Alternative Investment Fund Managers Directive II ((EU) 2024/927) (AIFMD II) goes into effect on April 16, 2026. How are credit managers preparing for these new regulatory requirements that impact funds managed by EU managers and, in certain cases, EU funds managed by non-EU managers? In this discussion originally published as part of Dechert’s The Cred Convos video series, financial services partners Mikhaelle Schiappacasse and Katie Carter dive into the policy behind the regulations, additional requirements that apply to loan-originating funds, liquidity management tools and much more.
Schiappacasse: To really frame the conversation, I think we need to talk about the policy behind the regulations, because you really only understand the details and why certain things have come into play if you understand the background and what the regulators were considering.
Carter: So, the European regulators have long been looking at what they have historically called the “shadow banking industry.” They're aware that there's a huge volume of lending that's happening outside of banks, and a lot of the lending that happens outside of banks takes place through funds. They are concerned about transparency, the management of systemic risk, and in connection with that liquidity management in respect of loans in both stressed and de-stressed market conditions.
Schiappacasse: If we look at loan origination, what are we focusing on?
Carter: Loan origination is a concept that's been newly added into AIFMD II. Effectively, what the regulators are looking at are any loans that are issued directly by the funds – where the fund is the lender of record – but we're also looking at any lending that takes place in the downstream structure underneath the fund. So, if you've got, for example, a wholly owned special purpose vehicle (SPV) that is lending, and that SPV is being managed by the manager of the fund, then that origination activity is also within scope. One of the conversations that we've had with clients is, what is a loan? When are we within scope? We’re looking at the life cycle of loans as well.
Schiappacasse: That's a good point. If you look at a private credit fund, it could be originating loans, but it could also buy bonds and notes. As you said, the key point, obviously, is whether you are the originator of record, and whether it's loan. If it looks like a loan contract, then that's what it's going to be. There are different ways this comes up in different types of structures. But if you think of a bond, that's an issuance where the manager or the fund isn't going to be involved, normally speaking, in determining how the terms of that agreement are structured. It's not a bilateral contract that's been entered into with negotiated terms in the way a loan agreement has. A note, as a general matter, probably isn't a loan. But you can't just call it a note to avoid the implication that it is a loan. So, if it looks and smells like a loan, then it probably is one.
I think one of the things to remember is that when they're looking at origination, they're not just looking at whether the fund has done it, or even whether the SPV has done it, but has the manager or the fund been involved in designing that loan? Because that's where it starts crossing over into origination of a loan and substitutes for being the lender of record. If they subsequently acquire the loan after the fact, they're not initially a lender of record for that loan.
Carter: That point is also worth expanding on. One of the conversations we've had with clients is, "OK, well, we buy in the secondary market, but sometimes, once we've bought in the secondary market, we then need to restructure the loan, or we get to a point where the loan is being restructured as part of the normal life cycle. And does restructuring the loan look like origination?” It’s fact specific – it depends on whether you are renegotiating the terms of the loan or if additional money is being lent under the agreement. Sometimes, restructuring will not, in and of itself, be origination that pulls you into the rules, but sometimes it will be.
Schiappacasse: So, there's the act of loan origination, which is subject to regulation, but there's also, then, another concept, which is a loan-originating fund, or loan-originating AIF. Here, we're really concerned about the intention behind the operations of the fund, or to what degree it is involved in the origination of loans. So, if a fund’s stated purpose is loan origination, it will be considered a loan-originating AIF. For funds whose originated loans have a notional value that represents at least 50% of the net asset value (NAV), those are also considered to be loan-originating funds. If we're looking at an evergreen fund that does private credit, generally – not just loan origination – there’s the potential for the fund to move in and out of being a loan-originating fund. So, it's something to be sensitive to in the management of the fund. And why do we care? Well, we care because there are certain additional requirements that only apply to loan-originating funds: One of them is leverage.
Carter: It’s important that people categorize their products, and we've helped a number of clients with their categorization, looking at what's in and out of scope. As you mentioned, leverage is one of the key issues that we've been looking at for several reasons. If you are a loan-originating AIF, say, you're in that bucket where your investment policy is focused on loan origination or you hit that 50% threshold, then you become subject to the leverage caps in AIFMD II.
Now, leverage is not a new concept under AIFMD. It was in AIFMD I, so it's been there the whole time. I think it's also important for people to be aware that the calculation methodology that was in AIFMD already – their gross method or commitment method – hasn’t been touched as part of AIFMD II. That is business as usual, and the calculation methodology everyone's familiar with is still there. What is new are the caps that regulators have put in, which focuses on not only whether you have a loan-originating fund, but whether your loan-originating fund is open-ended or closed-ended, because different caps are applicable.
