Alternative Investment Funds (AIFs) providing loans can be a source of alternative financing, especially aiding EU SMEs, which have seen their access to traditional lending become more complex.

While certain EU jurisdictions apply and regulate, to an extent, such loan origination activities, diverging national regulatory approaches may lead to regulatory arbitrage, thereby obstructing the establishment of an efficient internal market for loan origination. Simultaneously, the rapidly expanding private credit market, makes it necessary to address the potential micro-prudential and macro-prudential risks that loan origination by AIFs could pose to the broader financial system.

The upcoming Alternative Investment Fund Managers Directive (AIFMD II) can be seen as the first attempt to harmonize loan origination activities of AIFs, at a European level, for the improvement of risk management across the financial market and for increasing transparency for investors.

This article aims to brief on the key provisions introduced by AIFMD II in relation to loan originating activities.

Loan origination is defined as 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, which originates a loan for or on behalf of the AIF, or for or on behalf of the AIFM in respect of the AIF, in each case, where the AIFM or the AIF is involved in structuring the loan, or defining or pre-agreeing its characteristics, prior to gaining exposure to the loan.

Certain AIFMs may be able to rely on exemptions from some of the new requirements imposed on AIFs that originate loans. AIFs that follow private equity strategies, and which only grant loans alongside equity investments in portfolio companies, can rely on the shareholder loan exemption, provided that the notional value of the shareholder loans of the AIF does not exceed in aggregate 150% of the capital committed to the AIF.

Under AIFMD II, AIFMs and AIFs engaging in loan origination, must have a robust, appropriate, and effective procedures in place, as well as to address all related aspects and risks. Transparency obligations are also imposed to AIFMs managing AIFs that engage in loan origination, for periodic disclosure of the composition of the originated loans portfolio to investors.

AIFMD II sets certain restrictions to restrict conflicts of interests and ensure a uniform level of investor and public interest protection. Particularly, it restricts AIFs from granting loans to related parties such as its AIFM or its staff or other group entities (save for certain exceptions), to the depositary or sub-depositary, or to an entity being part of the same group as the AIFM.

Furthermore, it restricts AIFMs from managing AIFs engaged in originating loans solely for the purpose of selling them to third parties (referred to as an 'originate-to-distribute strategy') while it provides the authority to Member States to prohibit loan origination activities targeting consumers, i.e. natural persons acting outside their trade, business, or profession.

In addition, certain risk mitigation rules are introduced, to preserve market stability. Reference is made to a concentration limit of 20% on loans granted when the borrower is a financial undertaking or another AIF, as well as to the obligation to retain at least 5% of the notional value of each loan the AIF has granted and subsequently transferred to third parties, for a period of 8 years or up to maturity for loans of less than 8 years.

With respect to safeguarding of the stability and integrity of the financial system, stricter rules apply for certain AIFs that their investment strategy is primarily the provision of loans, or which have granted loans with notional value greater than the 50% of the AIFs net asset value, the so-called Loan Originating AIFs. Such AIFs must be closed-ended unless, by way of derogation, the AIFM can demonstrate that its liquidity risk management system is compatible with the AIF’s investment strategy and redemption rules. Such AIFs are subject to leverage restrictions, varying depending on whether the AIF is closed-ended (capped at 300% of NAV) or open-ended (capped at 175% of the NAV), as open-ended AIFs are perceived to pose greater stability risks due to their susceptibility to high levels of redemptions. National Competent Authorities may impose stricter limits should they deem it necessary.

In conclusion, being probably the most significant of the requirements introduced under AIFMD II, as well as most extensively negotiated during the legislative process, loan origination regime intends to assist the EU market for such funds, under a harmonized framework.

Whether or not harmonization will be eventually achieved, remains to be seen. Numerous details require further discussions among EU policymakers and industry participants, while it appears that the new framework is viewed positively by the funds industry.