In the wake of the Global Financial Crisis and certain momen­tous events such as the Madoff scandal,¹ European policy makers looked to reshape the EU alternative fund landscape with a heightened investor protection regime. The solution to this apparent under regulation of alternatives was the Alternative Investment Fund Manager Directive (AIFMD).

First introduced in 2011, AIFMD had a turbulent beginning owing to its recast of the entire alternative fund model in Europe, impact­ing fund distribution particularly for non-EU funds selling into the bloc, delegation models, trade reporting, liability standards, the depositary regime, and remuneration.

However, despite its bumpy start, AIFMD has largely worked as intended and for the most part it has been a policy success if measured by the criteria of making the EU alternatives fund market better governed, reducing adverse investor impacts and increasing the ability to supervise for regulators. AIFMD set a high governance bar for alternative funds in Europe: funds under the regime have grown significantly year on year to now stand at over €7.6 trillion assets under management based on the European Fund and Asset Management Association’s (EFAMA) September 2021 Fact Sheet.

AIFMD II: A Feelgood Sequel?

Since AIFMD’s inception, the plan was always to review the framework with a view to ensuring it was fit for purpose. Kicking off in January 2019, that process has taken longer than expect­ed, but with the European Commission’s proposal publication on November 25, 2021,² at long last AIFMD II is finally here (see Figure 1). In this article we look at the major plot points of this much anticipated regulatory sequel. Spoiler alert: the sequel is more of a feel-good film than a horror movie.

Based on an initial review, the proposed revisions are very targeted in nature. This mild revision of the Directive owes to the fact that, for the most part, many stakeholders believe that the AIFMD has worked as intended since its introduction and there is no need to disrupt its functioning with wholesale revisions. In addition, certain areas of the AIFMD proposal contain cross references to the UCITS Directive and seek alignment in key areas such as delegation, liquid­ity risk management, regulatory reporting, and treatment of depositary/custodians. This is a positive for asset managers who operate under both regimes and is in line with the EU’s aspiration for greater supervisory convergence across Member States.

Figure 1: The AIFMD Review Journey So Far

What Happens Next?

The Commission’s proposals are merely the opening gambit of the detailed EU trilogue process. They will now move on to the reviewing and debating phase at both national level and by the Council and the European Parliament. Given the revisions are quite targeted and specific rather than broad based, it’s expected that agreement on the proposals will be reached quickly, so likely in the second half of 2022. The EU Council is expected to begin its work immediately with an initial reading of the text, followed by more intense negotiations, so industry advocacy on areas of importance initially noted will be crucial.

That would be followed by publication of the final AIFMD II in the EU official journal in early 2023. EU Member States would then be given 24 months to implement the required changes in domestic legislation and regulations. On that timeline and the assumption of no problems or undue delays with adoption of the proposals would mean AIFMD II would apply from late 2024 or at the start of 2025. As always with these highly complex policies, the devil is in the detail. So, while it may seem like a relatively benign time­line for revision, a flurry of action should be expected in early 2022 when the technical details of the proposals will be digested and discussed at industry level.

Indicative AIFMD Trilogue Timeline

AIFMD II Proposals: The Major Plotlines

The proposals are wide-ranging, but the “Top 10” most important elements are:

1. Delegation Models

AIFMD permits alternative investment fund managers (AIFMs) to delegate certain tasks as long as certain criteria continue to be met. However, in the wake of Brexit there was an intense focus among EU regulators on delegation particularly to non-EU third countries. Despite industry’s ongoing insistence that global del­egation models provide better investor outcomes and are already robustly supervised, modifications to the existing delegation models were expected. It remained a question of how disruptive the proposed changes would be. After much anxiety and bated breath, the largely positive news is that delegation will continue in much the same manner as it does now. A couple of bells and whistles have been added but overall, it’s a good news story for global asset managers.

