EC’s proposals for reform of AIFMD and the ELTIF regime – how will the changes affect real estate managers?
Following its review of the scope and functioning of the Alternative Investment Funds Manager Directive1 (AIFMD), the European Commission (the EC or the Commission) has concluded that the AIFMD’s standards for ensuring high levels of investor protection are mostly effective, but that amendments are required which are intended to be targeted in scope but may have far-reaching effects for real estate fund managers.
The European asset management industry has more than tripled since 20082 and so has the European Real Estate asset class.3 Therefore, macro prudential oversight of EU investment funds, together with the wider systemic risk debate (given the interconnectedness of investment funds and asset management in the broader financial sector) feature prominently in the AIFMD and ELTIF Regime (the Commission Proposals), as expected. Liquidity risk management is front and center in these new reforms.
Under AIFMD, other important changes relate to delegation (which are expected to be more extensive and thus will be more onerous for real estate fund managers), data reporting for market monitoring purposes and regulatory treatment of custodians. These proposals are clear indicators of a move towards rule alignment with the UCITS Directive and a single investment funds rulebook to “support fund market integration.” Moreover, harmonized requirements at EU level for loan origination/direct lending funds are also introduced in the new directive.
The amended framework of the ELTIF Regulation seeks, for its part, to reduce regulatory costs for ELTIF managers and to remove barriers access for retail investors seeking to invest in ELTIFs (while maintaining the protections currently in force).
Liquidity risk management
Liquidity risk management is center stage in this review, which was to be expected given previous liquidity issues faced by some investment funds (eg 2008 financial crisis, property funds, COVID-19). As well as proposed changes to the rules for loan origination funds (detailed below), the rules on availability and use of liquidity management tools (LMTs) by real estate fund managers are to be harmonized to ensure that any response by real estate fund managers of open-ended AIFs or by EU regulators in market stress situations can be more effective and ensures fair treatment of investors. At present, AIFMD does not provide for a harmonized set of LMTs.
A minimum list of LMTs should be developed at the EU level. These include suspension of redemption and subscriptions, gates, notice periods, redemption fees, swing pricing mechanisms, anti-dilution levies, redemption in kind and side pockets. Real estate fund managers would be required to incorporate at least one LMT from the defined list in the fund’s constitutional document. ESMA is tasked with developing draft regulatory technical standards to provide definitions and specify the characteristics of the LMTs.
Real estate fund managers of open-ended funds will be able to suspend the repurchase or redemption of AIF units or shares temporarily in situations of market stress and they will have to implement detailed policies and procedures for the activation and deactivation of any LMT and the operational and administrative arrangements for the use of LMTs.
Finally, real estate fund managers will be required to disclose to investors under Articles 23 the conditions for using LMTs and to notify EU regulators about the activation or deactivation of an LMT. EU regulators may be granted the power to step in and require real estate fund managers (including non-EU AIFMs) to activate or deactivate a relevant LMT.
Loan origination/direct lending funds
The Commission Proposals introduce harmonized requirements at EU level for alternative investment fund managers (AIFMs) managing loan-originating AIFs to promote sound processes for loan origination/direct lending by AIFs and to further market integration in this segment. This should increase the aggregate level of non-bank financing available in the EU, with positive competition effects, while ensuring that the risks to the financial stability are better monitored overall. The Commission Proposals do not include a definition of what constitutes “loan origination.” However, importantly, a distinction is drawn between the granting of loans and loan purchasing. In addition, it is not envisaged that there will be grandfathering provisions for existing direct lending structures. In practice, direct lending funds may be used to provide credit facilities to real estate funds; however, real estate funds typically take advantage of loan facilities from other traditional bank and non-bank credit providers.
AIFMs managing AIFs, which grant loans, will be required to implement effective policies, procedures and processes for the granting of loans, including a credit risk assessment, and to administer and monitor their credit portfolios, which should be reviewed annually. This also covers the activity of purchasing loans on the secondary market.
Where a borrower is a financial institution or an AIF or a UCITS, AIFMs must comply with exposure limits to diversify their risk and must ensure that a loan originated to any single borrower by the AIF it manages remains below 20% of the AIF’s capital.
Annex I of AIFMD will be amended to recognize lending as a legitimate activity of AIFMs (meaning that AIFs will be able to extend loans anywhere in the EU, including cross-border in EU Member States where this activity is not yet permitted). As loan origination is an activity of the AIF rather than the AIFM, the current proposals could give rise to some ambiguity. Annex I of AIFMD has also been amended to legitimize servicing of Securitization Special Purpose Entities (SSPE) by AIFMs.
To avoid the immediate sale of loans on the secondary market, AIFs will be required to retain an economic interest of 5% of the notional value of the loans they have granted and sold off on an ongoing basis. They must also adopt a closed-ended structure where they engage in loan origination to a significant extent (in excess of 60% of NAV).
An AIF will be precluded from lending to its AIFM or its staff, its depositary or its delegate and it will be required, as part of Article 23 disclosure rules, to report to investors on their “originated loan portfolios” under the Article 23 disclosure rule.
The ELTIF Regulation
The review of the ELTIF Regulation aims at improving the attractiveness of the ELTIF as a fund structure for long-term investments and as a non-bank source of finance to the real economy. The amended framework seeks to reduce regulatory costs for ELTIF managers and to remove barriers to access for retail investors seeking to invest (while maintaining the protection currently in force).
To ensure that ELTIFs investment strategies can pursue a global investment mandate, the reference to European long-term projects is no longer included, given that the ELTIF framework explicitly allows the eligible assets and investments to be located in third countries.
The scope of the real asset investment strategies that ELTIF managers can pursue has been broadened. It now includes any assets that have intrinsic value due to their substance and properties, and implies that such assets include infrastructure, intellectual property, vessels, equipment, machinery, aircraft or rolling stock, and immovable property, including rights attached to or associated with real assets, such as water, forest and mineral rights. It also includes investments in commercial property, education, counselling, research, sports or development facilities, or housing, such as senior residents or social housing.
ELTIFs can invest in real assets provided that the minimum investment value of such assets is equal to at least EUR1 million and it is no longer necessary that real assets are owned directly or via “indirect holding via qualifying portfolio undertakings.”
What changes have not been included?
Finally, it is also interesting to note which reforms are not addressed in the Commission Proposals, including the lack of an AIFMD passport for sub-threshold real estate fund managers and the introduction of a depositary passport (although there appears to be movement in that direction in the longer term). Significantly, no changes are proposed to remuneration rules or leverage calculation methodology requirements. The non-listed companies’ rules, although noted as not adding any value in the AIFMD review process by DG FISMA, were not amended.
Timing and next steps
EU Member States will have 24 months after the entry into force of the amending omnibus directive, which is expected in early 2023, to transpose the legislation and new requirements into national legislation, meaning that the legislative changes are expected to take effect in early 2025.
1 Directive 2011/61/EU
2 Source: COM(2021) 721 reference 2021/0376 (COD), page 2
4 Source: “Fund Manager Survey 2021” by ANREV, INREV and NCREIF