Since the European Commission (the Commission) published a proposed amending Directive (together with the results of its evaluation of AIFMD) in November 2021, there have been ongoing discussions between the European co-legislatures over numerous proposed amendments.
On 24 January 2023, the European Parliament’s Committee on Economic and Monetary Affairs (ECON Committee) voted by a substantial majority to approve its amended draft text. We expect that the ECON Committee proposals are likely to be well received by the industry.
The revised ECON Committee text still addresses delegation, a key issue for UK and other third country managers looking to provide delegated portfolio management for EU AIFMs, However, the focus is more on strengthening the supervision and oversight requirements on AIFMs rather than imposing stringent restrictions on delegated portfolio managers.
The text is now subject to debate and amendment as part of the ‘trialogue’ process, between the Commission, the European Council and the ECON Committee (on behalf of the Parliament), a process that is likely to take a few months. The changes to AIFMD will then be made through another European Directive, meaning member states will have to incorporate these changes into their national laws within two years of publication. We, therefore, anticipate that the changes will not have effect until 2025. However, even with some expected grandfathering and transitional provisions, managers structuring and planning their funds will want to start thinking carefully about how these provisions may bite, in particular on their delegation arrangements, where they manage or advise on credit funds; and on their cross-border marketing arrangements.
While the text is still not final, there does seem to broadly be conformity in approach between the Parliament, Council and Commission. The summary below highlights the state of play on the key area of delegation, as well as in relation to loan-originating funds, liquidity management for open-ended funds, increased reporting, substance, and depositary services which remain important areas of impact.
The requirement in the Commission’s original draft for national competent authorities (NCAs) to notify ESMA (and provide details) on an annual basis where an AIFM delegates more portfolio or risk management function than it retains to entities in third countries has been removed. Instead AIFMs are to provide various information as part of their annual reporting to regulators under Article 24 (see below). ESMA is to develop implementing technical standards on content and form.
On applying for authorisation, the AIFM will have to provide additional and more detailed information on its delegated risk and portfolio management functions (in each case whether a full or partial delegation) and on: each delegate; the ‘Other’ Annex I functions that the AIFM performs in addition to portfolio and risk management; the human and technical resources of the delegate for performing the delegated services and for the AIFM for monitoring and controlling its delegate; and how the delegation adds value to the investor. An AIFM is also under a new duty to report to its NCA any material changes to its delegation arrangements.
More substantively, and building on the proposals in the Commission’s original draft, the ECON Committee text expands the concept of delegation to more than just portfolio and risk management. The delegation net is extended to include all functions listed in Annex I of AIFMD (itself expanded to include originating loans and servicing securitisation special purpose entities and the management of JVs and mandates in respect of real estate as an additional ‘Other’ function) and the Annex 6(4) ancillary services (e.g., collective portfolio management services, segregated mandates, investment advice, and custody services under MiFID II), which are also to be expanded to include benchmark administration and credit servicing permitted by EU laws. This brings in services such as administration and marketing, functions that are often carried out by third party administrators and placement agents.
The revisions clarify that delegation (or any further sub-delegation) does not affect the AIFM's liability to the AIF and its investors for the matters delegated, regardless of the regulatory status or location of any delegate. There is a carve out so that functions of distribution agents who are acting on their own behalves are not to be considered delegation, irrespective of any distribution agreement with the AIFM.
There are new heightened conflict of interest provisions for third party AIFMs and ESMA is empowered to develop regulatory technical standards around this.
At least 12 months before the five-year point when the amended Directive is due to be reviewed, ESMA will conduct a one-off comprehensive peer review analysis to assess how rules on delegation are being applied, in particular measures to prevent the creation of letter-box entities located outside the EU. This allows a bit longer for the revised rules on delegation to bed in than the two-year frequency specified in the original draft.
Loan Origination Funds
Credit funds that have a focus on loan origination have been under the spotlight, as the Commission believes AIFMD does not have specific requirements to address the risks of direct lending activities, and different rules and regulations at a member state level have the effect of “promoting regulatory arbitrage and varying levels of investor protection.” The ECON Committee’s key proposals on this (set out below) are detailed and comprehensive but an improvement on previous proposals. There is a five-year transitional arrangement for AIFMs managing loan originating AIFs before the amending Directive is adopted and deemed compliance for pre-existing loan originating funds that do not raise additional capital after expiry of the five-year period.
- A ‘loan-originating AIF’ is an AIF whose principal activity is to originate loans (where the AIF is the original lender) where the notional value of those loans exceeds 60% of the AIF’s NAV.
- A 20% limit on loans to a single borrower if that borrower is a financial undertaking, collective investment undertaking or MiFID investment firm. The 20% calculation allows flexibility for fund’s raising or reducing capital or selling assets at the end of the AIF’s life.
