Dechert On Reg

AIFMD 2.0: New Rules Impacting Loan Origination Funds

• Dechert LLP • Episode 8

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The latest episode of our On Reg podcast dives deep into the AIFMD's new rules and their transformative effects on loan origination strategies and fund management. Whether you're navigating the complexities of today's financial regulations or just interested in learning the latest industry developments, this episode is essential listening. Special guest Marianna Tothova offers her insights on what's changed for AIFMD, what's to come, and how it may affect your business.

Show Notes:

Hello everyone, and welcome to Dechert On Reg, the podcast Music. where we explore the ever-changing landscape of financial regulations and the key issues that are shaping the future of asset management. I'm Angelo Lercara, partner at Dechert and co-head of our regulatory product line, and in each episode we'll be joined by expert colleagues and guests to explore the most pressing issues in financial regulation. In today's episode, we're talking about loan origination and the upcoming AIFMD rules, which will have a major impact on loan originating funds. So whether you're an industry insider or simply interested in the world of financial regulation, you don't want to miss this episode of Dechert on Reg. I'm excited to have Marianna Tothova joining us today to discuss this exciting topic. Let's dive in. Hi Marianna. Hi Angelo, thanks for having me again, and I'm very excited to speak to you about the loan origination again. Yeah, actually, we spoke about the AIFMD and loan origination in episode two of our podcast. I think it was back in August of last year. A lot of things happened since then, I guess. And what has changed actually, since we spoke in the loan origination space? So what changed is that we now have the final text of the AIFMD 2.0. It has been published, and AIFMD 2.0 also entered into force on the 15th of April 2024. So we now know what we have just been guessing back at a time last year. We also know when AIFMD 2.0 will come to have effect, which will be in 2026, and we also have some transitional provisions that relate to loan origination, but we'll get to that a little bit later. Essentially what we have discussed back then in rough terms is still the case, but I think it would be useful to reframe and share the new rules with our listeners before we get deeper into how these changes may affect the market. We cannot be exhaustive, because there is a lot that we could cover, and we cannot cover every exemption and exception to the rules, but we have picked some topics that we think might be of interest to our listeners. Yeah, absolutely. Please. Let us know some some more details. AIFMD 2.0 regulates the loan origination by funds as such, but also specifically funds which have loan originating as their strategy. We originally thought that AIFMD 2.0 would only regulate the so-called loan originating funds, so those that have loan origination as their main strategy. But when the final text was published, the way it's structured is that there is a lot of rules which apply to any fund which originates loans. Right, and I guess then the question is, what does loan origination mean? And how is it defined, actually, in AIFMD 2.0? Yes, we have a few quite helpful definitions in AIFMD 2.0. One of them is loan origination, or what it means to originate a loan. And the definition is very wide. I will try and go through it, even though this is not a teaching session, but I think it's useful to reframe and let our listeners know what is covered by loan origination. So it means granting of a loan directly by a fund as its original lender, or indirectly through a third party or an SPV which originates a loan for the fund or for the AIFM on behalf of the fund, or where AIFM or the fund is involved in structuring of the loan, or defining or pre-agreeing its characteristics prior to gaining exposure to the loan. So AIFMD 2.0 is trying to capture all of the ways in which loans may be originated on behalf of funds. So for so long as there is some involvement of the founder of the AIFMD 2.0 in creation of the loan, we want the rules to apply, because there is a strong willingness from the European legislator to ensure that those loans which are generated on the market are of high quality and that they follow certain rules, so as wide as possible, for so long as you're involved in the creation of that loan, you should be captured by the new rules. However, funnily enough, we do not have a definition of a loan. We don't really know what a loan is. I mean, we all know what a loan is, but The question is how wide or restricted this term should be. There are certain texts in the EU legislation which allude to what a loan is and what it is not. But at the end of the day, in the context of AIFMD 2.0, we do not really know whether a loan where certain securities would be issued, let's say bonds or nodes, whether those would be excluded from the scope or not. There are many views, and the market is making its way through the texts, and I think it's a bit too early to make a view on this, but naturally, we would all definitely put contractual loans in scope, but what else should be covered is another question. Right. Right. Assuming you are a fund that originates loans, what are the rules that would apply? Okay, so there are two sets of rules. One set of rules, which would apply to any fund that even originates just one loan. So as soon as you are a fund that within its strategy would originate one or two loans, you have to follow certain rules. And then there are rules which apply, in addition to funds which have loan origination as their main strategy. So