Schiappacasse: Historically, when you're dealing with a private credit product, you wouldn't have been so concerned about it, because most private credit funds are term funds. You invest in them; you hold and then you realize. But, with the rise of evergreen funds in recent years, it's much more common to have a fund that may be considered open-ended under AIFMD. And really, what you need to look at there is, how is liquidity made available to investors? If an investor can basically request a redemption, and that redemption is then honored at NAV rather than, say, on a run-off basis, then you've probably got an open-ended fund. If the ability to come out of the fund really sits with the GP, whether through operating a runoff mechanism, or through, for example, using a tender mechanism, much say, like interval funds use in the U.S., then you could probably look at it and say it's closed ended, but it really is very fact specific, and so you have to look at it on a case-by-case basis.
So, it does matter whether you're open-ended or closed-ended, because if you're open-ended, you are subject to leverage limit of 175%, calculated in accordance with the commitment method under AIFMD, not the gross method. There's no change there. If you're closed ended, you have a higher leverage limit at 300%. So, it does matter whether you're open- or closed-ended, and once again, you then get into discussions around what is leverage or, rather, at what point is the fund considered to be levered?
Carter: And, again, because leverage before has been more of a reporting issue than a more general issue, a lot of people haven't really focused on this in a huge amount of detail. Much like the rules required downstream for loan origination, the leverage rules require you to look downstream for leverage calculation as well. So, if you have lending happening downstream – in a downstream SPV for example, and there’s borrowing that causes leverage at that entity’s level – then you need to most likely take that into consideration when you're calculating leverage at the fund level as well. There are different things that need to be taken into consideration when you do that, but if we step back to the policy, we're looking at loan origination; we're looking at managing liquidity and risk in the fund structure as a whole, not just in the fund that sits at the top. So, if we're being told by the regulators the expectation is for us to look down the structure for loan origination, it also makes sense that you would look down the structure for the purposes of calculating your leverage as well. But again, this is all very fact specific.
Schiappacasse: Now, there are requirements around when you need to be in line with the leverage limits, and so that is also a fact-specific analysis around the nature of the fund when it started lending – basically, what the overall leverage in the fund is at the point in time the rules come into effect. It’s a threshold that needs to be met. But there's some grandfathering of those positions depending on the nature of the fund and timing.
I think one of the biggest concerns we're running into for managers is a new concept that's been introduced of risk retention. And unlike leverage, where it matters whether you're open-ended and closed-ended, and whether you're a loan-originating fund – the leverage limits don't apply if you just happen to originate loans but aren't a loan-originating fund. It doesn't matter whether you have one loan in your portfolio or the portfolio is completely composed of loans, risk retention applies to the origination of that loan. So, we focus on the issue of risk retention, specifically as regards origination and as regards the onward sale of that loan. The sale of that loan to a third party is critical in terms of evaluating it, and this is one of those ones that is based on policy again. So, Katie, you're our policy guru. Why do we care again here?
Carter: This is really the regulators being concerned that people are issuing bad loans and not having to keep any skin in the game. For them, there's no incentive to necessarily make sure that those loans are good loans. This is the risk retention requirement, which we should mention, as it's a 5% risk retention requirement to effectively incentivize people to carry out proper due diligence on those loans. But also it has to be a loan that you're willing to keep 5% skin in the game of when you issue it. So, it really is encouraging people to be more risk averse when they're originating from the get-go, because they're not going to be able to divest of that investment straight away upon issuance.
I think one of the most important things that we've focused on is, what does “third party” mean? So, the rules kick in when you're on selling to a third party. There are different views in the market about what that means. A conservative reading of that would be if you pass that loan on to any entity that wasn't the original lender of record.
The other end of the spectrum is that you get comfortable with various fact patterns. One of the things that we've talked about a lot is, what if that “third party” is just another fund that's managed by the same manager? What does that look like? Going back to the policy, the point is that you must be happy to retain some risk in the loan that you’ve issued. Arguably, if you're keeping it all in-house but you're just splitting it across several clients, it's not really a third party, because you're not passing that risk onto the market in the way that the regulators are thinking of when they write those rules.
