What U.S. Fund Managers Need to Know About the EU’s AIFMD II

Jean-Thomas Pradillon:

Thank you very much for having us today. We're very exciting to discuss this topic today with you.

TaNeka Ray:

Can you give us an overview of AIFMD-II?

Jean-Thomas Pradillon:

AIFMD-II is the evolution of and not a revolution of AIFMD. This is what AIFMD-II is about, spotting specific points to value or to give more accuracy or more security to the investors and the overall market. We arrived to the point where AIFMD-II would come into the game and that there would be a need to make evolution and evaluation and improvement of this AIFMD. The main points that are covered in the AIFMD-II are mainly to modernize the framework for certain source of financing and certain liquidity management tools. There is also a need to strengthen the governance and the substance of the AIFM. And so there have been a little change in the AIFMD-II about how to delegate to certain responses, the condition of putting portfolio management or other kind of services into the hands of the U.S. sponsors. How are they going to be monitored by a home? What's the substance? All that kind of key questions that come into play that the institutions in the European Union believed needed to be tightened. And the third part is how first you're going to report. Because if we want to tighten a little bit the discussion, if we want to tighten a little bit the scrutiny, need the supervision while we still want to protect the market, then the idea is to try and ensure that the reporting obligations between the sponsors and the institutions is right, is good.

TaNeka Ray:

Well, thank you so much for that overview. And now we'll shift our focus to some of the changes. Can you explain some of those changes and how it has impacted the industry at large?

Jean-Thomas Pradillon:

Sure. So, one of the first impact, that is a key impact that was very well expected and very, very feared by the industry because of the discussions is about the delegation. The risk was to remove the possibility to just delegate to everybody. Again, acknowledges that the delegation as a way to have access to certain sources of expertise, sources of expertise, and also efficient management. You want to manage your fund properly, you want to have the experts, if the experts are in the U.S., you want to have access to these experts in the U.S. So, the way the delegation has been reviewed protects this. And there was also a second point to give a little bit of background about the delegation. A second point in the discussions that was extremely dangerous. When the proposal of the commission came on the table, it was the fact that it would, the AIFM could not delegate. And I quote here, "more portfolio management or risk management that it retains."

That was an extremely dangerous way of putting things because you were putting quantitative parameter into portfolio management, risk management. The first thing that is important is that AIFM arguing to have more functions, they are going to be able to provide certain service in particular servicing securitization of SPVs and originating loans on the behalf of an AIF. These are two functions that are going to be provided by AIFM, first one to be AIFMD-II. And also there is an addition of certain services. Now, because the market wants additional sources of income, they would be capable of providing certain services without being authorized for portfolio management. So, these pre-authorizations has been removed from AIFMD-II, and they were added certain node core services were added, in particular the credit services activities and the administration of benchmarks, which are two non-core services that can be provided by the AIFM without them being untrusted or authorized for the portfolio management.

All these functions that I described and all the new services, if the AIFM delegates it, then these services fall within the scope of the AIFMD delegation. And if you set delegation under the AIFMD, you have to say monitoring, you have to say liability, you have to say substance. So, the three words are extremely important because you will want to make sure that when you delegate to a U.S. sponsor certain functions, you will want to make sure that the AIFM is capable of monitoring, having due care of how it selects this delegate, that the delegate has sufficient resources, that the delegate has sufficient skills. There are all the rules of delegation that have not or barely moved that are going to be applicable to all that kind of services. And the AIFMD-II is also clarifying very well.

Whatever you do, whatever you delegate to a U.S. sponsor or anywhere else in the world, the impacts for the U.S. sponsors will be limited in the way that there would be more interactions with the E.U. AIFM, a little bit more monitoring, a little bit more, a little bit more due diligence, but nothing that is mainly and majorly impacting the U.S. sponsors as they are working now. So, the second point that we want to mention today about the AIFMD-II is the larger origination. Lot of changes here. Again, the rationale, a little background here is that a European commission after these ten years and after that COVID wanted to find new ways of financing and lower reaction is one of them. And I'll leave the floor to Nicolas for this one.