- A much more preferable provision to the Commission’s requirement (for the fund to be closed-ended if the notional value of all loans originated is greater than 60% of the fund’s NAV) is the provision that a loan origination AIF has to be structured as closed-ended unless the AIFM cannot demonstrate to its NCA its AIF’s liquidity robustness (i.e., sound liquidity risk management tools system that ensure the compatibility of its liquidity management system with its redemption policy). ESMA will adopt regulatory technical standards on criteria for this.
- A new prohibition that AIFs should not follow an originate-to-distribute investment strategy, being an investment strategy under which loans are originated with the sole purpose of selling them.
- An AIF has to retain at least 5% of the notional value of loans it has originated and subsequently sold on the secondary market. There are various carve outs, including where the AIF has purchased the loan on the secondary market (as it did not originate the loan) or where the AIF needs to dispose of the loans to redeem investors on a wind down of the AIF, to comply with EU sanctions, or to avoid an unintentional possible breach of the AIF’s investment or diversification rules. These changes helpfully provide flexibility if there are legal or regulatory reasons why an AIF may want to dispose of the interest in full, say on a wind up.
- AIFMs must have effective policies, procedures, and processes in place (and review them at least annually) for granting loans, assessing credit risk and administering and monitoring their credit portfolios. Shareholder loans (granted by an AIF to an undertaking where the AIF holds directly or indirectly at least 5% of the capital or voting rights and where the loan cannot be sold independently to third parties) that do not exceed 150% of the AIF’s capital are carved out from this requirement.
- In addition to its AIFM or its staff, depositary, or any of its delegates, an AIF cannot lend to group entities of the AIFM (except for third party finance) or to delegates of its depositary.
Liquidity Management for Open-Ended Funds
The stated context of these provisions is to allow supervisory authorities to handle potential spill-overs of liquidity tensions into the wider market more effectively. In addition to any other liquidity management tools (LMT) set out in the fund rules/constitutional documents, open-ended AIFs (save for where the AIFM is the manager of an authorised money market fund, who can select one) have to select at least two LMTs from those set out in a new Annex V, and implement detailed policies and procedures to operate, administer, activate, and deactivate any such tools. The list includes partial redemption gates, notice periods, redemption fees, swing pricing, anti-dilution levies, redemptions in kind, and side pockets. An AIFM can temporarily suspend redemptions, but only in exceptional circumstances and where justified having regard to the interests of the AIF’s investors.
We would point out the following points of impact in the ECON Committee proposals:
- An AIFM has to inform its home member state NCA in certain circumstances: when redemption and subscription suspensions or gates are activated in times of liquidity stress; when activating side pockets (at any time); or when any other LMT is activated or deactivated outside the ordinary course of business, as envisaged by the fund documentation. This information is to be shared with the AIFM’s host member state and ESMA who will then, if necessary for risk reasons, notify the European Systemic Risk Board (ESRB).
- NCAs can require an AIFM to activate or deactivate certain LMTs (suspension of redemptions/subscriptions or redemption gates), but this is limited to where it is in the interest of investors, in exceptional circumstances, after consulting with the AIFM and if there are “reasonable and balanced investor protection or financial stability risks” that necessitate it. ESMA is to develop regulatory technical standards to set out these situations (as well as for when an AIFM host member state can request the AIFM’s home member state to step in), whilst recognising that the primary responsibility for liquidity risk management remains with the AIFM and that intervention by regulators is a last resort. There will also be an adaptation period for existing AIFs.
- ESMA is empowered to request NCAs to require a non-EU AIFM marketing in the EU (or an EU AIFM managing a non-EU AIF) to apply redemption suspensions or gates (or other LMT selected by the AIFM) where there is a substantial threat to market function and integrity originated or aggravated by the AIFM’s activities and the relevant NCA has not taken measures to sufficiently address such threat. ESMA must first consult the ESRB and other relevant authorities and the measures the NCA takes cannot create a risk of regulatory arbitrage or result in reduced liquidity or market uncertainty in a way that is disproportionate to the benefit of the measures taken. Any measures taken are to be reviewed at three-month intervals (and if not renewed by ESMA, will automatically expire). ESMA’s decision can be challenged by the non-EU AIFM member state of reference.
AIFM Authorisation and New Retail Requirement
A new condition of AIFM authorisation is that it has to have at least two senior managers resident in the EU, being individuals who are either AIFM employees or committed to the conduct of the AIFM business, in each case on a full-time or full-time equivalent basis. In addition, for AIFs marketed to retail investors, at least one member of the AIFM’s governing body should be an independent non-executive director (NED). As part of its authorisation application, an AIFM will need to provide descriptions of their role, title, and level of seniority, and reporting lines of those conducting the AIFM business as well as an overview of their time allocated to each responsibility and a description of the human and technical resources that support their activities. This should not be an issue for most fund managers, reflective of existing substance and governance matters, but it is a new point for those looking to retail wealth where the appointment of a NED becomes a prerequisite.
