On 25 November 2021, the European Commission proposed a number of legislative amendments to the Alternative Investment Funds Manager Directive (AIFMD)1, the UCITS Directive2 (UCITSD) and the ELTIF Regulation3, namely the “AIFMD 2 Proposal”.
The proposed amendments set out in the AIFMD 2 Proposal will be introduced by way of an omnibus directive amending the AIFMD, the UCITSD and the ELTIF Regulation. One of the key amendments relates to loan origination funds, which have experienced increased popularity in recent years.
These funds generally provide financing to small businesses with growth requirements or a business model that excludes them from the banking system. The private debt market overall has grown tremendously since the 2008 financial crisis, and even more since the COVID-19 pandemic, increasing by 40.6% in the past year to reach 181.7 billion euros in assets under management in Luxembourg.
The rise of loan origination funds can be linked to the erosion of the banking quasi-monopoly over the last few years in the European Union. However, some jurisdictions such as Italy, still require that a pre-approval process be conducted by the Central Bank (Bank of Italy4) on the regulated alternative investment fund manager (the “AIFM”) managing the foreign loan origination fund prior to starting the lending activity in the Italian market, unless such loan origination fund is structured as an ELTIF. Still, some jurisdictions like France require that a foreign loan origination fund be structured as an ELTIF in order to lend to small and medium-sized French enterprises. Such an unlevel playing field can lead to a fragmented landscape for loan-originating funds since loan-originating fund managers are, in practice, forced to target only a few EU domestic markets.
To address the above and enhance market integration, the AIFMD 2 Proposal introduces a new framework at EU level for alternative investment funds originating loans.
What are the new activities and services opened to AIFMs?
According to the AIFMD 2 Proposal, the following activities should be included in Annex I of the AIFMD:
- loan origination (even if, in practice, it is the alternative investment fund (the “AIF”) itself which originates loans); and
- the servicing of securitization special purpose entities.
AIFMs with a MiFID top-up license should also be authorized to provide two additional ancillary services, namely benchmark administration and credit servicing. The AIFMD 2 Proposal clarifies which MiFID provisions apply to the provision of ancillary services under Article 6(4) AIFMD (where those ancillary services are being provided in relation to MiFID financial instruments).
Loan origination under AIFMD II: what it is and what it is not
In this regard, the AIFMD 2 Proposal introduces harmonized requirements at the EU level for EU AIFMs managing loan-originating EU AIFs. It is important to note that there is currently no detailed legal definition of which activities may be included within “loan origination”. However, a distinction is made between granting of loans and loan purchasing. The Luxembourg regulator (Commission de Surveillance du Secteur Financier or “CSSF”) defines “loan origination” as “the process, initiated by its AIFM or, where applicable, by the AIF itself, of actively creating/granting/extending a loan as part of its investment policy”.
This loan origination concept refers to, and may comprise, all relevant steps in the issuance process, including, inter alia, receiving and processing loan applications, performing the risk credit assessment and borrower selection, setting the characteristics of a specific loan (e.g., the loan’s duration, the periodicity of its repayment, its pricing, etc.) but also post issuance activities such as periodic credit control, covenant monitoring, servicing, and security realization or provisioning against default on loans which must be written-down or written-off, partially or in full.
While neither the CSSF nor the International Organization of Securities Commissions (“IOSCO”) draw a straight line between loan participations and loan acquisitions, IOSCO notes that a fund’s investment policy and strategy must specify that its loan participation/acquisition strategy should be pursued to the exclusion of any loan origination5 in order for the strategy to qualify as loan participation/acquisition. It remains to be seen whether the final version of the AIFMD 2 Proposal will be aligned on the above-mentioned IOSCO/ CSSF approach.
Who is in scope and to whom can loans be issued?
The AIFMD 2 Proposal does not clarify which entity in a typical fund structure may trigger these new requirements: the AIFM, the AIF and/or special purpose vehicles (SPVs) related to the AIF. It is also important to note that the proposal is not limited to loans originated with EU borrowers: all loan origination activity should fall in scope irrespective of the location of the borrower or collateral.
The AIFMD 2 Proposal introduces a “loan issuance passport” for European loan-originating AIFs managed by a fully authorized EU AIFM. This means that national regulatory requirements currently applicable to loan origination AIFs will have to be adapted in conformity with the principles laid out in the AIFMD 2 Proposal.6
Finally, although many market participants were in favor of introducing a concept of semi-professional investors in order to widen the scope of the marketing passport (which permits marketing to professional investors only), the Commission has not taken this point forward in its proposals.
How does AIFMD 2 frame the loan origination activity?
According to the AIFMD 2 Proposal, the following requirements should apply:
- Loan origination policies and procedures: AIFM should establish, maintain up-to-date, and review at least once a year, policies and procedures for the granting of loans, the assessment of credit risk and the monitoring of credit portfolios. The impact of these provisions should be limited for Luxembourg funds which are subject to similar requirements pursuant to the CSSF FAQ on AIFMs.
- Closed-ended: loan origination AIFs engaging in loan origination to a significant extent (exceeding 60% of the AIFs’ net asset value) should be closed-ended. It results that the European legislator intends to create an additional restriction for this asset class, compared to other illiquid asset classes (such as Private Equity, Real Estate and Infrastructure). Indeed, there is a market trend to structure more and more private equity and real estate funds as open-ended funds where (i) the required liquidity disclosures and risk warnings are given to investors prior to their investment and (ii) liquidity management procedures applied by the AIFMs of such funds are adapted to the relative illiquidity of their underlying assets. It seems that policymakers aim to introduce a distinction between AIFs qualifying as ELTIFs and those that do not, as indeed, loan originating ELTIFs may be open-ended.
- Risk retention obligation: the loan origination fund must retain on an ongoing basis 5% of the notional value of the loans it has originated and subsequently sold on the secondary market.. In this way, AIFs’ capital should remain exposed not only to the returns but also the risks linked to the underlying assets in which they invest.
- Concentration limit applicable to certain types of borrowers: the percentage of the AIF’s capital that may be lent to a single borrower that is either a financial undertaking, an AIF or a UCITS is capped at 20%. There is no definition of “AIF’s capital” under the AIFMD 2 Proposal. It should therefore be clarified whether this threshold should apply by reference to the undrawn commitments or the (net or gross) assets of the AIF. Furthermore, one should note that the legislator goes further than the ELTIF Regulation which is more restrictive in relation to the ability of ELTIFs to lend to financial undertakings as defined therein. This being said, the proposal may create an issue for managers of AIFs whose strategy is to provide фridge-financing to private equity, real estate and infrastructure funds who typically secure the financing received against investors’ commitments and grant a pledge on the funds’ bank account. Indeed, this restriction could impact bridge-financing opportunities.
- Conflicts of interest: the loan origination fund cannot lend to its AIFM, the AIFM’s staff or delegates or its depositary.
When should AIFMD II become applicable?
The AIFMD 2 Proposal is now considered by the European Council and European Parliament. It is difficult to anticipate when an agreement will be reached or whether the proposal will be modified substantially. Once the text of AIFMD2 will be in final form, it will be implemented into the respective national legislations, meaning that the legislative amendments are expected to occur in 2025.
