AIFMD II: an evolution more than a revolution

It has been more than 10 years since the AIFMD (EU) 2011/61 came into force. All EU countries had until July 2013 to transpose this directive into domestic law.

Following the example of the UCITS directive, which was amended a number of times before UCITS V was enacted in 2018, the European Commission wanted to review this directive to strengthen investor protection.

On 26 February 2024, the Council adopted the Directive, which amended the Alternative Investment Fund Managers Directive (AIFMD) and modernised the framework governing Undertakings for Collective Investment in Transferable Securities (UCITS) at European Union (EU) level.

Among the key elements, the amending directive modernises the framework for liquidity management tools, clarifies the EU framework for funds that provide loans to companies and introduces enhanced rules for delegation by portfolio managers to third parties. It confirms that a central securities depository (CSD) is considered to be a delegate of the depositary bank when acting as depositary, and it does not alter the requirement that the depositary must be located in the country in which the fund is domiciled, even though it grants exemptions to certain States.

The Directive has been published in the EU's Official Journal on 26 March 2024,  an will enter into force in twenty days. Member States will have 24 months to transpose it.

Although this is an evolution rather than a revolution of the AIFMD, there are three notable changes:

• Modernising the framework for liquidity management tools

• Supervising funds that provide loans to companies

• Strengthening the governance of AIFMs, in particular with regard to the delegation of managers to third parties.

1. Liquidity management tools for AIFs

Liquidity management practices have highlighted that some AIFs use tools that are not suited to the liquidity risk profile or investment strategy, or that, more simply, the fund's incorporation documents do not always provide for the use of such mechanisms. As a result, market practices have been disparate across jurisdictions, resulting in unequal results and differentiated treatment of investors.

In order to rectify these disparities, AIFMD II introduces a European framework aimed at enabling AIFMs to manage liquidity and market stress issues in a coherent system that guarantees investor protection. The new directive harmonises liquidity risk management and requires each fund to integrate and implement detailed liquidity management tools (LMTs).

AIFMD II sets out a list of LMTs:

1. Suspension of subscriptions, repurchases and redemptions

2. Redemption gate

3. Extension of notice periods

4. Redemption fee

5. Swing pricing

6. Dual pricing

7. Anti-dilution levy (ADL)

8. Redemption in kind

9. Side pockets

AIFMs must choose at least two liquidity management mechanisms in the AIF's constituent documents, with the exception of money market funds for which a single tool is required. The manager's choice of tools must be consistent with the fund's investment strategy, liquidity profile and redemption policy. This involves formalising in detail the policies and procedures for activating and deactivating LMTs, with the usual administrative and operational provisions.

AIFMD II requires AIFMs to notify their competent authorities of the activation and deactivation of such LMTs. AIFMD II thus strengthens the supervisory powers of national authorities.

Managers must communicate to investors the conditions for activating LMTs. Enhanced information is also essential to ensure that LMTs can function properly.

2. The granting of loans by AIFs (Loan-originating AIFs)

Lending has become an essential alternative source of financing for the real economy, especially since traditional lending channels have become less accessible. However, disparities in national lending laws have led to unbalanced competition between jurisdictions that prohibit lending by the non-banking system and more flexible jurisdictions.

For this reason, AIFMD II establishes common rules on the granting of loans, which cover the management of conflicts of interest, the supervision of credit risk and the diversification of risks based on the type of fund (open or closed). It provides explicit authorisation to fund managers in the EU to grant loans.

New definitions are introduced into AIFMD II, including the definition of loan-originating AIF. A loan-originating AIF is defined as an AIF whose investment strategy is mainly to originate loans or if the originated loans represent at least 50% of its net asset value.

A leveraged AIF is a fund whose exposures are increased by the manager through borrowing of cash or securities, leverage embedded in derivative positions or any other means.

This new directive introduces limits on indebtedness.

• The leverage limit of open-ended loan-originating AIFs may not exceed 175% and the leverage limit of close-ended AIFs may not exceed 300%. This ratio is calculated based on the fund's exposure, divided by the net asset value, using the commitment methodology.

• It sets exposure and diversification limits at 20% where the counterparty is an AIF, a UCITS or a financial institution.

• Lastly, the funds are required to maintain at least 5% of the notional value of the loans issued. All income from loans must be returned to the fund. Investors must be informed of the loan administration costs.

• The management company must formally document loan authorisation policies and procedures. These must be drafted to properly assess and control credit risk and are subject to periodic review.

3. Governance and minimum substance of managers

The new directive strengthens the governance structure for managers, aligning with industry practices and post-Brexit regulatory changes. It reinforces "minimum substance" obligations applicable to asset managers.

The new rules specify that the management company's business must be carried on by at least two natural persons, either full-time employees or executive members or members of the management company's management body domiciled in the European Union.

Regarding delegation agreements, AIFMD II strengthens the current regulatory framework. The AIFM must be able to justify its entire delegation structure to the competent authorities before the provisions of the delegation take effect, and all appropriate human and technical resources used to monitor the delegate must therefore be described in detail. The management company must be able to give additional instructions to its delegates at any time and to withdraw the mandate with immediate effect where the interests of investors and clients so require. This requires careful oversight and control to ensure effective governance and compliance.

Lastly, it should be noted that the prudential reporting obligations to the competent authorities will be strengthened, as will the declarations on delegations. To that end, ESMA will draw up draft RTSs (Regulatory Technical Standards) specifying the detail and standards for the information to be reported, thereby replacing the current AIFM declarations.