AIFMD rev2 – What are likely impacts of the future loan-origination fund regime for Luxembourg

The revised AIFMD is set to enter into application by the end of 2025 and will introduce harmonized EU rules applicable to loan-originating funds.

Contrasting with the manager regulation approach of the Alternative Investment Fund Managers Directive (AIFMD), the upcoming revised Directive is set to introduce specific rules applicable to loan-originating funds. In 2016, the Commission de Surveillance du Secteur Financier (CSSF) had already confirmed that loan-origination was an activity permitted for AIFMs, provided certain organizational and risk management requirements were met, but this will now be enshrined in AIFMD 2 and this authorization will be applicable throughout the European Union.

So far, Luxembourg has proved to be the most appealing European domicile for global asset managers launching such funds thanks to its flexible rules and an extended toolbox providing for both regulated and unregulated vehicles. Such flexibility for structuration, in comparison with stricter rules and narrower scope applicable in other major domiciles such as Ireland or France, enabled Luxembourg to take a decisive competitive advantage and to become the premier European hub for private debt funds.

For certain Luxembourg vehicles, restrictions such as risk-spreading requirements applicable to Reserved Alternative Investment Funds (RAIFs) opting for the Specialized Investment Fund (SIF) regime, investment eligibility rules for Investment Companies in Risk Capital (SICAR) or complex rules for European Long-Term Investment Funds (ELTIFs) must be complied with. On the other hand, if a significant proportion of private debt funds remain unregulated and/or managed by sub-threshold AIFMs, RAIFs and AIFs managed by authorized AIFMs will be impacted by the upcoming regime which will strengthen and harmonize baseline requirements to guarantee minimum investor protection, address financial stability concerns arising from the growth of direct lending and ultimately foster market integration.

As the negotiations at Parliament to reach a compromise on the AIFMD revised text progresses, the appropriateness of the risk retention requirement has emerged as one of the most controversial requirements introduced in the future loan-originating regime. The latest amendments foresee that an AIF should retain, for the period of two years from the signing date or until maturity, whichever is shorter, 5% of the notional value of the loans it has originated and subsequently sold on the secondary market. This obligation was already included in the European Commission in order to avert moral hazard, maintain the general credit quality of loans originated by AIFs and to avoid situations in which loans are originated with the sole purpose of selling them. If exemptions were already provided for loans purchased on the secondary market and shareholders’ loans which do not exceed 150% of the AIF capital, more comprehensive exemptions have been proposed to cover a range of specific situations. For example, it would be possible to sell the loan where it becomes necessary to avoid breaches of an applicable investment or diversification rule where such breach was beyond the control of the AIFM (e.g., as a result of the exercise of subscription or redemption rights). The manager would also be allowed to sell the retained portion of the loan in case the borrower’s solvency would deteriorate and impact its capacity to abide by the terms of the loan, or the credit outlook would deteriorate and indicate that the value of the loan is likely to decline. More generally, a disposal would also be possible in order to avoid a material loss to investors, when the sale is carried out to fulfill a payment obligation of the fund or when the loan is sold to a professional investor, to an AIF dedicated exclusively to institutional investors or to a credit institution. Finally it is also proposed to allow such disposal where it is not possible to sell the loan otherwise than in full or when it is necessary in order comply with EU sanctions.

All these carve-outs, if they make their way to the final text, will provide a certain degree of flexibility for loan-originating fund managers facing the specific events covered. It is indeed critical for fund managers not to overly expose investors to credit risk by locking them into bad performing loans otherwise the requirement to implement ongoing monitoring procedures would be pointless. There are also situations where the retention of a minority portion of loans may have detrimental effects. Loans are not standard assets and frequently embed binding commitments and covenants which may have to be assigned or novated in case of sale. This may lead to a situation where the fund would remain exposed to a non-performing loan without having the capacity to control enforcement of covenants and other recourses. However, such closed list of possible exemptions will limit the fund manager’s ability to sell loans at its own discretion in adverse circumstances which could be detrimental to investors but have not been foreseen in the Directive. The minimum holding period, which is currently set at two years but is still subject to discussions, will be of paramount importance in this context, but also from a liquidity management perspective.

Another key proposal of the Commission which has crystallized quite divergent views is to impose a closed-ended structure to funds if the notional value of the loans they originated from corresponds to at least 60% of the fund’s net asset value for a continuous period of 15 days. Even if it is standard market practice to set-up loan-originating funds as closed-ended structures, there is currently no obligation to do so in Luxembourg. Nonetheless, a recent amendment proposes to introduce an exemption to this obligation for funds which do not exceed EUR 5 billion. If adopted, such carve-out would exempt a large proportion of Luxembourg loan-originating funds and would leave the door open for semi open-ended structures, but it remains to be seen whether it will be incorporated in the final Directive.

Overall, while some changes are expected to impact the sector, they should not excessively undermine the Luxembourg position as a domicile of choice for direct lending funds. If the final exemption regime is well calibrated, it should not impose excessive burden on AIFMs and it should remain possible to launch and operate moderately regulated structures while taking advantage of the different structuring options available.

While interinstitutional trialogues are likely to start during the second quarter of 2023 to reach a final compromise, it is expected that the final Directive will enter into application at the end of 2025.