The ECON text does not reference an amended definition of professional investor (which had previously been proposed to be expanded) so that it remains the MiFID II ‘professional client’ definition. There are useful provisions on marketing (in an EU AIFs home member state and to retail investors) not applying to employee savings schemes.
Third Country Depositary Services
In its original evaluation, the Commission recognised that the requirement for a depositary to be based in the same member state as the fund does not fully serve investors’ interests, as in smaller markets this leads to a lack of competition and increased costs. Pending a review of the possibility of introducing a “depositary passport”, the proposals include giving NCAs power to allow an EU AIF to deviate from the general rule, and appoint a depositary located in another member state when requested by an EU AIFM (provided that the AIFM demonstrates the lack of relevant depositary services to meet its AIF’s operational strategy and either (i) the AIFM’s home member state’s market consists of fewer than 7 AIF depositaries and that none have assets safekept that exceed €1bn; or (ii) the aggregate market of EU AIF depositary assets safekept does not exceed €60bn).
The amending Directive also confirms that a Central Securities Depositary (CSD) can be a delegate of a depositary and that no additional due diligence checks will be required as part of its appointment (as the CSD will have been sufficiently vetted on authorisation). This is to ensure that a CSD is part of the custody chain and there is a stable information flow between the custodian of an AIF’s assets and its depositary.
A review on the effectiveness and impact on financial stability of a depositary passport (amongst other aspects) is earmarked within five years of the amending Directive coming into force (to be facilitated by a comprehensive study on the potential benefits and risks of a depositary passport within 24 months of the amending Directive coming into force).
Tax Blacklist for Third Country AIFs/AIFMs
References in AIFMD for third country entities to comply with FATF listings and OECD exchange agreements (e.g., in conditions of marketing and managing and on depositary appointments in third countries) are to be updated to align with current EU money laundering standards and requirements. This includes that, at the time of the application for authorisation, non-EU AIFMs and non-EU AIFs and any third country depositaries cannot be located in a third country identified as high-risk under EU legislation or that is deemed non-cooperative in tax matters (as set out in the periodically-updated Council of the EU’s list). For closed-ended funds only there is a two-year grace period from the date of its marketing notification or authorisation when that fund will be deemed compliant even if the third country is subsequently added to the non-cooperative list. Jurisdictions that appear on the ‘Annex II’ state of play list (do not yet comply but have committed to implementing reforms) for over three years are considered to be ‘non-cooperative’ for these purposes.
Firms will need to be alert to the impact of any published changes made to these lists.
Investor and NCA Disclosures
The Article 24 NCA reporting obligations are broadened to include “other relevant economic and accounting information” on the data to be provided, and specifically to include:
- The total amount of leverage of the NAV employed by the AIFM.
- More detailed information on an AIFM’s delegated and any sub-delegated functions (in each case whether a full or partial delegation and when those arrangements come to an end), on each delegate, on the human and technical resources employed by or committed to the AIFM for performing its portfolio and risk management tasks and for monitoring and controlling the delegate; of the delegate for performing the delegated services and confirmation that the AIFM has implemented periodic due diligence and record-keeping measures to oversee, monitor, and control the delegate.
The following additional items are to be included in Article 23 investor disclosures:
- The AIF’s liquidity risk management and details of circumstances for using the AIFM’s selected LMTs, existing redemption arrangements, and investors’ redemption rights in normal and exceptional circumstances.
- A list of all fees and charges to be borne by the AIFM in the operation of the AIF.
Additional periodic disclosures to investors include:
- Details of portfolio composition of an AIF’s originated loans.
- On an annual basis, all direct and indirect fees and charges charged to the AIF and any parent company, subsidiary, or SPV established in relation to the AIF’s investments by the AIFM. Helpfully, reference to fees of affiliates and to quarterly reporting, both in earlier drafts, have been removed.
Remuneration Policies and Practices and SFDR Alignment
AIFMs subject to the EU’s Sustainable Finance Disclosure Regulation (SFDR) have to include in their remuneration policies information on how they are consistent with the integration of sustainability risks. ESMA is to update its Guidelines on sound remuneration under AIFMD regarding aligning incentives with ESG risks in remuneration policies.
Conclusion: UK Impact?
It is not yet clear how and if the UK will apply equivalent changes through the FCA Handbook and UK AIFM Regulations. In any case, many of the provisions will still be relevant for UK fund operations, whether marketing cross-border under the Article 42 national private placement regimes or acting as a delegate of an EU27 AIFM. In particular, we would note the unusual ability (albeit limited to any occurrence of particular market instability or investor protection concerns) for NCAs to require a third country AIFM marketing an open-ended fund in Europe to activate or deactivate a liquidity management tool.
To discuss the content of this alert, please contact the authors or your usual Goodwin contact.
Chris OrmondKnowledge Management Counsel
Brian O'NeillKnowledge Management Counsel