliates.
Not covered by the Proposal
Several anticipated changes were not covered by the Proposal, such as:
- A concept of “semi-professional investors” in order to widen the scope of the passporting regime which is currently locked for professional investors only
- Clarification of the concept of “reverse solicitation” in order to introduce greater harmonization and restrictions around the scope of reverse solicitation
- A depositary “passport” to allow additional cross-border depositary options
Key provisions of the Proposal re ELTIFR
Since the adoption of the original ELTIF legal framework in April 2015, only 57 ELTIFs (as of October 2021) have been launched with a relatively small amount of net assets under management (total assets under management are estimated at approximately EUR 2.4 billion in 2021). Such authorised ELTIFs are domiciled in only four Member States (Luxembourg, France, Italy and Spain), and the other Member States had no domestic ELTIFs.
While the ELTIF is still a relatively new framework, the available market data indicates that the market’s development has not scaled up as expected, particularly given the European Commission’s objective of promoting long-term finance in the European Union. To this end, and to make this product more attractive, the European Commission in its Proposal suggested, inter alia, the following changes to the ELTIFR:
- Expansion of the scope of eligible assets so they can (i) be located in third countries and (ii) adopt a so-called “fund of funds” strategy and thus invest in other AIFs;
- Broadening of the scope of “real assets” to ensure they cover all assets that have fundamental value due to their substance and properties e.g. to include infrastructure, intellectual property, machinery, aircrafts etc;
- Permission of ELTIFs to make minority co-investments in investment opportunities (rather via majority owned subsidiaries);
- Permission of ELTIFs to invest in real assets if the minimum investment value of such assets is at least EUR 1 million (down from EUR 10 million), without the imposition of the requirement that real assets are owned directly or via “indirect holding via qualifying portfolio undertakings”;
- Clarification that eligible investments can also include simple, transparent and standardized (STS) securitizations where the underlying assets consist of long-term exposures;
- Raise of the market capitalization threshold for listed qualifying portfolio undertakings from EUR 500 million to EUR 1 billion, ensuring it is only applied at the point of initial investment;
- Lowering the 70% threshold for eligible assets to 60%;
- Disapplication of concentration limits for ELTIFs marketed only to professional investors;
- Allowing for the possibility of setting up a master-feeder structure and/or to structure its investments via securitisation vehicles provided sufficient investor protection is ensured.
A key innovation of the Proposal is to create a differentiated regime between ELTIFs that will be solely marketed to professional investors and ELTIFs that can be sold to retail investors also.
At the time of writing, the proposal is open for feedback and will go through a series of readings by the European Parliament and the Council of the European Union to review and amend the Proposal. It is too early to predict that this revised text of ELTIFR will be available this year, but once adopted by the European Parliament and the Council of the European Union, the amendments will be directly applicable in all Member States without the need for transposition.