For example, AIFMs may continue to delegate more of the port­folio and risk management functions than they retain. There had been widespread concern that a requirement to retain a majority proportion of activities within EU-based AIFMs would be imposed, but this has not ultimately come to pass. That allows the continued unfettered access to asset manager expertise. A new delegation reporting requirement is now placed upon national regulators who must report to the European Securities and Markets Authority (ESMA) instances where AIFM’s delegate more risk and portfolio management activities to third countries than are retained. ESMA must develop the “form, content and procedures” for these notifi­cations and there will be additional work for AIFMs, but it remains far more palatable than additional restrictions to use of third coun­try delegates overall. It is further expected that this new delega­tion reporting will help ESMA make future decisions on whether further rule making is required particularly if they sense that that “too much” activity is happening beyond their EU regulatory perimeter or if they consider too much reliance on third country expertise to represent a systemic risk.

The issue of delegation dovetails also with the concept of domi­cile “substance.” The proposals require the AIFM to employ or commit to employ two natural persons resident in the EU on a full-time basis. In practical terms, the horse has already bolted on this topic since the two largest EU AIFMD fund centers, name­ly, Luxembourg and Ireland have already imposed quantitative substance requirements on AIFMs above the AIFMD II proposal. Nevertheless, the clarity and putting regulatory substance on a pan-EU legislative basis is important.

2. Delegation Notifications

So, while there is no imposition of a requirement for an AIFM to retain more risk or portfolio management than it has delegated, there will be a new reporting regime implemented where this is the case. The proposals request national regulators to notify ESMA annually of delegation arrangements where more risk or portfolio management is delegated to non-EU third-country entities than is retained. ESMA is tasked with development of the required standards and procedures for such delegation notifications. These delegation notifications also seem to apply to current delegation arrangements. Therefore, a review of existing delegation arrange­ments will be required regardless and the detailed Level 2 rules will draw much focus from industry.

Firms can take comfort from the fact that in Ireland and Luxembourg much of the work on delegation has already been carried out. There is also already a body of existing work in both the ESMA Brexit opinion and the recent supervisory work of the Central Bank of Ireland and Commission de Surveillance du Secteur Financier (CSSF). That should hopefully place most AIFMs in the two dominant AIFM domiciles in a relatively good position to deal with these reporting obligations regardless.

The Commission’s proposals also require ESMA to provide the European Parliament, the Council, and the Commission with regular reports (at least every two years) analyzing prevailing EU AIFM delegation practices involving entities located in non-EU third countries. This includes the United States and the United Kingdom, both significant providers of required risk and portfolio management services to EU AIFMs. Five years after AIFMD II is effective, the Commission is then required to review the function­ing of the new delegation regime with a view to preventing the creation of EU letter-box entities. The proposals also include similar amendments to the UCITS Directive on delegation.

While it’s hugely positive that no substantial changes are deemed necessary to the delegation model currently in situ, ESMA’s role on supervision of delegation will be further codified. The industry may currently be confident that no fundamental changes to the global AIFMD delegation regime are necessary or will apply into the future. However, it does seem like the new delegation notifica­tion regime is a basis for future rulemaking of some kind by ESMA so will remain one to watch for all asset managers globally.

3. Third-Country Marketing

The proposals materially amend the AIFM third-country marketing rules. They state that non-EU third-country alternative investment funds (AIFs) may only be marketed within the EU if their home states are not on the EU list of non-cooperative jurisdictions for tax purposes. This marks a significant deviation from the current reference to the Financial Action Task Force Anti-Money Laundering blacklist.

Also, there may not be much time or pre-warning before a jurisdic­tion is re-characterized as ‘non-cooperative’. The dynamic nature of changes to the EU’s list also means increased uncertainty and if a particular third country became ineligible, for example in the middle of a fund raising, this would be very disruptive to an asset manager’s distribution strategy.