Nicolas Fermaud:

Exactly. Thank you. Thank you, JT, for the intro on this. So, first off, loan origination. Some of your clients will remember the times when you had to do a study all over the European Union to see in which jurisdiction loans can be originated and in which jurisdictions that activity is prohibited because it's reserved to a local or locally licensed actor. And that's now the AIFMD is changing and starting from when the AIFMD-II will need to be implemented, i.e., in two years’ time, loan origination activities will be something that will be harmonized across Europe. A European AIFM will be allowed to originate loans in the European Union and actually beyond it will be in the EEA when the EEA countries will have implemented the AIFMD-II as well. Obviously, a big carrot for the industry. Now it comes with certain, I'm going to call them guardrails in the sense that it comes with a number of guardrails in that there are provisions in the AIFMD-II that will be applicable to loan origination activities.

And here, first off, I think sponsors need to be aware that there are two loan origination activities. There's generally loan origination, which is defined by the AIFMD-II as the activity to either directly or through a string of SPVs to originate loan in a jurisdiction. And you will have quote-unquote, "loan origination fund," which are funds that whose investment policy is dedicated to originating loans or whose national value of originated loans represents more than 50% of net asset value. Okay? So, either the fund is indeed purposefully a loan originating funds as defined by the directive, or it just so happens that more than 50% of the net asset value of the fund is represented by originating loans. In either case, those are quote-unquote, "loan originating funds." And there are some additional rules that will be applicable to that. Now, rules that are applicable to those quote-unquote, "Loan originating funds," as well as to any other funds that just happens to be originating some loans in the EEA or in the E.U. for the time being, you will have first off, a prohibition activity. The activity of originating loans cannot be to distribute those.

So, originating to distributing is prohibited under the directive. As an ancillary point to that there's a risk retention requirements. That risk retention requirement is set as 5% of the notional value of the loan. Again, it ties into this concept of not originating to distribute. Last thing, there is a prohibition on concentration ratios to avoid having a too concentrated systemic risk in the financial sector, funds cannot originate loans to banks, credit institutions, and other funds for more than 20%. That 20% is applicable to an individual bar, though, it's not the total portfolio of the loan originating funds. So, those rules are applicable to all loan origination activity. As I was saying earlier, there are some additional rules that will be applicable to the quote-unquote, "loan originating funds." First off, there is a principle under which loan originating funds should be closed-ended. It's a principle, not an absolute prohibition. Meaning, if the AIFM has the liquidity management tools in place to allow for an end, the portfolio lends itself to having an open-ended fund. There is a possibility of having an open-ended fund.

However, from a principal perspective, those loan originating funds should be closed-ended. Where does that impact sponsors? Well, currently you will have seen in the market a number of evergreen structures. And so there, there is a question as to how you fit that evergreen structure in this new concept of either closed-ended or open-ended. But do you satisfy all the requirements to have an open-ended loan originating fund? The second additional requirement for loan originating fund, and this is probably the most controversial provision in the AIFMD-II as passed, is the limit on leverage that can be put on a loan originating fund. It is said that 175% of net asset value for open-ended fund and 300% of net asset value for the closed-ended funds.

TaNeka Ray:

Now that we've discussed the changes in the impacts to the industry, let's discuss the impact to fund managers specifying the difference between the impact to U.S. fund managers versus the impact to non-U.S. fund managers.

