On this episode of “The Preferred Return,” co-hosts Greg Norman and Abigail Reeves look at the Alternative Investment Fund Managers Directive, particularly updates to the EU legislation, which are the most significant to date. The discussion touches on a number of those changes, including increased disclosure obligations and specific rules for certain private credit funds.
Episode Summary
Beyond marketing a fund, which we spotlighted in our last episode, there are other issues that founders of a new fund business need to consider.
In April 2024, the EU’s Alternative Investment Fund Managers Directive received its most significant legislative update since it was first adopted in 2011. In this episode of “The Preferred Return” podcast, Skadden attorneys Greg Norman and Abigail Reeves provide an overview of AIFMD II, including the original drivers behind AIFMD, new disclosure requirements for alternative investment funds in the EU and new regulations related to loan origination.
Tune in as Greg and Abigail provide a overview of how the rules will impact fund managers’ operating models.
Key Points
- Uncertainty Regarding AIFMD II in the U.K. Since AIFMD II was passed after the U.K.’s exit from the European Union, the new rules will not change the U.K.’s implementation of AIFMD. Whether the U.K. will make align its existing laws to match the changes in AIFMD II remains to be seen.
- AIFMD II Aims To Change Its Predecessor’s Catch-All Approach. According to Greg, the alternative investment fund market is extremely broad, and the AIFMD was seeking to regulate all asset classes.The catch-all approach has not been entirely successful, nor did it anticipate the potential growth and development of the fast-moving private capital space. AIFMD II seeks to remedy these shortcomings.
- AIFMD II Includes New Disclosure Requirements. AIFMD II will require AIFs to make more disclosures to both investors and regulators and mandates the disclosure of what functions the AIF has delegated.
Voiceover (00:03):
Welcome to the Preferred Return, Skadden’s Investment Management podcast covering legal and regulatory developments in the UK and Europe.
Greg Norman (00:15):
I’m Greg Norman, and I’m here with my co-host, Abby Reeves.
Abigail Reeves (00:19):
The Preferred Return is a Skadden podcast series providing short summaries of legal, regulatory, or other topical developments in the UK and European investment management space.
Greg Norman (00:27):
Our podcasts are intended to be accessible by professionals across the sector. We welcome any feedback, particularly if there are topics people would like us to discuss. Today we’re going to try and tackle the AIFMD, and in particular, some of the upcoming updates to that legislation.
Abigail Reeves (00:43):
We thought we should start off with a brief summary of what the AIFMD is. the Alternative Investment Fund Managers Directive is an EU legal act, which formed the basis for a harmonized framework for the management and distribution of alternative investment funds or AIFs in the EU.
(00:57):
The AIFMD came into force on the 1st of July 2011 and was required to be implemented in EU member states’ national legislation by the 22nd of July 2013 and so has been in effect for over 10 years now. The regime imposes a number of requirements on alternative investment fund managers or AIFMs. AIFMs are legal persons whose regular business is to manage one or more AIFs, and AIFs are a type of collective investment vehicle, which raise and pool capital from a number of investors with a view to investing it in accordance with a defined investment policy for the benefit of those investors.
(01:32):
Broadly speaking, an AIF captures any fund that is not a UCITS fund.
Greg Norman (01:36):
Thanks, Abby. Following the introduction of the AIFMD, any person carrying out the business of an AIFM in an EU member state was required to be authorized and regulated by the regulator in that member state. For example, the FCA in the UK, the AMF in France or BaFin in Germany.
(01:53):
Regulated AIFMs are subject to a range of governance and regulatory standards that also impact how they manage and operate their AIFs, such as by introducing increased reporting obligations, disclosure obligations regarding side letter provisions, and for AIFs acquiring EU or UK companies asset stripping rules.
(02:12):
At the house level, the AIFMD introduced remuneration rules as well as restricting the ability of the AIFM to delegate certain functions and enshrining certain liability standards. So Abby, where are we now?
Abigail Reeves (02:23):
As with most EU financial regulation, the AIFMD has been subject to review and update throughout its lifetime. There have been small updates via regulation, such as the introduction of the pre-marketing regime, which we discussed in a prior podcast.
(02:36):
However, in April 2024, an amended version of the AIFMD came to force, which we’ll refer to as AIFMD II. EU member states will now have two years to transpose the rules international law, meaning that AIFMD II should apply across the EU from the 16th of April 2026.
(02:54):
Since these rules were passed after the UK’s exit from the European Union, the rules will not change the UK’s implementation of the AIFMD, although it remains to be seen whether the EFCA or the UK government will make any aligning updates in any event. AIFMD II represents the most significant update to the AIFMD to date and will have a material impact on a number of important sectors of the private fund market.
(03:18):
To understand these changes, Greg, can you give listeners a bit more background on the original drivers of the AIFMD?
Greg Norman (03:24):
Very happy to. The AIFMD was introduced, at least in part, in reaction to the financial crisis and the growing importance of the alternative fund sector on financial markets. EU regulators wanted to improve supervisory practices in relation to alternative funds with the end goal of increasing market stability and reducing systemic risk.
