AIFMD 2 – let the negotiations begin

The AIFMD review – where have we got to?

It has taken time but …

The vote by the European Parliament’s ECON committee at the end of January means that we now know the starting position of each of the three parties – the European Commission, the Council of the EU and the European Parliament - for the AIFMD 2 trilogues which are due to begin today (8 March).

In due course (and many think it may be by the end of April), these negotiations will lead to an agreed text for a new directive, which will make amendments to the AIFMD.

The amendments themselves, though, won’t be effective for some time - any agreement reached will need to be tidied up by the EU’s Legal Services, formally adopted by the Parliament and the Council and published in the Official Journal (OJ). All of which takes time.

Even then, its provisions won’t start to apply for two years after publication in the OJ – i.e., they may not be effective until perhaps Q3 of 2025.

What does this mean for UK AIFMs?

Our expectation is that the UK government will not follow the EU in making whatever changes are agreed in trilogues. This means that UK AIFMs would remain subject to the current version of the AIFMD as onshored in the UK. It is also possible that the UK version of the AIFMD will be looked at as part of the FCA’s separate review of the UK’s asset management industry.

Who has said what so far?

The Commission’s proposals for targeted amendments to (rather than a wholesale revamp of) AIFMD, were published November 2021 in the form of a draft amending directive and associated annexes. Our summary of those proposals can be seen here.

The Council and EP then assessed what changes they would wish to make to the Commission’s draft – the Council’s ‘general approach’ was agreed in June 2022 and the EP, through its ECON committee, finally agreed its position, after much political wrangling between the various parliamentary groupings, in January 2023.

What are the main changes going to be?

Right now, all we know is what stance each of the three parties will be taking. Overall, the differences between them are not great and the Council’s and EP’s positions are fairly well aligned – this is what gives rise to the view that a deal will be reached relatively quickly. The topic on which the parties seem most widely apart on is loan originating funds (LOFs).

We don’t know for sure which elements of its position each institution is prepared to dig its heels in on and which it is prepared to give up, so no one can say for sure where the final agreement will come out.

We can, though, at least see where the three positions are aligned – and also where some of the likely battlelines are being drawn.

We will be following the course of the negotiations closely but, as the talks get underway, we would assess the following five areas as the key ones to keep an eye on over the coming weeks:

A. Delegation

None of the three parties seeks to introduce major changes here – the delegation model as it currently exists is not under threat (as it once appeared it might be in the immediate aftermath of the Brexit vote).

All three institutions are in agreement that the two persons required to conduct the AIFM’s business must be (a) natural persons (rather than, say, a corporate body), (b) either full time employees of the AIFM or committed on a full-time equivalent basis and (c) resident in the EU. So, it is fair to assume that this will be included in the amended AIFMD in due course

Equally, all three positions would require the AIFM to submit additional information to their NCA when making an application for authorisation – including “a detailed description of the appropriate human and technical resources that will be used by the AIFM” in complying with its obligations under the AIFMD.

The Council and EP would require an authorised AIFM to keep updated any information it provides to its NCA regarding arrangements for the delegation and sub-delegation to third parties of functions referred to in Article 20 and to provide a detailed description of the human and technical resources which the AIFM would use to monitor and control the delegate.

The EP (alone) would require ESMA to develop draft RTS which would “specify situations where the name of the AIFs it intends to manage could be materially deceptive or misleading to the investor” – a stance which, if accepted, could cause duplication – or, worse, inconsistency - with the work already being done around fund names under ESG legislation.

On the issue of costs, the EP is again alone in proposing that ESMA should prepare a report which (a) assesses costs charged by AIFMs to investors, the reasons for cost levels and the reasons for differences between them, (b) proposes criteria by which it can be assessed whether or not the level of such costs is appropriate and (c) proposes options for action in respect of inappropriate or undue levels of such costs.

On the question of delegation to entities located in third countries, the Commission proposal would require ESMA to report regularly (and at least every two years) on market practices around this topic. The Council would prefer a single report, to be provided before the review of AIFMD which is due to be conducted five years after the amendments enter into force (i.e., on the twentieth day following publication in the OJ) – not five years after they start to apply. The EP, on the other hand, looks for a single report to be submitted ’24 months after the date of application of this amending directive’. The upshot, then, is that there will be a report analysing market practices on third country delegation – the question though, is how many and when?

B. Liquidity Management tools (LMT)

Again, there is not a great deal to separate the parties’ starting positions.

An open ended AIF would be required to employ either ‘at least one’ liquidity management tool (LMT) as per the Commission proposal or ‘at least two’ (under the Council’s and EP’s), in each case selected from the list in a new Annex V. The Council and EP would allow a derogation for Money Market Funds, which would only need to employ one LMT.

Under all three texts, an AIFM would have to implement detailed policies and procedures for when any selected LMT would be activated and deactivated.

The Council’s general approach would allow redemption in kind to be activated as a LMT only to meet redemptions requested by professional investors and where the redemption in kind corresponds to a pro rata share of the assets held by the AIF.

The three parties are apart, though, on what should be the appropriate status of any work in this area by ESMA.

In specifying the characteristics of the available LMTs in Annex V, the Commission and Council would require ESMA to draft formal RTS, while the EP’s mandate would be for Guidelines specifying best practice as to the LMTs’ characteristics.