Nicolas Fermaud:

First off, as I'm sure that plenty of your clients and yourself are well aware of, the distribution regime in Europe is composed of two parallel regimes. There's a harmonized one under the marketing passport and there's one which is called National Private Placement Regime, which is a fragmented approach. And by the way, National Private Placement Regime in short NPPR. And NPPR is referred to also as marketing under Article 42 under the AIFMD because that's the article that foresees this kind of marketing and that lays down the conditions that mergers have to fulfill to be allowed to rely on the NPPR. There, AIFMD-II brings a little change again, along with the recurring theme today, it's not a revolution, it's just an evolution, but it is a noteworthy evolution for U.S. managers because a number of your clients will probably be relying on the NPPR for the current distribution. And the most evident example of that is when they do have a Delaware or Cayman entity that they are marketing into one or two targeted European jurisdictions where such marketing is allowed on the base of Article 42.

There, the change of rules impact the conditions that the AIFM as well as the AIF have to meet. First off, with respect to the AIFM, the AIFM itself cannot be on the list of non-cooperative jurisdiction from an AML perspective. For U.S. sponsors, that should not be a problem. The U.S. is not on such list, and so traditionally when U.S. sponsors have marketed, say a Cayman or Delaware fund into a few of the European jurisdictions that allow this Article 42 marketing regime, the AIFM will be in the U.S. And so there are not much of a change. Where it gets a little more interesting though, is on the conditions that the funds, the AIF itself has to comply with. The fund must be in a jurisdiction. That is, the fund cannot be on a jurisdiction that is included in the European list of non-cooperative jurisdiction for tax purposes. And the fund must be in a jurisdiction that has signed an agreement for the exchange of information based on the OECD model into each of the jurisdiction where the fund will be marketed. With that said, maybe JT on to you for the other topics.

Jean-Thomas Pradillon:

There have been some additional changes in particular to two key Articles: Article 23 and Article 24. The Article 23 is very well known, and the Article 24 as well actually. But Article 23 is very well known because it's a list of the disclosures that should be made to investors. 24 is a list of reporting that should be made by certain AIFM to authorities. And so, these two Articles, 23 and 24 are related to disclosure and reporting, and they have been substantially changed for 24 and change materially for 23. These two articles are obviously going to impact the E.U. AIFM, but if according to Nicolas said, if you market under NPPR in a European country, you are going to have to comply with Article 23 and Article 24. If you are a non-E.U. AIFM managing an E.U. AIF that you distribute in such country. These changes are going to impact every single AIFM, E.U. or non-E.U. that is marketed certain AIFM.

TaNeka Ray:

So now that we've discussed, what are the next final steps that fund managers need to know about implementation?

Jean-Thomas Pradillon:

If there is one thing that needs to be taken away is that the Directive needs to be implemented. There are two years as of the 15th of April 2024, so we'll have until the 16th of April 2026 if you are a member state to implement the directive. Now, a key, very key point that has been conveyed by the AIFMD is that we're still waiting for certain clarification from the ESMA that will provide certain RTS and guidelines. There would be guidelines about, for example, the selection or calibration of the liquidity management tools, how to mitigate financial stability. There will be some clarification regarding requirements for a loan origination. I have to be open-ended. There will be also a specification of certain characteristics of that liquidity management tools. We are waiting for more input from the major stakeholders of the industry. So, the two things that the sponsors need to keep in mind is that the directive is in place. Let's look forward to its implementation. And the second thing is we are also looking forward to receiving the input of ESMA and other big stakeholders of the industry about their first impressions. And the way we're going to clarify certain key concepts. What should be done by a U.S. sponsor or by any sponsor in general in this context is that you want to make an analysis. You want to make a gap analysis and an impact assessment about how this AIFMD-II is going to impact your everyday work and what are the key steps and what would you expect from process standpoint from this AIFMD-II. This is where you want to reach out to your specialists, where you want to analyze what are the next steps and how to absorb and to digest this AIFMD-II, the best way possible in your industry and business.

TaNeka Ray:

All right, so that concludes today's discussion about AIFMD-II. Jean-Thomas and Nicolas, thank you for joining me and sharing your invaluable insight. Again, my name is TaNeka Ray with EisnerAmper. I welcome you to connect with us on LinkedIn and thank you so much for watching.