End of the Beginning: AIFMD II’s Final Text

7 February 2024

ESMA to draft Level 2 measures on criteria for an open-ended loan-originating AIF and on specific characteristics of liquidity management tools

ESMA to develop guidelines on the selection and calibration of liquidity management tools

By September or October 2025

ESMA to report on costs

Deadline for member state implementation

ESMA to develop guidelines on the following:

• AIF names and circumstances in which the name of an AIF could be unfair, unclear, or misleading
• Supervisory intervention on liquidity risk management
• Information exchange procedures between relevant national competent authorities (NCAs) and supervisory authorities

End of (limited) grandfathering rules on loan origination

The 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 as set out below) and the Article 6(4) (MiFID top-up) ancillary services.

This brings in services such as administration and marketing, functions that are often carried out by third-party administrators and placement agents. MiFID top-up services are subject to the AIFMD II delegation regime rather than the MiFID II outsourcing rules.

The revisions clarify that delegation (or any further sub-delegation) of functions or services 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 behalf are not to be considered delegation, irrespective of any distribution agreement with the AIFM. A distributor acting on behalf of the AIFM will therefore be deemed a delegate.

On applying for authorisation under Article 7, the AIFM will have to provide additional and more-detailed information on its delegated Annex I functions, including on the following:

• For each delegate: its name and relevant identifier, jurisdiction of its establishment, and supervisory authority
• The AIFM’s human and technical resources for performing the portfolio or risk management tasks within the AIFM and for monitoring delegated activities
• For each AIF, a description of the delegated functions (for both portfolio management and risk management functions) and whether such delegation is full or partial
• A description of the periodic due diligence measures to be carried out by the AIFM for monitoring the delegated activity

An AIFM is also under a new duty to report to its NCA any material changes to its delegation arrangements (and therefore allow one month’s advance notice to its NCA for anticipated changes).

The amended Directive includes reference to the purpose of data collection to provide a greater overview of the operation of delegation and not to be taken on its own as an evidential indicator for determining the adequacy of substance or risk management or the effectiveness of manager oversight or control arrangements.

AIFMs are to provide various information on delegation as part of their annual reporting to regulators under Article 24 (see below).

The Annex IV reporting template will be replaced, but not until 2027. Regulatory technical standards are to follow.

There are new, heightened conflict-of-interest provisions for third-party AIFMs. A host AIFM is to submit to its home state NCA detailed explanations of how it complies with the AIFMD conflict-of-interest provisions, in particular to specify the following:

• What reasonable steps a white-label AIFM has taken to prevent conflicts of interest arising from the relationship
• Where they cannot be prevented, how those conflicts are identified, managed, monitored, and disclosed in order to prevent them adversely affecting the AIF and/or its investors

This puts the third-party-host AIFM model under more scrutiny, and the effectiveness of these provisions will be studied when they are reviewed.

Annex I of AIFMD is expanded to include originating loans on behalf of an AIF and servicing securitisation special purpose entities as additional ‘other’ functions.

An additional amendment to that previously debated is that a firm can now be authorised under Article 6(4) if only providing noncore services (and the MiFID provisions on initial capital, organisational requirements, conflicts, general principles, and assessment of suitability will apply). In other words, a firm can hold a top-up permission (such as investment advice) without having to also be authorised for portfolio management.

Article 6(4) ancillary services (e.g., collective portfolio management services, segregated mandates, investment advice and custody services under MiFID II) are expanded to include benchmark administration and credit servicing permitted by EU laws.

A new condition of AIFM authorisation is that it has to have at least two senior managers resident in the EU, individuals who are either AIFM employees or are committed to the conduct of the AIFM’s business (in each case on a full-time basis).

This should not be an issue for most fund managers, reflective of existing substance and governance matters. There is no requirement to appoint a nonexecutive director (NED).

Recital (5) notes: ‘Regardless of this statutory minimum, more resources may be necessary depending on the size and complexity of the AIF.’

We would flag that for those managers considering marketing to retail investors in the future, the appointment of a NED may become a prerequisite rather than a recommendation.