Schiappacasse: I suppose it's worth mentioning a connected restriction, which is that the operating of a strategy where the purpose is to originate to distribute is prohibited now under the rules, and it's based on the same principle. You can't just be going out and making any kind of loan and then selling it on to a third party. That needs to be distinguished between where, say your flagship fund does the origination, and then you do internal syndication among your various vehicles. Most firms would get comfortable that that isn't an originate-to-distribute activity. And on top of that it is also likely not a risk retention scenario. Every single fund that takes a slice of that was really an originator, because the manager structured that loan for those funds and knew that was going to be the case.
The one nuance here that is particularly relevant for managers who operate U.S. lending strategies is to make sure that the approach to risk retention and origination is consistent with any kind of season-and-sell policy. You don't want to be saying that you're not originating for season-and-sell purposes, but you are originating for AIFMD purposes. To be fair, they are slightly different concepts, but it doesn't help the fact pattern if there's some distinction. So, you need to think that through on your various funds.
It's worth noting that a lot of what we've talked about are key aspects of AIFMD II – they're not all the aspects of AIFMD II that would be relevant for a credit manager, but these are the ones that people are focusing on – which makes me recall one of the things we should say about that risk retention element. It's 5% right, but you only need to retain for loans where there's a maturity of eight years or more and for loans that are the shorter for the duration of that loan. So, if you originate something that has a 12-year term, then after eight years, you can sell on 100% without being subject to the to the retention requirements.
There are exceptions to this – or derogations, as they call them – where you need to analyze the scenario on a loan-by-loan basis and a sale-by-sale basis. So, it's not that you have to always retain, but you do need to think about it and determine whether one of the derogations will apply in that scenario, which would allow you to sell the whole loan. One that comes to mind, for example, is if there's a decrease in the credit quality of the loan, that's a basis on which you can actually sell it. But you need to tell the buyer that that's why you're selling it and give them the information about that reduction in credit quality. So, if your buyer is interested in stressed and distressed, then they probably would be happy to take it. Katie, should we talk about liquidity management tools (LMTs)?
Carter: We should. But first, on the derogations, they are intended to be exceptions. They're not expected to be the rule. There are internal governance processes that need to be put around that. So, you’ll want to keep a written record as to why you found it appropriate to rely on the derogation. Reduced credit quality of a loan is a good example, especially if your fund is only supposed to be investing in loans that have a certain credit quality to them and this loan stops having that credit quality. But you need to pay for it. You need to explain, maybe in your investment committee memo or elsewhere, why it is that you've decided to rely on derogation for that, because there is expected to be loan-origination policy that you use in relation to both originating loans.
But yes, as you said, we should, it's not an AIFMD II chat if we don't talk about LMTs, because that's what we spend a lot of our lives talking about at the moment. There is a new requirement under AIFMD II for any open-ended funds to select LMTs out of a list that is now set out in a new annex to AIFMD II. There are two, for want of a better terminology, mandatory ones. Those are the ability to use side pockets and the ability to suspend subscriptions and redemptions to a fund. The expectation is an AIFM will be able to use both of those. And then, there's a set of others that open-ended funds need to select two from, and need to disclose which ones you're going to use.
As you said, in an evergreen structure, a large part of our open- versus closed-ended discussion, for the purposes of AIFMD II, comes down to not only the leverage caps we’ve been talking about, but also whether we need LMTs. We've done a lot of detailed conversations around those. Not all the LMTs listed that you can pick from are appropriate for credit funds, we've found as we've gone through our conversations. There are certain ones, like swing pricing and dual pricing, that we're just not seeing any uptake on from credit managers, but others that we're discussing in a lot of detail; things like redemptions in kind and extension of notice periods. So, it's one to bear in mind. It's more of an uplift than it looks on the face of it, in that it's not necessarily the selection of them, although that is also giving people food for thought because the AIFMD II notion of some of these LMTs isn't necessarily the way the market looks at them, or the way that you may have been using them in managing the fund. For some of the governance requirements around them, you have to set thresholds at which point you’re going to operate the LMTs. It can mean opening fund documentation, it can mean opening constitutional documentation. And so, we are spending a lot of our time discussing those.
Schiappacasse: I think the key point is that whatever you choose needs to work for the strategy. And as you were saying, AIFMD II was written primarily with highly liquid exchange-traded securities in mind, rather than private credit structures. There’s a default assumption that any kind of loan-originating fund or any serious private credit fund will be closed-ended. And so, there was an assumption that these LMTs don't apply. But with the rise of evergreen structures, there are arguably open-ended forms of private credit funds that do direct lending, where you're going to need to think very closely about which LMTs you're going to apply.