those are regulated in a more strict way. Let's go back to the rules which will apply to all and any funds that originate loans. So first of all, there is a prohibition of originate to distribute strategy, which means that as a fund, you cannot have a strategy of originating loans and then selling them on to third parties immediately. With that is linked to the risk retention requirement, meaning that if you originate a loan, you have to hold it to its maturity, or to maximum eight years, if the maturity is longer. And if you sell the loan before that time, you have to retain a 5% of the notional value of those loans. So you have to keep the skin in the game, again, to make sure that if you have originated that loan, it has been of good quality, and that until a certain time, you will remain exposed up to 5%. Then, there are some other rules which relate to the fact that you need to have appropriate processes and procedures if you originate loans, You need to manage credit risk, there are some disclosure and reporting requirements. There are restrictions on certain borrowers to which you can lend or you cannot lend. So, for instance, the fund should not be lending to its AIFM or to the depository or delegates and member states have the right to restrict lending to consumers. There are also some diversification requirements for certain types of borrowers. So those are the general rules that apply. And I didn't go into too much detail, but those will apply to all the funds that originate loans. Right, right. You were saying that even if a fund originates a single loan, you have to abide to the rules. Is that correct? That's right, if a loan is originated before the 15th of April 2024, so at the time of of the recording of this podcast, that's a few weeks ago, those rules do not need to be followed. So if you originated before, you're fine. You can continue managing your portfolio as it was before. However, if the loan has been generated after the 15th of April 2024 and if that loan is still in the portfolio of the fund by the time AIFMD 2.0 comes into effect in 2026 then all those loans have to be managed in line with those rules. Okay, so we've heard about the requirements. Which of those have caused most discussions in the industry? What have you heard so far? Well, it will depend, obviously, on the types of managers and types of funds and what their strategies are. But obviously there has been a lot of discussion on risk retention and the prohibition of originate to distribute. The principles are not that problematic, because in reality, you would not see many direct lending funds, for instance, that would put in place a strategy where they would want to sell their whole portfolio within a year. So as a principal, these rules do not seem to cause an issue, or it's not what we heard in the in the industry, especially because there are some sensible exemptions from risk retention requirements. So, for instance, you would be, in principle, supposed to hold your loan for eight years or until maturity, or you would have to keep the 5% risk retention. But there are some exemptions. For example, you can sell a loan if you are in liquidation, or you've received an important redemption order, if you're changing your investment strategy. But also, interestingly, in case that the quality of the loan deteriorates, and you, as a good manager, as part of the management of the portfolio, want to sell the loan. But then it's quite interesting that AIFMD 2.0 imposes an obligation on you as a seller to inform your buyer that you're selling because the quality has deteriorated. So you're protecting the other party in a way, which is quite interesting, because the other party is also a professional in the financial markets. But again, there is this wider context of the protection of the financial stability, so that the buyer knows what they're buying and that it's a loan of a lower quality, presumably. So as a principal, this should hopefully cover all the situations when you want to sell a loan that you have intended to keep in your portfolio for a longer time. But where these rules may become problematic is if you work in the credit funds industry, you may know that loans are not necessarily originated by the fund directly there. They may be originated through SPVs. They may be sourced by the manager first and then allocated to the funds, or they may be originated by one entity and then sold to the other funds. So this is where questions arise and where we may have some discussions with our client as to what is the technique that they are using for various reasons, and those reasons may be very relevant, such as jurisdictional requirements, various regulatory reasons in specific countries. So that's where I believe we will receive a lot of questions to make sure that we are on the right side of the regulation and that we do not necessarily apply risk retention where we should not be applying it. So that is where we receive the most questions. Right, right. I think what we discussed back in August in the podcast was the diversification requirements. Can you talk about that, please? Yes. So under the new rules, if you are lending to a specific borrower, you can only invest a maximum of 20% of your NAV into that loan, so at least five loans and five borrowers up to 20% but that diversification rule only applies to certain types of borrowers, and those are financial undertakings and AIFS and usage. So other funds. And financial undertakings are all sorts of financial institutions. The definition and the list is very long, so at any point when you want to lend to that type of borrower, you just need to check whether they are captured or not by the definition and then other funds. So, interestingly