For AIFs marketed to retail investors, a recital (that is not an operative provision) that states that at least one member of the AIFM’s governing body should be an independent NED with sufficient expertise and experience to assess whether the AIFM is managing the AIF in the best interests of investors. This is to be reviewed within five years of AIFMD II entering into force.

As part of its authorisation application, an AIFM will need to provide information about the persons conducting the AIFM’s business, including descriptions of their role, title, and level of seniority; a description of their reporting lines and responsibilities inside and outside the AIFM; an overview of the time each of those persons allocates to each responsibility; and a description of the human and technical resources that support their activities and that the AIFM is to use for monitoring and controlling the delegate.

The proposed changes to the MiFID definition of ‘professional client’ are in the Retail Investment Package (see our client alert The EU Retail Investment Strategy and Private Fund Managers for more), which is cross-referenced in the amended Directive.

Loan origination is one of the following:

• The granting of a loan directly by an AIF as the original lender
• The indirect granting of a loan through a third party or special purpose vehicle (SPV) (on the AIF/AIFM’s behalf) where the AIF/AIFM is involved in structuring the loan or pre-agreeing on its characteristics in advance of being exposed to it

A ‘loan-originating AIF’ is an AIF whose principal activity is to originate loans or where the notional value of the AIF’s originated loans represent at least 50% of the AIF’s net asset value (NAV). This includes loans made via an SPV or another third party (i.e., credit strategies).

Most of the provisions relate to all AIFs when originating loans. Some additional provisions (such as the requirement to be closed ended and leverage limits) relate only to ‘loan-originating AIFs,’ or those that originate loans as a principal activity rather than alongside other activities.

Note that there is no definition of ‘loan.’ The expected market approach is that preferred equity and/or bonds and notes issued by a portfolio company to an AIF should not be caught.

Grandfathering provisions apply to certain loan-origination activities (see below).

A definition of ‘leveraged AIF’ is introduced, and describes an AIF whose exposures are increased by the AIFM that manages it, including via borrowing of cash or securities, or leverage embedded in derivative positions.

This is relevant for supervisory cooperation and leverage limits.

The provisions that relate to loan-originating AIFs are as follows:

• They have to be closed ended unless the AIFM can demonstrate to its NCA that the AIF’s liquidity risk management system is compatible with its investment strategy and redemption policy (without prejudice to the thresholds, restrictions, and conditions in European venture capital funds (EuVECA), European social entrepreneurship funds (EuSEF), and European Long-Term Investment Fund (ELTIF) Regulations).
• Specified leverage limits are 175% for open-ended funds and 300% for closed-ended funds (calculated according to the commitment method and expressed as the ratio between the fund’s exposure relative to the fund’s NAV and to exclude borrowing fully covered by contractual commitments), and include rectification provisions should caps be breached unintentionally.

This is preferable to the Commission’s original proposal (a 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).

ESMA is to determine the requirements with which a loan-originating AIF must comply to maintain an open-ended structure.

The origination of 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 is carved out from the leverage limit requirements. Therefore, for this exemption to apply, the loan will need to be ‘stapled’ to the equity. Note also that shareholder loans are exempt from the policies and procedures requirement for loan origination (see below).

For loan-originating activities, AIFMs must have effective and proportionate policies, procedures, and processes in place and review them at least annually for granting credit, assessing credit risk, and administering and monitoring their credit portfolios.

This requirement does not apply to the origination of 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.

An AIF cannot lend to its AIFM or its staff, any AIFM delegates, the depositary and its delegates, or group entities of the AIFM (except for third-party finance).

Member states can also introduce more-restrictive rules, in particular for overriding reasons of public interest and in relation to consumers in their territory (e.g., prohibit loan origination to consumers), unless the AIFMs/relevant AIFs comply with the requirements of the Consumer Credit Directive or the Directive on credit servicers and purchasers.

