The European Commission’s recently published proposals to revise and update the Alternative Investment Fund Managers Directive (AIFMD) come a decade after the original Directive; a decade that has seen some very significant changes in the private funds industry across the European Union. While many of the proposed changes to AIFMD are of general application, private debt funds or, as they are referred to in the proposed Directive, “loan origination” funds, are a key focus of the proposed amendments. Although AIFMD was in principle intended to regulate fund managers rather than product types, this change of focus is not surprising given the recent exponential growth in the private debt fund sector from a niche investment product to a circa €250 billion industry.
Though there seems to be little evidence of macroeconomic concerns in the direct lending sector, or of a lack of investor protection on the basis of current regulatory provisions, some additional restrictions and regulatory burdens will be added to funds operating in this space. However, these are generally light touch and focused, and there are also some beneficial developments proposed that will assist the industry and make the operation of funds more efficient.
The Commission has recognised that regulatory fragmentation across the EU risks undermining the internal market in this sector. The support for the sector is perhaps not surprising given the benefits it has brought since the global financial crisis and that during the pandemic the availability of finance from private capital investors has kept many small businesses across the EU afloat.
The proposed Directive will introduce a structural requirement that any funds whose assets consist of 60%+ originated loans will be required to adopt a closed-end structure in order to reduce potential issues with maturity mismatches between investors and the instruments the funds invest in. The vast majority of direct lending funds utilise a closed-end structure in any event so this is unlikely to have a substantial effect on the market, but there has been a small but growing interest in establishing effectively evergreen structures, and for funds focused solely on short-term and liquid instruments.
Although the recitals to the Directive refer to the risk where funds make long-term illiquid loans, the proposed text will apply to all loan origination funds. A more nuanced approach to potential liquidity mismatches would be welcome to avoid restricting this sub-sector unduly or pushing such strategies to use non-AIF or non-EU fund structures.
A rule is also proposed that all funds will be required to retain at least 5% of the notional value of any loans the fund has originated and subsequently sold on the secondary market; the rationale being to avoid a “moral hazard” where loans are originated for the sole purpose of immediate sale. Most private debt funds invest intending to hold loans to maturity, so this may not be an immediate concern, but the limitation that such rules apply where a fund “immediately” sells the instrument is not in the body of the proposed text.
While clearly inspired by the risk retention rules applicable to securitisations under the Securitisation Regulation, a retention in this context doesn’t address the same mischief of “originate to distribute” that was a key issue in the sub-prime securitisation market that began the global financial crisis. There is no widespread distribution of loans originated by this type of fund and no evidence of any such development emerging. These rules may also prejudice the ability of private debt funds to enter into bona fide portfolio rebalancing transactions or to exit distressed situations outside the AIFM’s skill set and where an eventual realisation date is unpredictable. AIFMs should note that these rules will apply to all AIFs, not just loan originators.
The proposals to allow AIFs to originate loans across the EU are welcome given the current fragmented system of rules across Member States. Although a number of main EU jurisdictions had allowed AIFs to lend with minimal regulation, some of the countries that arguably needed access to the sector the most did not. These proposals should allow access to wider sources of capital for borrowers, increasing competition and removing some cost inefficiency. Hopefully local implementation by Member States will not significantly gold plate these requirements, and it would also be welcome if clarity could be brought that loans originated by AIFs through SPV structures or with co-investors enjoyed similar rights, and that loans sourced by AIFMs for their managed account and advisory clients are similarly permitted.
Many of the proposed amendments to AIFMD that are of general application to all fund types will also be beneficial for private debt funds. The proposals will allow a depositary to be appointed in a different Member State from the location of the fund itself. While falling short of a full passporting right for depositories, this will enable greater competition in a crowded market to the benefit of investors, and will often be more convenient in a private fund structure where the AIFM and many of the investments are in a different country from the place of incorporation of the AIF itself.
The rules on delegation of management functions by AIFMs outside the EU have not been materially changed, as had been predicted. Given the importance for EU small businesses of access to private capital managed from the world’s major financial centres this comes as welcome reassurance.
Sensible requirements for minimum staffing of AIFMs, assessment of credit risk, monitoring of portfolios and additional reporting and portfolio management duties reflect best market practice and the requirements of investors in this sector and should not be viewed as onerous. Similarly, restrictions on certain types of borrowers where a conflict of interest arises, or where an over-concentration in lending to financial institutions would arise, have been introduced but are less restrictive than the provisions investors generally seek to negotiate in the fund documentation.
The proposals are intended to come into force by national legislation in the Members State within two years of the date the text of the new Directive is finalised. In turn, the new rules are expected to apply to funds by around 2025.
About the author
Duncan Woollard is a partner in the Private Funds practice at Paul Hastings and is based in the firm’s London office. He advises on a wide range of fund-related work, including in private equity, private debt, real estate, mezzanine, venture, credit, natural resources, infrastructure, funds of funds, distressed and special situations, and activist funds. He also advises on the structuring of carried interest, co-investment and other incentive schemes, secondary transactions, fund restructurings and spin-outs, and the establishment of new investment management businesses.
T: +44 (0)20 3023 5134