and importantly, this diversification requirement doesn't apply to private companies. So most common direct lending funds should not be affected because they usually lend to private companies. But where we might see an effect is when the fund is a NAV finance fund lending to other funds. There they have to lend to at least five funds. And what about restrictions on leverage and the fact that the loan originating funds can only be operated as closed ended? Yes, so those are rules which apply only to funds which have loan origination as their main strategy. So everything that I mentioned before applies to all of the funds. Now we're going to speak about rules which apply only to funds that invest at least 50% of their NAV in loans that they originate, or which have loan origination as their main strategy. So let's start with leverage. AIFMD already contains rules about setting a maximum level of leverage in your fund documentation, how you're supposed to be calculating that leverage, that there are some additional disclosure if you use leverage on a substantial basis, that you need liquidity management if you use leverage. But so far, AIFMD has not set limits on leverage, and for the first time, we're doing this for loan originating funds. Open-ended loan originating funds will be limited to 175% of the NAV and closed ended loan originating funds will be limited to 300% of the NAV. This rule is subject to transitional provisions, so it doesn't enter into effect immediately. Funds which are in existence before the 15th of April 2024 and which do not raise any additional capital, are exempt from these rules, so they can remain as they are. If they're still raising capital, then they have until April 2029 to comply with these rules. And there are some other rules that apply during this transitional period, but I'm not going to go into detail on those. The most important thing is that if you're a fund created after 15th of April, 2024 then from 2026 you need to apply fully all these rules. Now, is this problematic? Is this not problematic? If you look at closed ended funds, 300% leverage is basically a ratio two to one. So that is generally what we see on the market. If we're talking about open ended funds, 175% of the NAV according to commitment method is basically 75% of the NAV, and that is not a lot, and we understand that there are many open ended or semi liquid or semi open ended funds out there which would exceed this limit, so that's where we see a potential impact. But another question, of course, is, what is an open ended fund? Because we see a lot of hybrid funds on the market which have certain liquidity features, but the question is, do they actually qualify as open ended within the meaning of AIFMD? So I believe there will be a little bit more focus on looking at those funds and see whether the liquidity features that they have actually qualify as open endedness within the meaning of the directive. That is a nice segueway to the second rule, which applies only to loan originating funds, because the AIFMD 2.0 says that loan originating funds have to be operated as closed ended unless the manager can demonstrate that the liquidity risk management system is compatible with the investment strategy and the redemption policy. So as a rule, loan originating funds have to be closed ended, and if you want to have them open ended, you need to demonstrate to the managers regulator that they comply with the new rules. So the existing loan originating funds, which are open ended, face the most uncertainty here, because first of all, are they open ended or are they closed ended? And second of all, if they want to remain open ended, what are the rules that they will have to follow? Many of them, we have to understand, are not regulated. And suddenly we will have the AIFM's home state regulator, which is maybe not the regulator of the fund or of the country where the fund is established, looking at the features of the fund and assessing whether they can remain or not open ended. So let's see how that is going to be implemented. But most importantly, we have very little information about the criteria that will be used. ESMA is supposed to develop technical standards by 2025 which will specify which rules must be complied with for such funds to remain open ended, and we have some indication about what they should be considering. So liquidity, pool of liquid assets within the portfolio, what is the redemption policy? Performance of stress testing, and all of these have to be calibrated specifically to the portfolio that each fund is holding. So the exposure of the loans, the maturity of the loans, and the overall granularity and composition of the portfolio,. That's interesting, actually, also in the context of the recent ELTIF discussions about liquidity. That's right. At the time of this podcast, indeed, we still haven't got the answer from the commission on what they think about ESMA's revised paper on liquidity in ELTIF, open ended ELTIF. For wider context, AIFMD 2.0 also contains some general rules relating to all funds that are open ended. So not only the funds that originate loans. And AIFMD 2.0 imposes some liquidity management tools that member states need to make available for the AIFMs, and then the AIFMs must pick one or two, depending on the type of the fund to use if they want to remain open ended. But loan originating, and we don't have much clarity on those either, because ESMA has to come up with RTAs on those as well. So open ended loan originating funds are actually in quite a lot of uncertainty. Because first of all, we're waiting on the general rules on liquidity management tools, and then we are waiting for those specific rules which will apply only