EC Proposals for reform of AIFMD, UCITS Directive and the ELTIF regime: Welcome changes or regulatory creep?
Following its review of the scope and functioning of the Alternative Investment Funds Manager Directive1 (AIFMD), the European Commission (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. Towards the end of November 2021, the Commission published new legislative amendments to AIFMD, the UCITS Directive2 (UCITSD) and the ELTIF Regulation3 (ELTIF Regulation) (the Commission Proposals).
Several commentators stressed that the amendments proposed are evolutions rather than revolutions. However, we believe that some of them may have far-reaching effects. After briefly contextualizing the proposals, we will come back to the main changes proposed and highlight those with highest potential impact for the asset management industry.
Context: towards a single investment funds rulebook?
The Commission identified three key drivers giving rise to the need to review the AIFMD, namely:
- incomplete or inefficient regulation (eg fragmented rules on and availability of liquidity management tools, differing national requirements for loan originating funds and different regulatory treatment of custodians, as well as overlapping or missing supervisory reporting data);
- market developments (eg growth in AIFMs managing loan origination funds, liquidity mismatches and limited supply of depositary services in smaller markets);
- inconsistent application of rules in EU Member States, with particular regard to the delegation regime.
The Commission is of the view that these drivers have given rise to difficulties in monitoring and managing financial stability risks; inefficiencies in the internal market (especially, in managing investment funds); and inadequate protection of fund investors, undermining trust in the market, which it has sought to address through these new proposals.
The European asset management industry has grown significantly since 2008 (from EUR5.5 trillion in assets under management assets to over EUR15 trillion4 in assets under management). Therefore, macro prudential oversight of EU investment funds, together with the wider systemic risk debate (given the interconnectedness of investment funds and asset management with the broader financial sector) feature prominently in the Commission Proposals, in line with the Financial Stability Board5 and Iosco agendas. It comes as no surprise that liquidity risk management is front and centre in the new reforms. The Commission Proposals seek to implement targeted amendments, but some are far-reaching and the overall scope is wide. Key amendments to both AIFMD and UCITSD, in relation to delegation, liquidity risk management, data reporting for market monitoring purposes and regulatory treatment of custodians are indicative of a move towards rule alignment and a single investment funds rulebook to “support fund market integration.”
While delegation rules were recognised as “robust,” the new requirements in relation to delegation are more extensive and onerous for AIFMs and will also be extended to the UCITS regime.
Significantly, and going far beyond initial discussions and feedback, the Commission Proposals seek to implement transaction reporting for financial instruments and transparency on costs and fees, akin to MiFID6 type requirements.
It is also interesting to note what reforms are not addressed within the Commission Proposals, including the lack of an AIFMD passport for sub-threshold AIFMs 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.
Overview of key changes to AIFMD, UCITS and ELTIF rules – Potential far-reaching effect
Liquidity Risk Management
Prominence of the liquidity risk management topic was expected given previous liquidity issues in investment funds (eg 2008 financial crisis, property funds, COVID-19) and recommendations made by the ESRB in 2018 to review AIFMD and UCITSD with a view to include additional liquidity management tools for open-ended funds.7
As well as proposed changes to the rules for loan origination funds (see below), the rules on availability and use of liquidity management tools (LMTs) by AIFMs and UCITS management companies are to be harmonised. At present, neither the existing AIFMD or UCITSD provide for a harmonised set of LMTs.
Delegation and substance framework
The review of the AIFMD aims at, inter alia, better protecting investor interests by ensuring that the investment fund managers, when delegating their functions to third parties, adhere to the same high standards applicable across the EU. In such a context, the Commission proposes that sufficient human resources are deployed to supervise the delegate as well as ensuring that the core functions are retained by the AIFM or UCITS manager.
Loan Origination/Direct Lending Funds (AIFs Only)
The Commission Proposals introduce harmonised requirements at EU level for AIFMs managing loan-originating AIFs in order to promote sound processes for loan origination/direct lending by AIFs and to further market integration in this segment, thus increasing 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.
