At a glance

  • The European Commission has published a legislative proposal for amendments to the Alternative Investment Fund Managers Directive (AIFMD) as part of its package on the Capital Markets Union. The proposal also contains changes to the Undertakings for Collective Investment in Transferrable Securities (UCITS) Directive in areas where the two regimes benefit from being aligned.
  • Key proposals include:
    • Delegation: setting minimum standards across the EU, aligning the UCITS and AIFMD rules, applying the rules to all activities carried out by AIFMs and UCITS management companies (“mancos”), and giving the European Securities and Markets Authority (ESMA) a greater oversight role.
    • Liquidity risk management: harmonising the availability of liquidity management tools, setting out a framework for the selection and use of liquidity management tools, requiring additional disclosures to investors, and giving national competent authorities (NCAs) the power to require firms to activate or deactivate tools.
    • Loan origination: introducing a harmonised regime under the AIFMD which intends to facilitate cross-border lending by AIFs.
  • Overall, the Commission’s proposals represent targeted amendments to the existing AIFMD rather than a fundamental change. Some of the more controversial ideas that had been put forward – such as ESMA’s suggestion to set out quantitative criteria on the maximum amount of delegation permitted – have not been included.
  • The legislative proposals will now be discussed by the European Parliament and the Council before the amending Directive is adopted. Under the proposal, Member States will have 24 months to transpose the new rules after its entry into force.

Overview

The European Commission has published a legislative proposal for amendments to AIFMD as part of its package on the Capital Markets Union. The proposed changes aim to make the AIF market more efficient and integrated, enhance investor protection, and improve the monitoring of financial stability risks. The proposal also contains changes to the UCITS Directive in areas where the two regimes benefit from being aligned.

Key proposals include setting minimum standards for the oversight of delegation arrangements, harmonising the availability of liquidity management tools across the EU and setting out a framework for their use, and introducing a new framework for loan origination for AIFMs. Other proposals include streamlining reporting obligations, allowing NCAs to permit AIF depositary services to be procured in other Member States, and increasing the transparency of AIF charges.

The Commission’s proposals do not go as far as some of the ideas put forward by stakeholders, which is likely to be a relief to the industry. For example, on delegation, the Commission has not taken forward ESMA’s suggestion to set out quantitative criteria on the maximum amount of delegation permitted, or a list of core functions that must always be performed internally. On liquidity risk management, the Commission has not taken forward the International Monetary Fund’s recommendation to prohibit daily dealing for funds investing in illiquid assets, although we could see more measures imposed via regulatory technical standards. Overall, the proposals represent targeted amendments to the existing AIFMD rather than a fundamental change.

Delegation

The Commission states that different national supervisory practices on the delegation of portfolio or risk management to third parties create inconsistencies that may reduce investor protection. It also notes that the UCITS delegation rules would benefit from being aligned to the more detailed AIFMD ones. The Commission’s proposals include:

  • A requirement for AIFMs and UCITS mancos to have at least two full time senior managers who are resident in the EU and are of sufficiently good repute and sufficiently experienced to conduct the business of the firm.
  • A requirement for AIFMs and UCITS mancos applying for authorisation to provide information to NCAs about the persons effectively conducting the firm’s business, including on their role, seniority, reporting lines, responsibilities and the technical and human resources supporting them.
  • Aligning the UCITS delegation rules to the AIFMD ones, including requiring UCITS managers to justify their delegation structure based on objective reasons.
  • Clarifying that the AIFMD and UCITS delegation rules apply not only to portfolio and risk management but also to other functions such as MiFID business, administration and marketing.
  • A requirement for NCAs to notify ESMA annually of cases where an AIFM or UCITS manco delegates more portfolio or risk management to non-EU entities than it retains.
  • A requirement for ESMA to conduct peer reviews of NCAs’ supervision of delegation at least every two years, focusing on preventing AIFMs or UCITS mancos from becoming “letter box entities”. ESMA must also produce reports at least every two years analysing market practices regarding delegation to third-country firms and compliance with the delegation rules.

Most AIFMs and UCITS mancos already have at least two senior managers based in the EU, and Ireland and Luxembourg – the two biggest fund jurisdictions in the EU – both already require this under national rules. The Commission’s proposal on this will therefore not introduce a change for most firms, but it will set minimum standards across the whole of the EU.

Supervisors may focus on whether the locally-based managers are sufficiently senior and experienced. The Central Bank of Ireland’s 2020 review of fund management companies’ governance, management and effectiveness found significant shortcomings in relation to how some individuals discharged their role, and called on all fund management companies to assess the time commitment, skills and expertise of their staff.

If the Commission’s proposal becomes law, AIFMs and UCITS mancos that use third-party service providers to carry out functions such as fund administration and tax accounting will need to ensure that they are complying with the delegation rules for these services. Until now, some Member States have treated such arrangements as outside the scope of these rules.

