The European Commission has proposed changes to the AIFMD, UCITS Directive and the ELTIF regime in its long-awaited overhaul of the EU funds regimes.
On 25 November 2021, the European Commission finally issued a proposed directive (AIFMD II) to amend the Alternative Investment Fund Managers Directive (AIFMD). Overall, the package of reforms is relatively limited in scope, but it includes significant proposals in respect of delegation, loan origination, liquidity risk management, data reporting and depositaries. Some of the proposed changes to AIFMD would also apply to the UCITS Directive.
In addition, the European Commission has issued a proposed regulation (ELTIF II) to amend the existing European Long-Term Investment Funds Regulation (ELTIF Regulation) as well as a regulation on a European Single Access Point (ESAP Regulation).
The draft proposals will now need to be considered by the European Parliament and European Council, which could potentially result in further revisions to, or extension of, the proposals. It is envisaged that AIFMD II would become effective two years after coming into force (so not before 2024 at the very earliest) and ELTIF II and the ESAP Regulation would become effective six months and one year after coming into force respectively.
The Commission's proposed changes will not apply to firms authorised in the UK under the UK versions of AIFMD, UCITS or the ELTIF Regulation. There is currently no indication that the UK is planning to make similar changes.
We set out an overview of the proposals below.
1. Alternative Investment Funds
Permitted activities for AIFMs
AIFMD II will extend the scope of permitted activities for alternative investment fund managers (AIFMs) to include benchmark administration under the EU Benchmarks Regulation and credit-servicing under the forthcoming EU credit servicers legislation as additional "top-up permissions". Other similar extensions sought by some trade associations are unfortunately not proposed.
Originating loans and servicing securitisation SPVs will also be included as permitted activities for AIFMs. This would allow for loan origination activities to be carried on in other Member States on a cross-border basis. However, it is not explicitly clear whether this would amount to some form of "passport".
AIFM delegation arrangements have been a concern of the EU authorities for some time. Although "letter-box entities" are already prohibited, the authorities remain concerned about the scope of many delegation arrangements and about differences in approach between EU Member States, fearing a race to the bottom. As a result, delegation is a key issue for the AIFMD review.
The Commission has put forward a number of proposals including:
- A requirement for competent authorities to determine, as part of the authorisation process, whether the AIFM will delegate more portfolio management or risk management functions to non-EU entities than it retains. The basis on which this determination is to be made is not yet clear. Interestingly, it is not proposed to restrict such arrangements (although the existing 'letterbox entity' test would still need to be satisfied) but competent authorities must notify ESMA annually of all such situations and ESMA must report to the Commission every two years on developing market practice. ESMA will also be conducting regular, two-yearly peer reviews of measures taken by competent authorities to prevent letter-box entities, which is intended to address inconsistencies in approach between Member States. This suggests that ESMA is generally keeping a watching brief for now, with the prospect of further restrictions in future if circumstances warrant it. A 5-year review by the Commission is hard-wired into the proposals.
- Competent authorities are also required to assess, at the point of authorisation, the "human and technical resources" to be used by the AIFM to monitor and control its delegates. It is implicit in the proposals that competent authorities are expected by ESMA to supervise delegation arrangements effectively, so the current focus from certain regulators on the practicalities of delegation arrangements is unlikely to abate.
- The AIFMD delegation requirements will also be extended to cover delegations of Article 6(4) "top-up services". In practice, this will mainly affect delegations of portfolio management services provided to individual clients.
Some of these requirements may require existing delegation arrangements to be re-papered.
AIFMD II would also introduce new EU substance requirements as a condition of authorisation. Again, EU authorities have been concerned about the level of substance, and particularly EU-based substance, within AIFM arrangements for some time.
Under the proposals, the business of the AIFM would need to be conducted by at least two natural persons, resident in the EU, who are either employed full-time by that AIFM or who are committed full-time to conduct the business of that AIFM. This standard is lower than the expectations which currently prevail in some prominent centres such as Luxembourg. Nevertheless, this may require some AIFMs to re-examine their management structures.
