AIFMD II – A Closer Look at the Impact for Loan Origination Activities and the Opportunity for Ireland

On 15 April 2024, Directive 2024/927/EU ("AIFMD II") entered into force, which marked a significant milestone for the European asset management industry, in particular, on the basis that AIFMD II will introduce a harmonised framework for loan originating activities across the European Union ("EU"). This should improve risk management across the financial market and increase transparency for investors.

In this article, we highlight the key changes for asset managers and funds pursuing loan origination strategies, in light of AIFMD II. With the entry into force of AIFMD II, this now provides an opportunity for Ireland to align its existing domestic loan origination rules applicable to funds and to further grow its reputation as a leading domicile for loan origination funds. 

A New European Loan Origination Framework

"Loan-Originating AIFs" versus "AIFs which originate a loan"

A significant change under AIFMD II is the introduction of a new regime applicable to alternative investment funds ("AIFs") which engage in loan origination activities. The new loan origination framework applies where an EU authorised alternative investment fund manager ("AIFM") manages an AIF, which is engaged in loan origination activities.

The loan origination provisions included in AIFMD II apply in respect of all AIFs which engage in "loan origination" or "originating a loan". A new definition of “loan origination” or “originating a loan” is being introduced as part of AIFMD II and means the granting of a loan:

(i) directly by an AIF (as the original lender); or

(ii) indirectly through a third party or special purpose vehicle ("SPV"), which originates a loan for or on behalf of the AIF, or for or on behalf of an AIFM in respect of the AIF, where the AIFM or AIF is involved in structuring the loan, or defining or pre-agreeing its characteristics, prior to gaining exposure to the loan. 

AIFMD II provides that certain of the loan origination provisions shall only apply in respect of AIFs, which engage significantly in loan origination. Known as a "Loan-Originating AIF", such funds are classified as an AIF, whose investment strategy is mainly to originate loans; or where the notional value of the AIF's originated loans represents at least 50% of its net asset value ("NAV").  

New Obligations Applicable to Loan Origination Activities

The new loan origination framework introduces a range of new requirements applicable to both Loan-Originating AIFs and to AIFs which originate a loan. However, certain provisions in relation to liquidity requirements and leverage limits, as detailed below are specific to Loan-Originating AIFs only.

a) Diversification (Concentration) Requirements

An AIFM must ensure that, where an AIF it manages originates loans, the notional value of the loans originated to any single borrower by that AIF does not exceed in aggregate 20% of the capital of the AIF where the borrower is an AIF, a UCITS or a financial undertaking (as defined in Article 13(25) of Solvency II (Directive 2009/138/EC)).

This 20% limit shall:

(a) Apply by the date specified in the AIF rules, instruments of incorporation or prospectus, which shall be no later than 24 months from the date of the first subscription for units or shares of the AIF (unless an extension in limited circumstances is granted by the AIFM's home state competent authority);

(b) Cease to apply once the AIFM starts to sell assets of the AIF in order to redeem units or shares as part of the liquidation of the AIF; and

(c) Be temporarily suspended (limited in duration to the period that is strictly necessary and no greater than 12 months in any event) where the capital of the AIF is increased or reduced.

b) Risk Retention Requirements

AIFMD II introduces a risk retention requirement, with the intention of reducing moral hazard and seeking to maintain the general credit quality of loans originated by AIFs. An AIFM shall be required (subject to certain limited exceptions) to ensure that each AIF it manages which originates loans must retain an interest of 5% of the notional value of any loan the AIF originates and subsequently transferred to third parties (i.e. subsequently sold on the secondary market). This amount must be retained for the following period:

(i) Until maturity for those loans whose maturity is up to eight years, or for loans granted to consumers regardless of their maturity; and

(ii) For a period of at least eight years for other loans.

c) Prohibition of "originate-to-distribute"

AIFMD II requires that each EU member state must prohibit AIFMs from managing AIFs that engage in loan origination where the whole or part of the investment strategy of those AIFs is to originate loans with the sole purpose of transferring those loans or exposures to third parties.

d) Allocation of Proceeds and Investor Disclosures

AIFMD II requires that the proceeds of originated loans, minus any allowable fees for their administration, shall be attributed to that AIF in full. All costs and expenses linked to the administration of the loans must be disclosed to investors (in accordance with Article 23).

Furthermore, AIFMs shall be required to ensure that the composition of the originated loan portfolio in respect of each EU AIF that it manages and each EU or non-EU AIF that it markets in the EU is also disclosed to investors. 

e) Connected Party Restrictions

The AIFM must ensure that an AIF it manages does not grant loans to the following entities: (a) the AIFM and its delegates (or the staff of the AIFM or its delegates); (b) the AIF’s depositary (or its delegates); and (c) members of the AIFM's group (save for certain exceptions).

f) Consumer Lending

EU member states may prohibit AIFs that originate loans from granting loans to consumers or from servicing credits granted to such consumers in the relevant EU member state.

g) Policies and Procedures

AIFMD II establishes rules in relation to the maintenance of specific policies and procedures in relation to loan origination activities. AIFs that engage in loan origination are required to have effective policies, procedures and processes for the granting of loans, assessing credit risk and administering and monitoring the credit portfolio, including where those AIFs gain exposure to loans through third parties. 