to them and how they will have to demonstrate to the manager's regulator that they can remain open ended. Yeah, definitely an uncertain situation for open ended AIFs. So with all these new rules for loan originating AIFs, how is this going to shake things up for EU funds in general? What do you think? Will fund managers start looking for ways to get around these rules, or maybe by starting to originate loans through funds or channels outside the EU maybe? Or where they don't have to deal with these restrictions, or and all in all, maybe, is there any silver lining? What do you think? So, yes, we hear from the industry that the jury is out there, mainly for the open ended funds, open ended loan originating funds. Everything depends, really, on the investors. Would they be willing to go into a non EU fund? Some of them are very comfortable investing through non EU funds. Another story is in terms of lending, would a specific jurisdiction have a preference or only allow an EU fund to lend, or would they also be ready to allow lending from non EU funds? So yes, we hear voices that this is very restrictive, especially for the open and advanced in terms of leverage. But you know, this is just the beginning. The rules have just been announced and and we need to see how things actually land, and what the impact is going to be on the on the existing products. On the new products, we can obviously adjust things, but for the existing products, that might be a little bit more more problematic. On the good news, or potentially good news, if you'd like, we can mention the cross border lending passport. As you may remember, this point was heavily discussed in the industry and in the working groups a few years ago, and the idea was that managers and the funds should be able to lend within the EU on a cross border basis, without barriers, and create the so-called cross border lending passport. As you know very well, Germany as well and other countries, there are currently restrictions as to which entities can lend and how they can lend in those jurisdictions. And that complicates things. It makes it difficult for companies and businesses in those countries to access financing on one hand and on the other hand, it makes it difficult or very expensive for credit funds to tap into those markets and to lend. So the recitals of the directive indicate that this should all be allowed, should be allowed to lend on a cross border basis. But there are no operative provisions that would make this principle more tangible. Annex 1 to the directive merely adds a new activity that can be performed by an AIFM, by the by the manager, and that is the origination of loans on behalf of AIFs. So we don't have much to go on. A lot will happen in the next two years, during which the member states have to implement AIFMD 2.0 and this provision, and we can only hope that they will play the game and allow the cross border landing. In my personal view, in those two years when the member states will be forced to think about the direct lending, the direct lending landscape will change a lot. because it will provoke the discussion. And member states may take it as an opportunity to regulate in that space. And I'm not necessarily speaking about anything negative or gold plating, but rather, regulators or legislators may take an opportunity to clarify certain points that are being discussed, or take a specific position, let's say on consumer lending or on the distribution of open ended funds to retail investors in their jurisdiction. So we are quite, quite excited, and we are sitting on the edge of our seats and following all of this closely, because we want to see what the local implementations are going to be. Maybe we'll get some better results in certain jurisdictions, some easier route to lending in certain jurisdictions. We are already doing this, and we are gathering the information through our local connections in the relevant markets in the EU. I think we are currently monitoring about 13 jurisdictions in the EU which are relevant for our clients, and we do that through our World Compass service, which we are also updating and expanding, specifically in terms of AIFMD 2.0 coming into force. So we are going to be monitoring how things are changing in those jurisdictions. It's a great, great initiative, and we're going to add a link to the show notes to the World Compass page so people can take a look. So I think my best guess is that we're going to see a cross border lending passport, at least for EU AIFs and AIFMs. It's going to be a bit more tricky, I'm sure, for non EU AIFs and AIFMs. So I'm not sure where the direction goes there, but it definitely wouldn't make any sense not to have a cross border lending passport for European funds. So doesn't make any sense to me. So let's keep fingers crossed that everything goes smoothly. And look, Marianna, big thank you for joining us and sharing your insights with us. We really appreciated your expertise, and it's been great having you in this conversation. Thanks a lot, Marianna. Thanks, Angelo, As we wrap up today's episode, I'd like to extend my thanks to our esteemed guests and colleagues for sharing their valuable insights and expertise. I would also like to thank our incredible production team. It is their dedication and hard work behind the scenes that make this podcast possible. So here's to our talented producers and engineers and everyone else involved in bringing this show to life. To our listeners, thank you for tuning in to our financial regulatory podcast. We hope that you found today's episode informative and engaging. If you enjoyed the show, please consider subscribing, rating and reviewing us on your favorite podcast platform. See you next time.