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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.
Delegation
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 study on the potential benefits and risks of introducing a
depositary passport 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.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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