The AIFM must keep those policies, procedures and processes up to date and effective, and review them regularly and at least once a year. Such policies, procedures and processes should be proportionate to the extent of the loan origination.

The above rules do not apply to AIFs whose lending activities consist solely of originating shareholder loans, provided that the notional value of those loans does not exceed in aggregate 150% of the capital of the AIF. A “shareholder loan” means "a loan which is granted by an AIF to an undertaking in which it holds directly or indirectly at least 5% of the capital or voting rights, and which cannot be sold to third parties independently of the capital instruments held by the AIF in the same undertaking".

h) Closed-Ended vs. Open-Ended Loan Originating AIFs (applicable to Loan Originating AIFs only)

AIFMD II places a regulatory onus on AIFMs to ensure that Loan-Originating AIFs are established as closed-ended funds, unless, the AIFM is able to demonstrate to the competent authorities of its home EU member state that the Loan-Originating AIF’s liquidity risk management system is compatible with its investment strategy and redemption policy. Where this is demonstrated, the Loan-Originating AIF may be established as an open-ended fund and provided certain requirements are fulfilled. These requirements are expected to include the establishment of a liquidity management system that minimises liquidity mismatches, ensures the fair treatment of investors and is under the supervision of the competent authorities of the home member state of the AIFM. In this regard, ESMA is mandated to develop draft regulatory technical standards, no later than the 16 April 2025, to develop those criteria, taking due account of the nature, liquidity profile and exposures of Loan-Originating AIFs.

i) New Leverage Limits (applicable to Loan Originating AIFs only)

Following extensive discussion as part of the negotiation of AIFMD II and with a view to ensuring the stability and integrity of the financial system and to introduce proportionate safeguards, AIFMD II introduces new leverage requirements which differ depending on whether the AIF is of an open-ended or closed-ended type and apply regardless of whether the AIF is marketed to professional and/or retail investors.

An AIFM must ensure that the leverage of a Loan-Originating AIF it manages represents no more than: (i) 175%, where that AIF is open-ended; and (ii) 300%, where that AIF is closed-ended, (in each case expressed as the ratio between the exposure of that Loan-Originating AIF, calculated according to the commitment method and its NAV). 

The above leverage limits do not apply to a Loan-Originating AIF whose lending activities consist solely of originating shareholder loans, provided that the notional value of those loans does not exceed in aggregate 150% of the capital of the AIF. National home state regulators in each EU member state may impose stricter leverage limits where it is deemed necessary to ensure the stability and integrity of the financial system.

The definition of ‘Leverage’ for the purposes of AIFMD (Directive 2011/61/EU) remains unaltered and borrowing arrangements which are temporary in nature and fully covered by contractual capital commitments from investors in the Loan-Originating AIF shall not be considered to constitute exposure for the purpose of leverage calculations.

In the event of a breach of leverage limits beyond the control of the AIFM, the AIFM must, within an appropriate period, take such measures as are necessary to rectify the position, taking due account of the interests of the investors in the Loan-Originating AIF.

Transitional (Grandfathering) Provisions

AIFMD II contains certain grandfathering provisions in respect of those AIFs which engage in loan origination and Loan-Originating AIFs that have been constituted before the date of entry into force of AIFMD II, namely, 15 April 2024 (the "Effective Date") giving them up to five years to comply with certain aspects of AIFMD II. It is expected that AIFMD II will be transposed into Irish law by 16 April 2026, at the latest.

AIFs which engage in loan origination that have been constituted after the Effective Date will be required to comply with the requirements of AIFMD II, upon transposition in the home EU member state of the AIFM. This is subject to adherence with any additional domestic framework for AIFs which engage in loan origination in the home EU member state of the AIF.

The opportunity for Ireland

From an Irish perspective, the Central Bank of Ireland ("Central Bank") established the domestic loan-originating qualifying investor AIF ("L-QIAIF") regime in Ireland in 2014, which introduced limits on the scope of activities, leverage and diversification requirements, borrower eligibility rules, as well as requirements to implement and maintain appropriate policies and procedures in relation to the assessment, pricing and granting of credit, the management of concentration risk and credit risk and the diversification of credit positions. It is noted that the loan origination related amendments introduced under the AIFMD II framework borrow heavily from the existing LQIAIF regime and, in this regard, should not present any material surprises for existing managers of such Irish funds.

It is noted that in a recent speech to industry at the Irish Funds Annual UK Symposium Derville Rowland, Deputy Governor of the Central Bank confirmed that the changes agreed as part of the AIFMD II review are appropriately targeted and the harmonisation of the rules for funds which undertake lending activity is seen as a positive development.

In light of the existing framework and service provider experience in Ireland with loan origination funds and the fact that an L-QIAIF can avail of a 24-hour authorisation process with the AIFM and legal advisers to the L-QIAIF confirming compliance with the relevant rules, it is expected that Ireland's reputation as a domicile for loan origination funds will continue to go from strength to strength.