Member states shall prohibit AIFMs from managing AIFs that follow an originate-to-distribute investment strategy, which is an investment strategy under which loans are originated with the sole purpose of selling them. They may prohibit AIFs that originate loans from granting loans to, and servicing credit for, individual consumers.

There is a 20% limit on loans to a single borrower if that borrower is a financial undertaking (which includes mixed financial holding companies), MiFID investment firm, AIF, or UCITS. For the 20% calculation, there is a ramp-up period of up to two years from initial subscription as set out in the AIF’s constitutional documents, which may be extended by a year by the AIFM’s NCA in exceptional circumstances on the AIFM submitting a justified investment plan.

Helpfully, there is flexibility around this limit for AIFs raising or reducing capital (with any temporary suspension not exceeding more than 12 months) or selling assets either to redeem or as part of the AIF’s liquidation.

This restriction is without prejudice to the thresholds, restrictions, and conditions in EuVECA, EuSEF, and ELTIF Regulations.

An AIF must retain at least 5% of the notional value of loans it has originated and subsequently transferred to a third party. This amount must be held until maturity for originated loans whose maturity is up to eight years (and any loans granted to consumers), and otherwise for at least eight years.

There are various exemptions to this retention requirement (that an AIFM must be able to justify to its NCA where relevant), including: where the AIFM needs to sell assets to redeem units or shares as part of an AIF’s liquidation; the disposal is necessary to comply with EU sanctions or product requirements or the sale of the loan is necessary to enable the AIFM to implement the AIF’s investment strategy in its investors’ best interests. Also, where the loan sale is due to a deterioration in the risk of the loan detected by the AIFM’s risk management and due diligence, and that the buyer has been informed about.

The proceeds of loans (minus any administrative fees) must be attributed to the AIF in full.

The costs and expenses of loan administration are to form part of the Article 23 investor disclosures.

There is a five-year transitional arrangement in relation to the following:

• Deemed compliance for certain provisions (leverage limits and requirement to be closed ended for ‘loan-originating AIFs’ and 20% single borrower limit) for AIFMs managing AIFs that originate loans before the amending Directive comes into force (which applies indefinitely for preexisting AIFs that do not raise additional capital after the date the amending Directive comes into force)
• Ongoing management of loans originated by an AIF that exceed the 20% limit to any single borrower or the AIF leverage limits for open and closed-ended funds (provided the AIFM does not increase those values or limits)

Note that the five-year transitional period begins when AIFMD II comes into force (i.e., in 2024, not in 2026 when member states implement) and therefore applies from 2024 to 2029.

AIFMs that manage preexisting AIFs that originate loans:

• Can choose to be subject to the new requirements on leverage limits, 20% limit, and requirement to be closed ended before the end of the transitional period, on notifying their NCA
• Do not have to comply with certain provisions - on policies and procedures; loan proceeds (and related investor disclosures); the restrictions on entities to lend to and originate-to-distribute strategies or on the 5% retention

In addition to any other liquidity management tools (LMTs) set out in the fund rules and constitutional documents, open-ended AIFs have to select at least two LMTs (except for AIFMs that manage an authorised money market fund, which can select one) from those set out in a new Annex V (points 2 to 7) and implement detailed policies and procedures to operate, administer, activate, and deactivate any such tools.

The relevant Annex V tools (points 2 to 7) are redemption gate (that provides a temporary and partial restriction on investors’ redemption rights), extension of notice periods, redemption fee, swing pricing, dual pricing, antidilution levy, and redemption in kind. ESMA is to develop regulatory technical standards to specify the LMT characteristics while taking into account the diversity of investment strategies and underlying assets of the AIF.

There are various rules around how LMTs can be selected, including the following:

• An AIFM cannot select swing and dual pricing only as its two LMTs.
• An AIFM can temporarily suspend redemptions and subscriptions or use side pockets (items 1 and 8 of Annex V), but only in exceptional circumstances and where justified with regard to the interests of the AIF investors.
• Redemptions in kind can only be used for redemption requests by professional investors and, unless solely marketed to professional investors or for AIFs that are EU-regulated exchange traded funds tracking an index, if the redemption corresponds to a pro rata share of the assets held by the AIF.