AIFMs would also have to provide to the relevant competent authorities, for the persons effectively conducting the business of the AIFM: a detailed description of their role, title and level of seniority; a description of their reporting lines and responsibilities in the AIFM and outside the AIFM; an overview of their time allocated to each responsibility; and a description of the technical and human resources that support their activities.
ESMA will be empowered to create supervisory forms and templates through Regulatory Technical Standards (RTS) and Implementing Technical Standards (ITS). Across the topics of delegation and substance, the devil will be in the detail of these proposals. It is rumoured that drafts of the implementing measures already exist and are with the European Commission, but they have not been published yet.
AIFMD II also proposes new provisions in respect of loan origination activities by AIFs. In addition to the new Annex I activity of originating loans (see above), there are proposed new risk management provisions. The existing provisions of AIFMD were not thought sufficient to provide for direct lending by AIFs and the associated risks. In particular, there were concerns about investor protection and regulatory arbitrage due to differing approaches to such lending by Member States.
These new provisions would include a requirement for AIFMs engaging in loan origination activities to implement effective and up-to-date policies, procedures and processes for the granting of credit, assessing credit risk and administering and monitoring their credit portfolio. Such policies, procedures and processes would also have to be kept up to date, reviewed regularly and at least once a year.
In order to avoid maturity mismatches due to redemption demands, any AIF which originates loans exceeding 60% of its net asset value would have to be closed-ended.
AIFMD II would also impose restrictions on loan origination activities aimed at preventing excessive interconnectedness in the financial system and conflicts of interest, including prohibiting direct lending funds from lending to:
- any single borrower which is a financial undertaking or a collective investment undertaking where the loan is in excess of 20% of the AIF’s capital; and
- the AIFM (or its staff), the depositary or any delegate of the AIFM.
Finally, in order to reduce incentives to originate poor quality loans to be immediately sold off on the secondary market, an AIFM would also have to ensure that the relevant AIF retains, on an ongoing basis, 5% of the notional value of the loans it has originated and subsequently sold on the secondary market.
These proposals are much more proportionate and nuanced than might have been feared.
It is proposed to extend the existing liquidity management provisions in AIFMD, with new obligations and powers for AIFMs that manage open-ended AIFs.
AIFMs that manage open-ended AIFs would be permitted temporarily to suspend the repurchase or redemption of the AIF units, in exceptional cases, where this is necessary in the circumstances and justified in the interests of the AIF investors.
They would also be required to select at least one additional liquidity management tool from a specified list set out in a new Annex V: redemption gates; notice periods; and redemption fees. Further guidance on liquidity management tools will be provided by ESMA in RTS.
AIFMs would have to implement detailed policies and procedures for the activation and deactivation of any selected liquidity management tool and the operational and administrative arrangements for the use of such tool. They would have to notify competent authorities of the activation or deactivation of the tools and provide information on selected liquidity management tools to investors.
In most cases, AIFMs would have the final decision as to whether to make use of their suspension power or a selected liquidity management tool in the appropriate circumstances. However, competent authorities would also have the power to require AIFMs to suspend (or resume) redemptions and subscriptions or impose or terminate redemption gates and/or activate or deactivate their selected liquidity management tools if necessary due to investor protection or financial stability concerns. Significantly, this power would also apply in respect of non-EU AIFMs marketing in the EU.
The AIFMD II proposal would relax the requirement for a depositary to be established in the same Member State as the relevant AIF. This reflects the limited market in depositaries in certain Member States and is expected, in due course, to be replaced by a passporting system for depositaries. This relaxation is balanced with a new requirement for depositaries to co-operate not just with their own competent authorities but also those of the AIF and (if different) the AIFM.
Where a third country depositary is used, the criteria would be amended slightly to exclude depositaries in jurisdictions which are identified as high-risk under the Fourth Anti-Money Laundering Directive (MLD 4) or on the EU list of non-co-operative tax jurisdictions.
Finally, to level the playing field with depositaries, AIFMD II would effectively clarify that central securities depositaries (CSD) providing custody services (rather than acting in the capacity of an issuer CSD) will be treated as delegates of the depositary and therefore subject to the custody delegation rules. When making use of a CSD acting in the capacity of an issuer CSD, depositaries will not be subject to the requirement to exercise all due skill, care and diligence in the selection and the appointment of that CSD. This is because authorised CSDs are already subject to regulatory requirements and supervision.
