Guest comment by Sam Brooks
The EU is deliberating reforms to the Alternative Investment Fund Managers Directive, with proposals that have been dubbed AIFMD II. Much of the attention paid to AIFMD II has focused on concerns around possible restrictions placed on the delegation of portfolio management outside the EU: a particular area of contention since the UK’s Brexit vote in 2016. However, less attention has, to date, been paid to a proposed new regulatory regime for loan origination funds.
The new regime looks set to be beneficial, in certain respects, for these funds; however, the EU also intends to introduce restrictions and increase the regulatory burden on them. We expect to see the final rules by the end of 2022.
What is a loan origination fund?
Currently there is no EU-wide definition of a “loan origination fund” or a comprehensive classification of the activities of a loan origination fund in EU law. However, national regulations often distinguish between the creation of loans and the purchase of loans (termed loan origination and loan participation).
For instance, the Luxembourg Commission de Surveillance du Secteur Financier defines loan origination as an alternative investment fund manager or alternative investment fund “actively creating/granting/extending a loan as part of its investment activity”. The consequence of this definition is that any fund that has the ability to undertake any of the elements of loan origination could be a loan origination fund, regardless of the actual scale of loan origination as a proportion of the fund’s investment activity (ie, there is no minimum threshold).
By contrast, loan participation funds can acquire and partially restructure loans originated by third parties such as banks. While not a part of the regulations, the International Organization of Securities Commissions recommends that if a fund is intended only to be a loan participation fund, its investment strategy and policies should explicitly exclude the possibility of the fund undertaking loan origination.
At present, the EU is a patchwork of rules for funds that originate loans. Different EU member states adopt different approaches, with some considering these funds should be regulated in a similar way to credit institutions under the Capital Requirements Directive V legislation, others providing special exemptions from regulation for EU AIFs with EU AIFMs, and others generally permitting non-retail lending.
AIFMD II proposes that EU loan origination funds managed by full-scope EU AIFMs should have the benefit of a loan origination “passport”, permitting them to lend to non-retail borrowers throughout the EU, in exchange for harmonised investor protection rules across the EU. The developing amendments to the proposal suggest a further distinction between loans to third parties and shareholder loans, in which an AIF lends to a business in which it directly or indirectly holds at least 5 percent of the share capital or the voting rights. The latter would be exempt from elements of the new regime.
Similar to securitisation
One reason the European Commission has decided to act is due to perceived risks to financial stability in the EU. Their concern is that loan origination and distribution by investment funds poses risks that are like securitisation of debt by banks. A fund might create and then sell a loan to a third party with the fund no longer bearing the risk of the creditor’s default. The danger is that this could incentivise the build-up of bad credit because the loan originator can reap the benefits of credit creation while passing on the risks to the third party.
In an isolated instance, the risk is low because it is incumbent on the loan purchaser to assess the risks that they are taking on. However, considered on a system-wide basis, there is the potential for non-performing loans to spread throughout the financial system, undermining its stability. These considerations hint at the dilemma in the EU’s negotiations: should policymakers seek to limit the ability of funds to create loans or simply introduce more transparency into the process?
This debate about the risks of loan origination funds closely reflects similar public concerns about bank securitisation following the global financial crisis. Indeed, policymakers are considering the same tools. Before the publication of the draft legislation in November 2021, the European Commission considered a 200 percent cap on fund leverage. The idea did not make it into the final draft, but the text’s preamble notes the inadequacy of current leverage and valuation rules – and the lack of a common approach in the EU – to address the perceived risks to financial stability.
What is at stake?
Certain parts of the proposals are not controversial. For instance, loan origination funds must have policies and procedures to assess and monitor credit risk. Asset holding companies are in scope to prevent managers circumventing the rules (also, helpfully, clarifying uncertainty in some jurisdictions as to whether asset holding companies below EU AIFs should have the benefit of exemptions from bank licensing requirements afforded to EU AIFs with EU AIFMs). A five-year grandfathering period is also proposed, giving managers with legacy funds time to comply.
However, three parts are contested. Unsurprisingly, these are the areas that are likely to affect managers of these funds the most.
The original proposal contained a requirement for all loan origination funds to be closed-end, due to the European Commission’s concern about liquidity mismatches (ie, the illiquidity of loans versus the likelihood that investors might wish to redeem their money from the fund). The negotiations have moderated this to allow loan origination funds to be open-end, but only if the manager has an “appropriate” liquidity risk management policy and can agree with their national regulator the availability of “suitable” liquidity risk-management tools. The crux of the matter will be which processes meet the required standard. We will likely not know until the European Securities and Markets Authority creates the relevant standards, perhaps in 2024.
Next is a “skin in the game” requirement: managers must retain 5 percent of the notional value of the loans that they create (ie, the invested capital rather than the market value). This reflects the risk retention requirement in the EU’s securitisation rules. It means that a loan must be held to term unless the borrower pre-pays and is a constraint on managers’ ability to dispose of a loan on the secondary market.
The most contested area is fund leverage. The European Council favours a cap at 150 percent of the fund’s net asset value, although confusingly suggests that it should “be expressed” as a percentage of exposure (eg, a cap at 150 percent of NAV would be expressed as 250 percent of the fund’s exposure). The European Parliament, by contrast, proposes transparency, requiring funds to report their leverage to regulators according to a method to be defined by ESMA. Where will this end up? A fair assumption is that a reasonably high cap plus reporting is likely, although the method of calculation may be controversial.
Final legislation by the end of the year is a possibility. One version of the draft suggests a two-year implementation period and, in the meantime, ESMA will draft detailed rules in some areas. Managers expecting to launch new loan origination funds from the end of 2024 or early 2025 will need to keep a close eye on AIFMD II, given these significant changes.
Sam Brooks is an investment management partner in the London office of law firm Macfarlanes