4. Liquidity risk management

The AIFMD II proposals include specific provisions relating to li­quidity risk management. Liquidity management in a fund context refers to a set of processes, strategies, and supporting mecha­nisms or tools that ensure a fund is able to access cash when it is needed, in particular to pay out redemption requests promptly as they are received. A range of liquidity risk management tools (LMT) exist including redemption fees, swing pricing, redemp­tions in kind, side pockets, fund suspension and more. Previous recommendations by the European Systemic Risk Board (ESRB) and ESMA, for the harmonization of rules governing liquidity man­agement tools,³ are not currently explicitly referenced in AIFMD or UCITS. There also currently exists a wide spectrum of divergent practices and supervisory approaches on LMTs across member state regulators.

The proposals provide that an AIFM that manages an open-ended AIF must select at least one appropriate LMT from a list (to be set out by ESMA in a new AIFMD Annex) for possible use in the interest of the AIF’s investors – this is in addition to being able to suspend subscriptions and redemptions. The AIFM must also implement detailed policies and procedures for the activation and deactivation of its selected liquidity management tools and the operational and administrative arrangements for their use.

The proposals also allow regulators themselves to step in where they see fit and demand that an AIFM activates or deactivates a relevant LMT. This is a novel approach, and it is also expected that this power be extended to cover non-EU AIFMs – the question of jurisdiction is particularly interesting here. Also, whether regulators will be capable of enforcing the activation of LMTs – which may not be in the fund documentation – remains to be seen. The major­ity of these LMT proposals will also extend to UCITS and it is pro­posed that UCITS management companies notify the competent authorities when they activate or deactivate an LMT.

ESMA will work on detailed technical standards - a process that will be watched with great interest as it adds a layer of complex­ity operationally and around the timing of such events. By their nature LMTs are used in times of great market stress, with funds quite reluctant to pull the trigger on them and they are in practice a last resort. The fact that a regulator may now formally instruct the activation or deactivation of LMTs is unprecedented and significantly curbs an asset manager’s autonomy and discretion. It is likely to be an area of robust industry debate when ESMA releases the detailed proposals. It does mark a more interven­tionist stance by ESMA on a topic it has long considered to be crucial to wider systemic risk consideration, so perhaps is not as unexpected as many suggest.

5. Loan Origination Funds

Loan origination is another area where the Commission suggests diverging national regulatory approaches have undermined the growth of the market, result in regulatory arbitrage and provide uneven levels of investor protection across the EU. The proposed loan origination changes therefore sit in the supervisory conver­gence and harmonization agenda that underpins many of the ESMA AIFMD proposals. What is also true is that loan origination has become a far larger market within the EU primarily due to certain bank retrenchment from lending, particularly to start ups and EU small and medium enterprise (SME) segments.

ESMA gave an opinion on the key principles for a European framework for loan origination funds in 2016, which largely mirrored the loan fund regime implemented in Ireland and where certain requirements are already applicable to Luxembourg AIFMs managing loan-originating funds. These proposals move this on a level playing field and look to strike a balance between preservation of financial stability and growth and development of the EU loan AIFs market. The most notable changes to the framework include:

• Closed Ended

Loan-origination AIFs (L-AIF) must be closed ended if the no­tional value of their loans originated exceed 60% of their net asset value (NAV).

• Lending to other Financial Institutions

A lending concentration limit of 20% of the AIF’s capital applies if the borrower is a financial institution under Solvency II (which directs the amount of capital insurers must hold to reduce the risk of insolvency), or a collective investment undertaking such as a UCITS or another AIF, but significantly not to other bor­rower types.

• Risk Retention

Intended to “avoid the moral hazard” of originated loans being immediately sold off on the secondary market. So, a loan-AIF must retain on an ongoing basis 5% of the notional value of loans originated and subsequently sold off to the secondary market.

• Conflict of Interests

AIFMs and their staff should not receive loans from L-AIFs that they manage. Similarly, the AIF’s depositary and its staff or the AIFM’s delegate and its staff should be prohibited from receiv­ing loans from the associated AIFs.