Disclosure to investors
Under the proposals, additional line items would have to be included in Article 23 investor pre-contractual disclosures, specifically:
- following the existing disclosure of the fees, charges and expenses to be borne by investors, a list of the fees and charges in connection with the operation of the AIF that will be borne by the AIFM or its affiliates; and
- (for open-ended funds) as part of the disclosure relating to the fund's liquidity risk management, information on the possibility and conditions for using liquidity management tools.
It is also proposed that, going forward, AIFMs would be required to report the following to investors on a quarterly basis:
- all direct and indirect fees and charges directly or indirectly charged or allocated to the AIF or to any of its investments and
- any parent company, subsidiary or special purpose entity established in relation to the AIF’s investments by the AIFM, the staff of the AIFM or the AIFM’s direct or indirect affiliates.
Whilst some of this information will already be covered as part of standard quarterly investor reporting, some of it will not be.
AIFMs would also be required to provide periodic reports to investors on the fund's originated loan portfolio (if applicable).
Annex IV regulatory reporting
Contrary to market perception, the Commission is of the view that data reported under the "Annex IV" reporting framework has supported effective macro-prudential supervision. However, it considers that the granularity of data collected could be improved, and so proposes that the reporting obligations to competent authorities under Article 24 are extended. Whereas currently, an AIFM has to report on the principal markets and instruments in which it trades and provide information on the main instruments in which it is trading and on the principal exposures and most important concentrations of each of the AIFs it manages, under AIFMD II AIFMs would need to report on all markets, instruments and exposures. ESMA will be tasked with developing draft RTS and ITS on the details to be reported and the frequency of reports and the impact of these changes will largely depend on the approach taken by ESMA. ESMA has been given a three-year period in which to develop the proposed technical standards, so these changes are not imminent.
Third country marketing arrangements (NPPRs)
The Commission has also proposed stronger AML and tax compliance requirements in respect of third countries accessing the EU single market.
Currently, non-EU AIFMs can market into the EU only under National Private Placement Regimes (NPPRs). The existing requirement for non-EU AIFMs and non-EU AIFs to be established in jurisdictions that are not Financial Action Task Force non-cooperative countries or territories (NCCTs) would, under the Commission's proposals, be replaced with a requirement that they must not be established in jurisdictions identified as high risk under MLD 4. As a new requirement, those jurisdictions would also need to have signed an agreement with each Member State in which the fund is to be marketed which fully complies with the standards laid down in Article 26 of the OECD Model Tax Convention on Income and on Capital and ensures an effective exchange of information in tax matters, including any multilateral tax agreements and they must not be on the EU list of non-cooperative tax jurisdictions.
Similar changes are made to the NPPRs for non-EU AIFs managed by EU AIFMs, and also to the third country passporting provisions (although there is still no indication that the third country passport is likely to be activated any time soon).
AIFMD II also proposes a more limited number of amendments to the UCITS Directive largely based on a number of those applicable to AIFMs. This is intended to ensure comparable treatment for AIFMs and UCITS (except where there is good reason for a different approach).
The proposals for UCITS include the following:
- The business of the UCITS management company to be conducted by at least two natural persons, resident in the EU, who are either employed full-time by that management company or who are committed full-time to conduct the business of that management company.
- As for AIFMs, additional information to be provided to the relevant competent authorities in respect of the persons effectively conducting the business of the UCITS management company and the resources for monitoring and controlling any delegation arrangements. Also, information on delegation arrangements would need to be provided as part of the application for authorisation.
- UCITS delegation requirements would also apply in respect of UCITS "top-up services". The UCITS management company would have to be able to justify its entire delegation structure on objective reasons.
- A requirement for competent authorities to notify ESMA annually of situations where a UCITS management company delegates more portfolio management or risk management functions to entities located in third countries than it retains. Further work aimed at preventing letter-box entities is also envisaged.
- New provisions regarding liquidity management tools which largely reflect those applicable to AIFMs (see above).