Furthermore, the Commission and Council would mandate ESMA to set out criteria for the selection and use of LMTs (including appropriate disclosures to investors), albeit the Commission would look for Level 2 RTS while the Council is content with Guidelines.

Although the EP proposes that ESMA should draft RTS on the disclosure to NCAs and to investors of “information related to the selection and calibration of liquidity management tools” by AIFMs, it does accept that these should recognise that “the primary responsibility for liquidity risk management remains with the AIFM” and that “adequate time” should be allowed for their adaptation before the new RTS apply, “in particular for existing AIFs”.

C. Loan origination funds (LOF)

In what is possibly the most contentious area under loan origination, the Council would impose a 150% leverage cap on a LOF, calculated under the commitment method. Neither the Commission nor the EP seem to support this position although we understand that the Council’s stance is strongly backed by a number of Member States.

Although the Commission proposes that all LOFs (i.e. funds where the notional value of originated loans exceeds 60 % of the fund’s NAV) should be closed ended, the EP would allow open-ended LOFs where the AIF has a sound liquidity risk management tools system.

The Council would pass the issue of open or closed-endedness to ESMA to develop Level 2 measures (or ‘RTS’) to determine the requirements with which a loan-originating AIF must comply to maintain an open-ended structure – these requirements would include “elements on the selection and use of liquidity management tools, the availability of liquid assets and stress testing, as well as an appropriate redemption policy given the liquidity profile of the AIF”.

Likewise, the EP would require ESMA to develop RTS to enable NCAs to assess whether a LOF has a sound liquidity management system (and so can be open-ended), “having regard to the underlying loan exposure, average repayment time of the loans and overall granularity and composition of AIF portfolios”.

The Council defines ‘loan origination’ broadly – its definition captures the granting of any loan by an AIF as the original lender. Under the EP’s proposals, on the other hand, a ‘loan-originating AIF’ means an AIF whose principal activity is to originate loans and for which the notional value of its originated loans exceeds 60% of its net asset value.

All three institutions propose that an AIFM must ensure that

• loans originated to any single borrower by an AIF it manages do not exceed 20 % of the AIF’s capital where the borrower is either a financial undertaking under the Solvency II Directive, an AIF or a UCITS
• an AIF it manages retains 5% of the notional value of the loans it has originated and (in the Commission’s and EP’s versions, but not that of the Council) subsequently sold on the secondary market. The Council would require the amount is retained for the shorter of (a) two years from the signing date and (b) the maturity date.

Under the Council proposals the AIFM must, where engaging in loan originating activities or purchasing loans from third parties, implement effective policies, procedures and processes to assess the credit risk and keep those policies, procedures and processes up to date and effective and review them regularly and at least once a year. (Member States would be able to apply a derogation for shareholder loans which (a) don’t exceed in aggregate 100 % of the AIF’s capital or are granted to portfolio undertakings which acquire and manage real estate or participations in real estate companies, and in which the AIF directly or indirectly holds 100% of the capital or voting rights).

D. Marketing of non-EU AIFs / marketing by non-EU AIFMs – black lists and grey lists

As we mentioned in our summary of the Commission’s proposal, a number of articles in the AIFMD (including Article 36 on the marketing in the EU of a non-EU AIF by an EU AIFM and Article 42 which deals with the marketing in the EU of any AIF by a non-EU AIFM) currently require that the AIF cannot be domiciled in a jurisdiction that appears on FATF’s list of Non-Cooperative Countries and Territories.

That list is no longer operative and the Commission, instead, proposes to refer, instead, to countries on Annex I of the EU’s list of non-cooperative jurisdictions for tax purposes (the so-called ‘black list’) and (in Articles 36 and 42) to the list of ‘high risk countries’ under the EU’s Anti Money Laundering (AML) rules.

The EP would include a helpful provision whereby the restriction only applies where the third country involved had been on the black list at the time that the AIFM applied for authorisation under the AIFMD. Where the third country was added to the black list subsequently, the EP would allow closed ended funds a two year grace period where the third country would still be deemed to meet the necessary criteria for marketing within the EU.

The EU, though, also maintains Annex II (the so-called ‘grey list’) to its list of non-cooperative jurisdictions for tax purposes. This covers third countries which do not comply with all required tax standards but have committed to implementing reforms to achieve compliance. The EP is advocating that a third country which has been on the grey list continuously for three years should be deemed to be on the black list.

Neither the Commission nor the Council has put forward a similar position and it remains to be seen whether this is the EP making a political point that it is being tough on non-cooperative tax jurisdictions or whether it is, in fact, wedded to this stance.

E. Depositaries

When the Commission originally started its work which led to its proposal for amending the AIFMD, one of the questions being asked was whether it would look to introduce a depositary passport. In the end, it didn’t. But the Council and EP have set out a very largely aligned proposal which would allow Member States to allow the appointment of a depositary established in another Member State on a case-by-case basis and provided that a number of conditions are fulfilled.

These include that

• the AIFM has made a ‘motivated request’ for the appointment of a depositary in another Member State on the basis of a lack of relevant depositary services and
• the depositary market in the AIF’s home Member State either
• consists of fewer than seven depositaries providing depositary services to EU AIFs, none of which has more than EUR 1 billion AIF assets under custody or
• the aggregate amount of assets in that market under custody on behalf of EU AIFs and managed by an EU AIFM does not exceed EUR 30 billion.