26 November 2021
Introduction
The European Commission (EC) has released its draft legislative proposals as part of reforms to the Alternative Investment Fund Managers Directive (AIFMD). The draft text also amends provisions in the UCITS Directive to align them with the AIFMD, especially on delegation, liquidity tools and depositaries.
This marks a key milestone in the AIFMD review process by which the EU legislation is evaluated to understand whether its objectives are being met and, if necessary, to propose appropriate amendments.
In its report of 10 June 2020, the EC concluded that, while the AIFMD had successfully contributed to the creation of the EU AIF market, there were a number of areas where the legal framework could be improved. The EC held a public consultation to seek wider views on the effectiveness of AIFMD earlier in 2021.
The changes being proposed by the EC are evolutionary rather than revolutionary and, crucially, preserve the current delegation model with only limited changes. This will be a great relief to the UK and other third country-based asset managers.
The targeted nature of the reforms appears to reflect a general consensus in the industry that AIFMD has broadly been a success, that as the framework has proved itself to be workable, useful and effective, it should be preserved. However, there are some important amendments to key areas, including in relation to delegation, loan origination and liquidity management, which we have set out below
Key changes
Delegation: The EC has decided against some of the substantial changes proposed in the consultation, such as establishing a legal threshold for what constitutes a letterbox entity. It has also opted not to enhance the role of the European Securities and Markets Authority (ESMA) in centrally enforcing delegation rules for third-country entities. However the more targeted changes include the following.
- Article 8(1)(c) will be amended to introduce an explicit substance test. Under this revised provision, an AIFM will have to employ at least two persons full-time, or engage two persons, who are not employed by the AIFM but who are, nevertheless committed to conduct that AIFM’s business on a full-time basis, and who would be resident in the EU, thus ensuring a minimum, stable substance within the AIFM.
- Article 7(2) will be amended to clarify that AIFMs should have appropriate technical and human resources when applying for an AIFM authorisation. Therefore, when applying for the authorisation, the capability of human and technical resources used to carry out its functions and to supervise the delegates will have to be described in detail. The purpose of this is to make a clearer link between the authorisation and envisaged governance over delegation practices.
- Article 7(5) will be supplemented to ensure that information is collected by local competent authorities and transmitted centrally to ESMA to map delegation practices. In particular, ESMA should receive notifications of delegation arrangements where an AIFM delegates more portfolio management or risk management functions to entities located in third countries than it retains.
- ESMA will also be empowered to develop draft regulatory technical standards (RTSs) prescribing content, forms and procedures for the transmission of delegation notifications. Moreover, ESMA will be required to present regular reports analysing market practices regarding delegation, and compliance with the requirements applicable to delegation and supervisory convergence in this area to the EC, Council and European Parliament.
- Under a new Article 38a, ESMA will be required to conduct a peer review of supervisory practices in relation to letter-box entities every two years.
- A new Article 69b (reviews clause) will also require the EC to review the delegation regime laid down in AIFMD to prevent the formation of letter-box entities.
Managing loan-originating AIFs
- Annex I will be amended by adding a new point (3) to recognise lending as a legitimate activity of AIFMs.
- The new Article 69b mentioned above will also capture a review of the functioning of the rules for AIFMD managing loan-originating AIFs.
Liquidity management tools (“LMT’s”)
- In addition to being able to suspend redemptions, AIFMs will have to choose at least one other LMT from Annex V (which will be a harmonised list across the EU). However, the choice of the individual LMT would still be left to the fund manager.
- AIFMs will need to notify competent authorities about their use of LMTs.
- The proposals also include the power for the competent authorities to require the activation or deactivation of an LMT.
- ESMA is to develop draft RTSs to provide definitions, and specify the characteristics, of the LMTs set out in Annex V, and guidance on selecting and using suitable LMTs.
Depositary passport
- The EC has dropped the idea of a depositary passport. This option was not deemed feasible given the absence of EU harmonisation of securities and insolvency laws.
- However, Article 61(5) will be amended to allow competent authorities to permit depositary services to be procured in other Member States, in effect copying the national placement regime.
- The new Article 69b mentioned above will also capture a review of the appropriateness of complementing AIFMD with a depositary passport.
Disclosure to the national competent authority
- Article 50 strengthens supervisory cooperation by inserting new provisions. If there are risks to financial stability the competent authority of a host Member State of the AIFM may request the competent authority of the home Member State of the AIFM to exercise its supervisory powers, specifying the reasons for its request, and notifying ESMA and the European Systemic Risk Board (ESRB). It also lowers the burden of proof for the host competent authority requesting action. ESMA is empowered to request a competent authority to present cases which may have cross-border implications or an impact on financial stability or investor protection. This strengthens the power of host state competent authorities.
What does this mean?
Delegation
The new substance test appears to be a balanced reform. Requiring specific resources to carry out the oversight duties of the AIFM gives the local regulator a point of access to management who are carrying out those oversight and governance duties without disturbing the commercial benefits of delegation. However, it will be interesting to see how the two full time staff requirements will be applied to the third party AIFM / UCITS Manco market. For instance, will it be two full time staff per fund, or per oversight function? These substance provisions appear to apply to all AIFM’s including those delegating within the EU. This bears further attention as the EC legislative proposals are considered by Parliament and Council.
The regular ESMA reports to the EU institutions that will be conducted in relation to letter-box entities every two years also means that the issue of delegation will remain on the political agenda.
Loan origination
ESMA believes the regulatory framework can support the diversification of companies’ funding by introducing a specific framework for loan origination and loan participating funds in the current review of AIFMD. The need for AIF’s which grant loans to require effective policies, procedures and processes to assess credit risk and administer and monitor portfolios may require some managers to consider whether they have the resources and skills to undertake these tasks and where those resources need to be deployed in situations where those loans might be issued out of platform structures beneath the AIF.
The proposals also require AIFs which engage in strategies with more than 60% loan origination to adopt a close-ended structure, which is in line with current market practice.
However, the proposals would also require that an AIF that originates loans retain 5% of any such loan that the AIF subsequently seeks to sell, which is a new requirement and not consistent with typical market practice.
The proposals also include additional requirements regarding concentration limits, disclosure to investors regarding the AIF’s loan portfolio, and lending policies for AIFs.
Importantly for existing AIFs that originate loans, there are no grandfathering provisions in the current proposals.
Liquidity management tools
The proposal to give regulators the power to impose the use of LMTs in certain circumstances is in response to the macroprudential issues which have been identified in the funds industry. However, the proposal requires ESMA to draft RTSs which will have a lot more detail about how this reform will actually work in practice.
Next steps
The publication of the draft proposals by the EC is only the start of the legislative process. The Council of EU Member States and the European Parliament will review the proposals to seek a political agreement on their final form. This inter-institutional process is likely to result in some further changes to the amendments proposed by the EC.
It should also be noted that there will be a French Presidency of the Council during the first half of 2022, coinciding with the French Presidential election. The French Presidency will set the tone and agenda for the Council’s position on the legislative compromise sought amongst EU member states for these new proposals. Therefore, it is possible that the proposals could face unforeseen political challenges.
What do firms need to do?
The overall process to finalise the new rules is likely to last between 12 to 24 months, so there will be no immediate changes to AIFMD. However, clients should continue to monitor the process as, although the changes are not wholesale or as yet final, there will still be some significant amendments.
For further information on any of the above issues or to discuss how PwC can assist you, please contact your usual PwC contact.
Robert Mellor
AWM Beyond Brexit Leader
M: +44 (0)7734 607485
E: robert.mellor@pwc.com
Nick Tye
Manager
M: +44 (0)7483 399351
E: nick.tye@pwc.com