- A new requirement for the UCITS management company regularly to report to competent authorities on the markets and instruments in which it trades on behalf of the UCITS. This is a broad requirement and, as with the comparable requirement for AIFMs, how onerous this will be in practice will largely depend on the RTS developed by ESMA.
- Clarification that a CSD providing custody services (rather than acting in the capacity of an issuer CSD) will be treated as a delegation and therefore subject to the custody delegation rules. As under AIFMD, when making use of a CSD acting in the capacity of an issuer CSD, depositaries would not have to comply with the requirement to exercise all due skill, care and diligence in the selection and the appointment of that CSD.
3. European Long-Term Investment Funds
The European Commission has also issued a proposal for ELTIF II which would amend the ELTIF Regulation. The driver for this proposal has been the relatively low number of European Long-Term Investment Funds (ELTIFs) established in the EU and therefore ELTIF II seeks to encourage greater uptake in the future.
The proposals in ELTIF II largely focus on extending the types of assets in which an ELTIF can invest and the activities that it can carry out. There is a further broadening of certain rules for "professional investor only" ELTIFs but we would not expect these to be widely used as the ELTIF is a product used very much for its retail marketing passport. There are also provisions regarding co-investment aimed at alternative asset management arrangements such as private equity and venture capital and largely codify certain practices that have already been adopted by regulators.
As a general principle, the objectives of the ELTIF Regulation have been broadened to encourage a wider adoption of the structure. The original objectives sought to raise and channel capital towards European long-term investments and included investments giving rise to economic or social benefit or contributing to smart, sustainable and inclusive growth. ELTIF II, by contrast, focusses on long-term investments in any jurisdiction (this is to be welcomed as there was some debate on whether a minimum EU asset exposure would be required) so that ELTIFs can pursue a global investment strategy and seek to invest in a broader range of assets.
In particular, it is proposed that assets in which an ELTIF may invest would include:
- units in UCITS and AIFMs managed by EU AIFMs which themselves invest in eligible investments and do not invest more than 10% of their assets in another collective investment undertaking;
- equity or quasi-equity instruments issued by an undertaking in which a qualifying portfolio undertaking (QPU) holds a capital participation (previously this had to be a majority-owned subsidiary) in exchange for certain instruments of the ELTIF – this change is generally to allow co-investment strategies through common asset holding vehicles;
- direct investment in real assets with a value of at least EUR 1 million (or equivalent) (previously such investment had to be through direct or indirect holdings in a QPU and the minimum value was EUR 10 million); and
- certain simple, transparent and standardised securitisations (up to an aggregate of 20% of the value of the ELTIF).
Where the requirement for a particular investment to have been issued by a QPU applies, under ELTIF II it would be possible for the QPU to be a collective investment undertaking and, if traded on a regulated market or multilateral trading facility, to have a market capitalisation of up to EUR 1 billion (it was previously EUR 500 million).
It is also proposed that many of the limits on portfolio composition will be increased allowing managers more flexibility in terms of portfolio composition. This will be useful, particularly where managers want to replicate investment strategies adopted by other funds under their management to the extent those funds invest in ELTIF eligible investments.
- investment in instruments issued by, or loans granted to, any single QPU limited to 20% of capital (previously 10%);
- investment directly or indirectly in a single real asset limited to 20% of capital (previously 10%);
- investment in units or shares of any single ELTIF, European Venture Capital Fund (EuVECA), European Social Entrepreneurship Fund (EuSEF), UCITS or EU AIF limited to 20% of capital (previously 10%) and no more than 30% of the units or shares of that fund (previously 25%);
- investment in certain eligible assets issued by any single body limited to 10% of capital (previously 5%) – this may be increased to 25% for bonds issued by certain credit institutions;
- aggregate value of units or shares of ELTIFs, EuVECAs, EuSEFs, UCITS and of EU AIFs in the portfolio limited to 40% of capital (previously 20%); and
- aggregate risk exposure to a counterparty from OTC derivative transactions, repurchase agreements, or reverse repurchase agreements limited to 10% of capital (previously 5%).
Despite the relaxations for professional only ELTIFs, we would not expect this structure to be widely adopted given the range of other professional only investment structures.
Master feeder ELTIF structures would also be permitted (i.e. where both the feeder and master fund are authorised as ELTIFs) which may prove attractive for fund of funds managers.