The Commission’s Proposals seek to dilute depositary market concentration in certain small markets and enhance efficiency by enabling cross-border access to the depositary services “where needed until the time where positive regulatory developments are observed in this area.” The Commission Proposals should lead to an increase in access to depositary services cross border. However, this does not yet equate to a depositary passport which was deemed unfeasible given the absence of EU harmonisation of securities and insolvency laws and also considering the negative potential effect that it could have, according to the Commission, on investor protection, considering that there could be a situation – challenging to supervise – where the AIF, the AIFM and the depositary could be situated in three different Member States.
Marketing under National Private Placement Rules (AIFs Only)
It is proposed that AIFMD will be amended to refer to the EU list of non-cooperative jurisdictions as opposed to the previous FATF list of Non-Cooperative Countries.
Significantly, two new requirements are proposed in relation to non-EU AIFs (managed by either an EU or non-EU AIFM) which seek to be marketed in an EU Member State:
- The non-EU AIF may not be domiciled in a non-cooperative jurisdiction as defined by the EU Council from a tax perspective.
- The non-EU AIF may not be domiciled in a “high risk country.”8
Data reporting: towards a new approach to supervisory data
The Commission Proposals seek to develop an integrated data collection system to deliver accurate, comparable, and timely data to European and national supervisory authorities, while minimizing reporting costs so they can support market monitoring, with ESMA developing draft RTS specifying the details to be reported. The new requirements seek to avoid duplication and overlap of reporting requirements applicable to managers, a prominent request from the industry during the AIFMD review process, while continuing to rest the requirement for additional reporting with the AIFMs, rather than national supervisory authorities.
In practice, an incremental approach relying on an in-depth feasibility study by supervisors including potential synergies under various EU laws is proposed. However, it is also proposed to “expand data coverage to enable better monitoring of markets.” Amendments to Art 24(1) and (2) of AIFMD to remove limitations on the data that competent authorities should be able to receive from AIFMs on managed AIFs will no doubt be carefully monitored by the industry. ESMA is expected to draft RTS and ITS to replace the current Annex IV AIFMD template on supervisory reporting and to submit to the Commission a report for the development of an integrated supervisory data collection two years after entry into force of the AIFMD.
On the UCITS side, ESMA is expected to produce a report for the development of an integrated supervisory data collection focused on avoiding duplications and inconsistencies and to improve data standardisation and efficient use of data already reported in the EU. This should be done two years after entry into force of the revised UCITSD.
Fees and Charges (AIFs Only)
Significantly, and in line with MiFID requirements, the Commission Proposals seek disclosure of fees that will be borne by the AIFM or its affiliates and periodical reporting on all direct and indirect fees and charges that will be directly or indirectly charged or allocated to the AIF or to any of its investments (which will have to be completed quarterly).
Summary of changes to 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 to ELTIF for retail investors (while maintaining the protection currently in force).
To conclude: data and substance, more than ever … at what cost?
In line with the original focus of AIFMD in relation to systemic risk monitoring and enhanced transparency towards investors and regulators – some asset managers even said at that time that AIFMD was all about creating data lakes and repositories – the new Commission proposals open the door to more granular data reporting and an “expanded data coverage.” In addition, UCITS might fall in the scope of supervisory reporting, and MiFID-type disclosure on direct and indirect fees are foreseen.
Substance requirements are not left out, with more prescriptive rules proposed in terms of minimum human resource, for instance.
It remains to be seen whether the Commission proposals will definitely be a source of new opportunities to seize for asset managers and service providers to the industry (see possible cross-border access to depositary services, availability of minimum LMTs, or ELTIF regulation amendments). But it is also an area that will require close monitoring and engagement from the industry to strike the right balance between feeding informative data able to trigger relevant signals and accumulating figures costly to produce while creating limited value for the market at large.
At a time when actual journeys remain constrained and limited, the Commission is inviting us on a new regulatory trip. Let’s embark, but remain cautious and let’s not lose sight of the competitive challenge for Europe and its asset management industry.
Nb: We expect legislative changes to take effect in early 2025 in EU Member States (24 months after the entry into force of the amending omnibus directive, which is expected in early 2023).
1 Directive 2011/61/EU.
2 Directive 2009/65/Commission, as amended.
3 Regulation (EU) 2015/760.
4 Source: COM(2021) 721 reference 2021/0376 (COD), page 2.
5 See FSB Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities January 2017
6 Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU Text with EEA relevance.
7 ESRB/2017/6 – Recommendation on liquidity and leverage risks in investment funds
8 Directive (EU) 2015/849.