Within 12 months of the amended Directive coming into force, ESMA is also to develop guidelines on the selection and calibration of LMTs by AIFMs for liquidity risk management and for mitigating financial stability risks while recognising that the primary responsibility for liquidity risk management remains with the AIFM.

The AIFM must communicate the LMT selected and the detailed policies and procedures to its home member state NCA. It must also notify its NCA without delay when it activates or deactivates a redemption or subscription suspension in a reasonable time frame in advance of the activation or deactivation of side pockets or any other LMT not in the ordinary course of business as envisaged by the fund documentation.

This information is to be shared with the AIFM’s host member state, ESMA, and, if necessary for risk to the stability and integrity of the financial system, the European Systemic Risk Board (ESRB). The aim is to allow supervisory authorities to better handle spillovers of liquidity tensions into the wider market.

The LMT of suspension of redemptions or subscriptions can be activated or deactivated by supervisory authorities as follows:

• By NCAs requiring AIFMs to do so; there is a mechanism where the host member state of an AIFM requests the AIFM’s home member state to do so, and ESMA can provide an opinion where there is disagreement
• By ESMA requiring non-EU AIFMs marketing in the EU (or an EU AIFM managing a non-EU AIF) to do so

In each case, this is limited to where it is in the interest of investors, in exceptional circumstances, after consulting with the AIFM, and if there are investor protection or financial stability risks that, in a reasonable and balanced view, necessitate it.

ESMA is to produce guidance on the selection and calibration of LMTs and on the supervisory intervention mechanic (again, while recognising that the primary responsibility for liquidity risk management remains with the AIFM).

The Article 24 NCA reporting obligations are broadened (mostly on information on delegation) to specifically include (in addition to the existing requirements) the following:

• All of the instruments in which it is trading and on markets, exposures, and assets for each AIF it manages (not limited to the principal instruments)
• The total amount of leverage of the NAV employed by the AIFM
• The list of member states in which the AIF is marketed by the AIFM or its distributor
• To provide additional and more-detailed information on an AIFM’s delegated and any sub-delegated functions in relation to portfolio management or risk management (in each case, whether a full or partial delegation) and on the following:
  • For each delegate, its name, domicile, any close links with the AIFM, their authorisation or regulation, supervisory authority, and relevant identifier
  • The number of full-time-equivalent human resources employed by the AIFM for performing its day-to-day portfolio or risk management tasks and for monitoring delegation
  • A descriptive list of the risk and portfolio management delegated
  • For portfolio management, the amount and percentage of assets under management subject to delegation
  • The AIFM’s human and technical resources for performing the portfolio or risk management tasks within the AIFM and for monitoring delegated activities
  • Number and dates of periodic due diligence reviews carried out by the AIFM to monitor delegation, an issues list, measures adopted to address those issues, and by when they will be addressed
  • Commencement and expiry dates of delegation and sub-delegation
  • For any sub-delegation, information on each sub-delegate, the activities and functions delegated, and on the quantitative data

Within three years of the amending Directive coming into force, ESMA will develop regulatory and implementing technical standards on the standardisation of this information and the reporting timing and frequency. It may also impose additional reporting requirements after consulting with the ESRB and in order to ensure the stability and integrity of the financial system or promote long-term sustainable growth.

There are enhanced provisions to allow information sharing for supervisory cooperation between ESMA, the NCAs, the European Supervisory Authorities (ESAs), and the ESRB (and with the European System of Central Banks for statistical purposes).

The following additional items are to be included in Article 23 investor disclosures:

• The AIF’s name, liquidity risk management, and, for open-ended AIFs, details of circumstances for using the AIFM’s selected LMTs along with existing redemption arrangements and investors’ redemption rights in normal and exceptional circumstances
• A list of all fees, charges, and expenses to be borne by the AIFM in the operation of the AIF directly or indirectly allocated to 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, charges, and expenses borne by investors and any parent company, subsidiary, or SPV used in relation to the AIF’s investments by or on behalf of the AIFM

Helpfully, references to fees of affiliates and to quarterly reporting, both in earlier drafts, have been removed.