(03:44):
They also wanted to increase the protection afforded to investors and to level the playing field across the EU by introducing harmonized standards. The EU had looked at the success of the UCITS regime, which is the legislation which covers the majority of retail investor facing funds across Europe. It sought to track that regime across to the alternative sector. The results included the introduction of a depository regime, which imposed standards on custodians to be responsible for monitoring investment activity, as well as imposing fairly high investor disclosure rules and reporting requirements to increase transparency. The alternative investment fund market is extremely broad, and the AIFMD was seeking to regulate all asset classes, whether that be hedge funds, private equity funds, real assets funds, or the most recent growth class, private credit funds.
(04:31):
Perhaps unsurprisingly, a catch-all approach has not been entirely successful, nor did it anticipate the potential growth and development of the fast-moving private capital space.
Abigail Reeves (04:41):
And that helps explain the focus of AIFMD II, which the EU hopes will enhance the regime. The changes that include increased disclosure obligations both investor-facing and to regulators, additional obligations on AIFMs, which delegate key functions as well as specific rules for certain private credit funds.
(04:59):
Looking first at the investor-facing disclosure obligations, investor disclosures are required by article 23 of the AIFMD, and this captures the information which all AIFMs must provide to potential investors before they invest. These provisions have been updated with a particular focus on fee disclosures and for open-ended funds, any liquidity management tools which have been put in place.
(05:21):
AIFMs will also have more extended reporting obligations to regulators through Annex IV reporting. Annex IV reports will now have to include detail on which member states an AIF is marketed to, the total amount of leverage employed, and a number of details regarding delegation arrangements.
Greg Norman (05:38):
To pick up on that last point, delegation has been a key area of focus for EU regulators, and it was a point of significant contention during the negotiation process of the AIFMD II. Under the AIFMD, portfolio management and risk management are stated to be an AIFM’s key functions. While an AIFM is permitted to delegate many of its ancillary functions, it may only delegate one of portfolio management and risk management.
(06:03):
This arrangement is similar to the delegation model under UCITS, and it gave rise to the very popular third-party AIFM model. Given the cost and complexity of establishing a regulated AIFM, a number of fund managers, particularly those outside of the EU, entered into third-party arrangements with EU-regulated AIFMs who would serve as the AIFM of the fund while the fund manager acted as the portfolio manager. For non-EU fund managers, this presented a very efficient way of operating an EU fund and accessing investors across the EU. EU regulators were wary of the potential to abuse this provision, which is why the AIFMD includes the so-called letterbox provision, where an AIFM must fulfill one of these functions properly, and as stated in the legislation, not simply act as a letterbox.
(06:50):
Third party AIFMs who typically retain responsibility for risk management must therefore ensure they have proper processes and resources in place to carry out that function.
Abigail Reeves (06:59):
Thanks, Greg. Despite the existing rules, there was a concern amongst EU rule makers that the delegation rules were not operating properly and that delegation arrangements were not subject to sufficient oversight by home state regulators. In the development stages, the changes considered by the EU were varied, and at one point included a ban on delegation of the core function.
(07:20):
However, AIFMD II ultimately settled on increased disclosure requirements. This means that any AIFM wishing to delegate its core functions or its ancillary functions such as fund administration, marketing, or fiduciary services, must make disclosures to its home state regulator of the delegation and must be able to demonstrate that the delegate is capable of performing the tasks delegated to it. We anticipate that this will have an impact on third-party AIFM arrangements given the increased scrutiny such firms will have to have on their delegates.
Greg Norman (07:51):
Another area to keep an eye on is the new loan origination fund rules, which will impact any private credit funds, which originate loans and where originated loans make up or are expected to make up at least 50% of the NAV of the fund. These rules will apply to any AIFs managed from the EU, but there will be no distinction between EU and non-EU borrowers. The regime introduces a number of requirements specifically targeting these funds, including a risk retention requirement, which is very similar to those rules applying under the securitization regulation.
(08:23):
There is also a concentration limit of 20% of the fund’s capital, governance and risk management requirements, leverage limits, and a requirement for such funds to be closed-ended amongst some other requirements and obligations. While a number of these rules will codify what is already market practice for many private credit funds, they do impose another layer of regulatory scrutiny at a time when the sector is already under increased focus.
Abigail Reeves (08:49):
Thanks, Greg. This really has been a whistle-stop tour of the new regime, and there is a lot of detail in AIFMD II to be considered. As a directive it needs to be implemented by member states, and so there is still potential room for gold plating and for different interpretations by member states. Although EU regulators will seek to ensure the framework is harmonized as much as possible.
(09:10):
Fund managers have had a bit of time to consider how the rules will impact on their operating models, but with further details to follow through regulations and regulatory technical standards, it will be important for anyone operating in the EU to stay on top of these changes as they develop.
Greg Norman (09:25):
Thanks again for listening, and we look forward to you tuning into our next episode. This was the Preferred Return. Stay invested.
Voiceover (09:32):
Thank you for joining us on the Preferred Return. If you enjoyed this conversation, be sure to subscribe in your favorite podcast app so you don’t miss any future episodes. Additional information about Skadden can be found at skadden.com.
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