While these proposals would not give ESMA the power to approve or deny delegation arrangements, they do give ESMA a greater oversight role. ESMA has been playing an active role in coordinating a common supervisory approach to Brexit relocations and is likely to maintain a strong interest in ensuring that EU firms have the resources and expertise to oversee non-EU delegates. The notifications to ESMA will capture the majority of delegation to non-EU entities, since EU AIFMs or UCITS mancos that use a delegation model typically delegate portfolio management and perform risk management internally, which will be captured under the notification rules where the delegate is outside the EU.

It is not yet clear whether the UK will adopt similar changes to its on-shored AIFMD and UCITS regimes. The FCA is already considering whether rule changes are needed to its regulatory framework in light of its recent review of host authorised fund managers - the UK’s term for third-party UCITS mancos or AIFMs managing authorised funds - which found that some lacked the expertise and resources to challenge their delegates effectively (see our blog).

Liquidity risk management

Following recommendations from the European Systemic Risk Board (ESRB) and ESMA, the Commission is proposing to harmonise the rules regarding the availability of liquidity management tools across EU member states. This currently varies significantly; major fund jurisdictions such as Ireland and Luxembourg already have a wide range of tools available, but in some Member States options such as swing pricing, anti-dilutions levies or redemption gates are not available. The Commission is also proposing rules regarding the selection and use of liquidity management tools.

The proposals include:

  • Member States must ensure that a designated list of liquidity management tools is available to UCITS mancos and AIFMs managing open-ended AIFs.
  • AIFMs and UCITS mancos must select at least one appropriate liquidity management tool that they could use in the interest of investors from the following options: redemption gates, notice periods, redemption fees.
  • AIFMs and UCITS mancos must 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 each tool.
  • Regulatory technical standards will set out the criteria for the selection and use of suitable liquidity management tools.
  • AIFMs and UCITS mancos must disclose to investors the possibility and conditions for using each tool.
  • If a firm activates a liquidity management tool, it must notify its NCA, which must notify ESMA and the ESRB.
  • NCAs will have the power to require AIFMs or UCITS mancos to active or deactivate liquidity management tools.

The Commission’s proposal to increase the availability of liquidity management tools across all Member States will be helpful to firms as it will give them more options. Firms that select new liquidity management tools for their funds will need to carry out significant work to ensure that they have clear policies for when such tools will be used and that they have appropriate monitoring and escalation procedures for when liquidity risks approach the thresholds for using the tools.

Under the Level 1 text, it is for fund managers to select at least one the available tools, taking into account the fund’s investment strategy, liquidity profile and redemption policy. It is not clear at this stage whether the forthcoming regulatory technical standards will leave this as a principles-based assessment with significant discretion for the fund manager, or will introduce more prescription on which tools firms should select. This is an ongoing area of policy debate internationally, and the International Monetary Fund recently recommended prohibiting daily dealing for funds investing in illiquid assets. The Financial Stability Board’s review of the availability and effectiveness of liquidity management tools for open-ended funds is expected to report back in 2022.

Internationally, where regulators have the power to require fund managers to activate liquidity management tools in a crisis, these have rarely been used. As noted by IOSCO, there can be a risk of moral hazard, as the fund manager may take less responsibility if it foresees that the regulator is likely to intervene. Moreover, if the market can predict when a regulator will intervene this may increase market stress.

In the UK, there are already a wide range of liquidity management tools available, and the FCA already has the power to require firms to activate liquidity management tools, but does not seem minded to use it. The FCA is consulting on introducing compulsory redemption notice periods for authorised open-ended property funds.

Loan origination

The proposals introduce a new framework for loan origination for AIFMs. Currently, loan origination by AIFs is partly or fully allowed in most Member States and several of them have bespoke frameworks. These proposals would create a harmonised regime across the EU with the intention of facilitating cross-border lending by AIFs and making financing more accessible to European companies.

The regime contains provisions to manage the risks associated with lending. These include:

  • To manage liquidity risks, an AIF is required to adopt a closed-ended structure if the notional value of its originated loans exceeds 60% of its net asset value.
  • AIFMs must implement effective policies and procedures for granting credit, assessing credit risk, and administering and monitoring their credit portfolio.
  • AIFs are allowed to lend to financial institutions or investment funds, but a loan originated to a single financial institution or fund must not exceed 20% of the AIF’s capital - this threshold is aligned with the diversification threshold applicable to ELTIFs that are only marketed to retail investors.
  • Where AIFs originate loans and then sell them in the secondary market, they will be required to retain an economic interest of 5% of the notional value of these loans to avoid moral hazard. AIFMs are also required to report to investors the portfolio composition of originated loans.

Overall, having a harmonised regime for loan origination funds is likely to be helpful to AIFMs, although there will be costs associated with complying with the new rules. In some areas, the Commission’s proposals are more favourable to AIFMs than the proposals in ESMA’s opinion on loan origination by funds, which had suggested banning lending to financial institutions and setting leverage limits.

Other amendments

The proposal includes a number of other provisions which are set out in this summary note.

Next steps

There is a public call for feedback on the proposal which is open until 21 January 2022.

The legislative proposals will now be discussed by the European Parliament and the Council before the amending Directive is adopted. Under the proposal, Member States will have 24 months to transpose the new rules after its entry into force.