Navigating AIFMD II Rules for Loan Originating Funds
Fund managers with loan originating strategies, such as private credit funds in the EU (including parallels to a master fund elsewhere) will soon have to abide by a new set of rules on diversification, leverage, etc.
The key restrictions introduced by the Alternative Investment Fund Managers Directive II (AIFMD II) in April 2024 include:
- Diversification: Loans are capped at 20% to single borrowers who are Alternative Investment Funds, UCITS or other financial undertakings, such as credit institutions, financial institutions and ancillary banking service undertakings
- Retention of economic interest: A minimum of 5% of the loan’s nominal value for two years from the date of agreement or until the loan’s maturity, whichever comes first must be retained
- Administrative cost: Administrative costs need to be disclosed to investors in the pre-contractual disclosures. Administrative costs are origination fees, servicing fees, legal and compliance costs, monitoring and reporting costs, and collection costs
- Leverage: The leverage restriction for open-ended funds is 175% of the fund’s net asset value (‘NAV’) and 300% for closed-ended funds
Is your fund in scope of the AIFMD II rules on Loan Origination?
Loan originating funds are those with a principal investment strategy of originating loans, or those where the notional value of loans accounts for more than 50% of the NAV. However, many of the restrictions that we address below also apply to any EU funds that originate loans, regardless of their principal strategy or notional value of loans.
How is AIFMD leverage determined? How is this different to commercial leverage?
The leverage restriction is tested based on the definition provided in Article 8 of the Level 2 AIFM Regulation: “Commitment method for calculating the exposure of an AIF.”
Exposure in a fund is a measure of the total risk the fund is taking on. To calculate this, you add up the total value of all the fund’s positions, which include investments, loans, and other financial commitments. This total is then divided by the fund’s net asset value (NAV). When calculating the total value, you consider the absolute value of each position, meaning you look at the total amount without considering whether it’s positive or negative.
There are some exceptions as to what counts towards exposure. For example, temporary borrowing arrangements, such as short-term loans that are fully secured by undrawn capital commitments, are excluded. Additionally, certain netting and hedging strategies that offset risks can reduce the overall exposure.
Enforcement timeline – Transition rules for Loan Origination funds under AIFMD II
Funds constituted before 15th April 2024 have until 16th April 2029 to comply with the following:
- 20% single borrower limit within 24 (and exceptionally additional 12) months from the date of the first subscription*
- Open-ended funds can only be those that can prove that their liquidity risk management is compatible with their investment strategy and redemption policy. The European Securities and Markets Authority (ESMA) intends to issue guidelines in April 2025
Funds constituted before 15th April 2024 that finished fundraising by this date have been grandfathered in terms of the above.
All funds that originated loans before 15th April 2024, are exempt from the following (in respect to those loans):
- Restrictions on borrowing entities
- Originate-to-distribute restriction
- Full allocation of loan proceeds minus allowable (administration) fees to the fund
- Retention of 5% of the notional value of each loan that is originated and subsequently transferred to third parties
Moratorium until 16th April 2029 on:
- Increasing notional value of loans originated to a single borrower if this value is above the limit (20%). Where the value is less than 20%, it may be increased up to the limit
- Increasing the leverage if above the limit (175% for open-ended and 300% for closed-ended). Where the value is below this limit, it may be increased up to the limit. Funds originating only shareholder loans provided that the notional value of the loans does not exceed in aggregate 150% of the capital are exempt from this requirement
Practical implications of AIFMD II on Loan Originating funds
AIFMD II will impose stricter rules on drafting fund documentation for non-EU master structures, with EU regulations impacting the fund’s investment strategy (single borrower limit) and the use of exposure-increasing instruments such as repurchasing agreements (AIFMD leverage restriction). Non-EU master structures may have to revise existing fund documentation, which could consequently need the approval of the advisory committee.
Parallel funds looking to raise money in Luxembourg will also need to ensure compliance with these new regulations. This may involve updating their documentation and obtaining necessary approvals to align with AIFMD II requirements.
AIFMD II is yet to be transposed in the member states. Most countries, including Luxembourg, are expected to enact the changes by 2026. Around the same time, ESMA will be due to issue the technical standards detailing the implementation of AIFMD II.