Note also that ESMA guidelines, taking into account relevant sectoral legislation, are to be developed on AIF names and circumstances in which the name of an AIF could be unfair, unclear, or misleading (set out in more detail below).

Third-country depositary services

Although there is no longer any reference to the introduction of a ‘depositary passport,’ an NCA can allow an EU AIF to deviate from the general rule and appoint a depositary that is an EU credit institution to be located in another member state when requested by an EU AIFM if certain conditions are met. These conditions are that the AIFM demonstrates the lack of relevant depositary services in its home member state to meet its AIF’s needs with regard to its investment strategy, including that the home member state’s aggregate market of EU AIF depositary assets safekept does not exceed €50 billion or equivalent (not including assets safekept by the depositary and its own assets).

The depositary must make any relevant information available to its NCA when performing its duties.

NCAs must still assess the AIF’s investment strategy and the home member state depositary market on a case-by-case basis and must notify ESMA when it allows a depositary to be appointed in another member state.

A third-country depositary cannot be based in an EU-specified jurisdiction that is high-risk or non-cooperative for tax purposes. There is a two-year grace period to allow for reappointment if an appointed depositary is subsequently so listed. Also, tax cooperation agreements must be in place with the AIFM home member state NCA and the third country where the depositary is established.

There are additional requirements in relation to information sharing where the AIF/AIFM NCAs are different from those of the depositary.

The provision of services by a central securities depository (CSD) acting in the capacity of an ‘issuer CSD’ is not to be considered a delegation of the depositary’s custody functions, but the provision of services by a CSD acting in the capacity of an ‘investor CSD’ will be.

New EU AML rules for third-country AIFs/AIFMs: not a high-risk country or non-cooperative tax jurisdiction

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, as set out above, 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, non-EU AIFs, and any third-country depositaries cannot be located in a third country that is identified as high risk under EU legislation² or that is deemed non-cooperative in tax matters.³

Firms will need to be alert to the impact of any published changes made to these lists. For instance, the AML list currently includes the United Arab Emirates and Panama (with the Cayman Islands having been recently removed), and the non-cooperative tax list includes the US Virgin Islands and Panama. 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.

To improve information exchanges with tax authorities, professional secrecy is no longer applicable to tax information supplied by AIFMs to NCAs. There remains a requirement for cooperation agreements to be in place between home NCAs and third-country regulators.

Inclusion on ‘undue costs’: Within 18 months of the amending Directive coming into force, ESMA is to report to the co-legislators with an assessment of costs charged by AIFMs to their investors, explaining the reasons and differences for the level of costs. NCAs are to provide data to ESMA for this on a one-time basis.

This is in the context of the AIFM’s general principle of treating all investors fairly and to promote convergence on the supervision of costs in AIFs. Also in order to collect data in anticipation of proposed amendments in the EU retail investment strategy that introduce the concept of ‘undue costs’ for AIFs and the introduction of a value-for-money concept with respect to retail investors (see our previous client alert for background).

EU’s Sustainable Finance Disclosure Regulation (SFDR) references to remuneration and marketing

ESMA is to update its Guidelines on sound remuneration under AIFMD regarding aligning incentives with ESG risks in remuneration policies.

No additional marketing requirements are to be imposed when an EU AIFM markets an EU AIF of an employee savings scheme on a cross-border basis.

In their remuneration policies, AIFMs subject to the SFDR must include information on how they are consistent with the integration of sustainability risks.

Within two years of the amending Directive coming into force, ESMA is to develop guidelines, taking into account relevant sectoral legislation, on AIF names and circumstances where the name of an AIF could be unfair, unclear, or misleading. This is likely to be aligned with the outcome of the SFDR review, which includes input on marketing communications, product names, and whether the SFDR should include additional rules on labelling and marketing communications. The ESMA guidelines on fund names using ESG or sustainability-related terms (expected to be finalised in Q2 2024) will be of relevance.