• Lending Policies and Procedures

AIFMs managing L-AIFs must implement effective policies, procedures, and processes for granting loans, which must include elements such as credit risk, and administer and monitor their credit portfolios. These policies, procedures and processes must be periodically reviewed.

• New reporting requirements

AIFMs will also be required to report to investors the portfolio composition of originated loans.

6. Depositary Considerations

The current AIFMD requirement is that a depositary should re­side in the same Member State as the appointing EU AIF. The Commission notes that in smaller, more concentrated markets, where there are fewer service providers, this requirement leads to a lack of competition, increased costs for fund managers and less efficient fund structures, impacting on investor returns. The introduction of a depositary passport was considered but was not deemed feasible without EU harmonization of securities and insol­vency laws.

So, rather than introducing a depositary passport, the proposals contain an interim measure permitting depositary services to be sourced cross-border, pending further review. Related to this, de­positaries must cooperate, not only with their home state com­petent authorities but also with the competent authorities of the AIF’s and its AIFM’s home states. For depositaries in non-EU ju­risdictions, the depositary should not be established in a high-risk third country pursuant to Article 9(2) of the AML Directive.

The Commission notes that, under current AIFMD rules, depositar­ies are sometimes prevented from performing their duties where the fund’s assets are held by a Central Securities Depository (CSD) as CSDs are currently not considered delegates of the depositary. The proposals however seek to bring CSDs into the chain of cus­tody and CSDs under AIFMD will be deemed to be delegates of the depositary where they are providing custody services, aligning with existing UCITS rules. This revision is seen as leveling the play­ing field among custodians and ensuring depositaries have access to all the information required to perform their asset safekeeping and oversight duties.

7. New Regulatory Reporting

AIFMD II suggests increased regulatory-reporting obligations for all types of AIFM. The Commission appears keen to increase the amount of data it receives, proposing that “limitations” are deleted from the data that competent authorities receive from AIFMs on their AIFs. In practice, this means that references will be to “the instruments traded” rather than “the main instru­ments traded.”

Further changes are also in the pipeline regarding Annex IV report­ing, as the Commission has mandated ESMA to develop level 2 standards to replace the current Annex IV supervisory reporting template. The general expansion of the scope of AIFMD reporting, inclusive of transaction level, liquidity, leverage, loan origination, direct and indirect fees, delegation models and servicing of securitization special purpose vehicles, just shows the direction of travel where regulators want to use data and analytics to supervise to a greater degree than ever before.

8. ESMA’s Wider Remit

Another important consideration is the Commission’s proposals to expand ESMA’s remit once more to have more direct supervi­sory authority. There has been an ongoing shift towards increased ESMA powers with a view to ensuring regulatory harmonization, which detracts somewhat from national regulator competency. ESMA is also charged with developing a significant amount of the Level 2 technical details on a range of AIFMD issues. The author­ity has in the past used its mandate on the regulatory technical standards as an opportunity to expand the scope and specificity beyond the principles outlined in the Commission’s original pro­posals. This has been the case in relation to several Brexit-related initiatives but also in terms of liquidity-risk management, delega­tion, and substance and certain Markets in Financial Instruments Directive (MiFID) revisions. The industry therefore will be watching for the AIFMD II technical details as they become available.

9. UCITS Impact

What’s good for the goose is good for the gander when it comes to delegation regulation it seems. And there are several AIFMD II themes that carry over into proposed changes to the UCITS re­gime also. This is very much in line with the general supervisory alignment agenda that ESMA is campaigning for and reflects the fact that a great number of asset managers and fund management companies operate within both regimes anyway.

10. Fees and Charges Disclosure

The proposals call for increased disclosure of all fees and charges which apply to an AIF and that will be borne by the AIFM and its affiliates. This includes quarterly reporting on all direct and indirect fees and charges. Across the board regulators are becoming increasingly focused on fee transparency and value for money. Unsurprisingly, this also makes its way into the AIFMD II proposals.