ELTIFs are required to invest at least 60% of their capital in eligible investment assets which has not historically been problematic.
ELTIF II also proposes changes to the permitted borrowing that an ELTIF may carry out.
ELTIFs marketed to retail investors would be able to borrow up to 50% of the value of their capital (previously this was 30%) and ELTIFs marketed solely to professional investors would be able to borrow up to 100%.
It would also extend the purposes for which borrowing may be carried out: ELTIFs would be able to borrow for the purpose of making investments or providing liquidity rather than just investing in eligible investment assets and would be able to grant security to implement the borrowing strategy of the ELTIF (with the previous cap of 30% of capital value lifted). Borrowing would also be able to be made in a currency other than that of the assets to be acquired with the borrowed cash in certain circumstances e.g. where the exposure has been hedged.
Borrowing which is fully covered by investors' capital commitments would not subject to the ELTIF borrowing restrictions.
Finally, the ELTIF prospectus would need to include details of the ELTIF borrowing strategy and limits, including how borrowing will help implement the ELTIF strategy and mitigate borrowing, currency and duration risks.
These changes are to be welcomed as they will remove a number of the issues that fund finance providers have faced when lending to ELTIFs and they should allow managers to utilise leverage for an ELTIF in much the same way as they would for equivalent professional only strategies.
Other changes proposed by ELTIF II include:
- Clarifying that the authorisation of an ELTIF should not be subject to a requirement for the AIFM to be established or carrying on activities in the home member state of the ELTIF.
- Removing the requirement to put in place facilities for investors in each member state where an ELTIF is marketed to retail investors.
- Removing the ability for investors to request the winding down of an ELTIF if their redemption requests are not satisfied within one year. This is intended to reflect the fact that many ELTIFs will have longer term investment strategies and therefore the ability to request a winding down may be inappropriate and detrimental to other investors.
- Removing the specific suitability requirements in the ELTIF Regulation, including the minimum EUR 10,000 investment requirement. Instead, ELTIF managers will be subject to the comparable requirements in the Markets in Financial Instruments Directive (MIFID II) when marketing to retail investors. There is an exemption from certain of the suitability requirements where the retail investor is a member of senior staff, portfolio manager, director, officer, agent or employee of the manager or its affiliate and has sufficient knowledge about the ELTIF concerned. This carve-out is intended to reflect that senior personnel of the ELTIF manager may co-invest in ELTIFs and that a suitability assessment would not be necessary for such persons.
- A carve-out in the conflict of interest provisions permitting the ELTIF manager, its affiliates and their staff to co-invest in that ELTIF and/or co-invest with the ELTIF in the same asset, provided that there are appropriate conflict of interest arrangements in place and these are adequately disclosed. Again, this is intended to reflect the market practice of senior personnel co-investing in or with the ELTIF.
- The possibility for ELTIF managers to operate an optional liquidity window mechanism to allow transfers out before the end of the ELTIF's life. This mechanism will need to meet certain criteria including a defined policy specifying key information and ensuring fair treatment of investors.
- Additional information requirements in respect of feeder ELTIFs.
- More granular information to be included on the central public register.
In combination, these changes are designed to remove some of the regulatory and structural impediments managers face when utilising an ELTIF and we believe they are to be generally welcomed and address the majority of concerns market participants have with the current rules. In combination, we believe that if these rules are adopted in the form proposed, an ELTIF would become a viable investment structure for the majority of alternatives managers to the extent they can construct a portfolio that falls within the eligible investment criteria. This should generally be possible although it may not be possible to exactly align investment mandates with other, existing institutional strategies so some degree of adaption will likely be required. In our experience, alternatives managers are now giving this more consideration owing to increasing demand from European advised wealth networks so we expect to see more ELTIFs in the future and these proposals would likely magnify that expectation.
4. European Single Access Point
The package of measures issued with AIFMD II and ELTIF II also includes the ESAP Regulation which provides for a European Single Access Point (ESAP). ESAP will be a centralised platform with public, electronic access to information required to be publicly disclosed by EU financial services entities including under AIFMD, the UCITS Directive, MIFID II and EU prudential legislation.