A European Framework for Loan Originating Funds
With the European Council lately agreeing its position on the updated rules on the Alternative Investment Fund Managers Directive – AIFMD II in jargon – and the provisional agreement reached shortly thereafter with the European Parliament, the path is now clear for the conclusion of the legislative process to revise the AIFMD for the first time.
The appraisal carried out in 2020 by the European Commission on the functioning and scope of AIFMD resulted in a verdict of overall effectiveness of the standards of investor protection afforded by the directive. The rules introduced on conflict of interest, disclosure and transparency requirements were deemed sufficient and appropriate. However, where there is always room for improvement, the revised rules ultimately seek to address also angles other than investor protection.
Proposed by the end of 2021, as part of a broader package of legislative measures related to Capital Markets Union, the new rules under AIFMD II aim also to introduce a pan-European regime on so-called loan originating funds.
Get in touch here with your contacts at Veneziano & Partners to see how we can help with European Loan Originating Funds.
European Framework on Loan Originating Funds
One of the realities of a well-functioning and supervised Capital Markets Union is that European corporates and SMEs – like the American ones – have access to a wide range of competitively priced funding options. In this paradigm, loan originating funds become one of the preferred funding options to support the economic growth as well as the digital and green transition objectives within the Union. At the same time, establishing themselves as an alternative source of funding, they can act as a cushion in case of liquidity crunches in the more traditional credit markets.
The issue of an European framework on loan originating funds has also been tackled by ESMA in one specific opinion dated 2016. Whilst that work was specifically focussed on a specific type of these credit funds, it is nevertheless useful to glean more details on the multifaceted aspects of credit provision via investment funds. That happens in different ways. On the one end of the spectrum we have true loan origination, where investment funds provide credit as sole or primary lenders. We have then loan participating funds, where exposure to loans is obtained through participation on the secondary markets. Lastly, we have funds used to invest in reaction to the restructuring of existing debt.
One of the main points of the opinion, which links back to AIFMD II and the Capital Markets Union, is that at European wide level, with the only exception of ELTIFs and EuVECAs, at the time only bespoke regimes on loan originating funds existed in a selected handful of member states in Europe.
This brings us to the core of the issue, manifesting at different levels, which the new rules under AIFMD II seek to address. On the one hand, the status quo created a scenario where true passporting of these funds across Europe was not possible. Existing bespoke regimes triggered compliance with additional requirements depending on the target domicile of distribution. On the other, the introduction of a pan-European regime would allow for these alternative sources of funding to flourish also in the other member states in Europe, where there was not yet a local regime and likely credit markets were dominated by traditional lenders.
Some of the Features of Loan Originating Funds
The design of a pan-European regime for loan originating AIFs starts with the inclusion of credit servicing, governed by Directive 2021/2167, as one of the authorised ancillary activities for AIFMs.
Based on the understanding that this is an opportunity to create an entirely new market in Europe, that comes with its own set of unique risks, specific attention is posed on the governance surrounding the activity of granting loans itself, as well as the ensuing monitoring of credit risk of portfolios. On the specific point of credit risk monitoring, the requirement for ad-hoc policies, processes and procedures will not only apply to pure loan originating AIFs, but also to AIFs that gain exposure to loans by purchasing those on the secondary market (so-called loan participating funds). Risk diversification also plays an important part in this new paradigm. In case borrowers are financial institutions, risk diversification measures and exposure limits will be imposed to loan originating AIFs.
It is also noteworthy to mention that the design of the pan-European regime for loan originating AIFs comes also with some clear don’ts. So as to ensure that a general standard for the credit quality of loans originated by AIFs is established and maintained, whilst it should be possible in principle for AIFs that originate loans to trade them on the secondary market, pure originate-to-distribute investment strategies shouldn’t be allowed for AIFs.
Lastly, given the illiquid nature of the underlying assets, closed-ended structures for loan originating AIFs should be preferred, with some early redemption features allowed under specific conditions.
Conclusions
Of course, the new pan-European regime on loan originating AIFs is introduced in an environment where selected member states have already developed their internal private credit markets, with corresponding national rules to suit the specific business climate and investor preference.
This reality is somehow acknowledged in the AIFMD II directive. More namely, the directive makes space for the fact that local member states remain sovereign in maintaining or implementing their local regimes on loan origination via investment funds, with those specific local rules applying to AIFs at their choice and to the extent that these are more restrictive than the ones introduced by AIFMD II.
And where we are used to gold-plating, this approach seems to be indicative of a different trend. The new pan-European regime on loan originating AIFs might have eased up the issue of pass-portability across Europe. Yet, existing local private credit markets have strong identities already. It pays to conform to the stricter rules to take part of the game on these markets.
Get in touch here with your contacts at Veneziano & Partners to see how we can help with European Loan Originating Funds.