Private credit fund managers prepare for stricter EU rules

Private credit fund managers in the EU are preparing for tougher regulations that have been described as a “shift change in approach”.

On 7 February, the European Parliament voted to update the Alternative Investment Fund Managers Directive (AIFMD) to add new requirements for managers of alternative investments, including loan origination funds.

The text of the Directive was then voted on by the European Council on 21 February.

Read more: EU Council adopts new private credit rules

Some of the key changes include limits on leverage, ensuring ‘skin in the game’, and new measures to limit exposure to a single borrower.

Private credit managers are already subject to certain rules and data reporting requirements, particularly if they are targeting retail investors. However, the new EU rules will implement higher standards for funds aimed at professional investors.

Under the new rules, the leverage of closed-ended loan-originating alternative investment funds (AIFs) will be capped at 300 per cent of their net asset value, while open-ended ones will be capped at 175 per cent.

Additionally, the EU has introduced a 20 per cent concentration limit on loans to a single borrower, if the borrower is a financial institution. This is intended to limit the risk of interconnectedness among loan-originating AIFs and other financial market participants.

The rules also require funds to retain five per cent of the value of each loan they originate.

And fund managers are prohibited from managing AIFs with an “originate-to-distribute strategy,” with the sole purpose of transferring those loans to third parties.

“The AIFMD was not conceived as a product-regulating directive and the inclusion of a loan origination framework represents a shift change in approach,” law firm Linklaters said in a recent report.

“However, there is a lot that still needs to be clarified either via regulatory technical standards (RTS) to be prepared by the European Securities and Markets Authority (ESMA) and then adopted by the Commission, or in member state implementation and guidance, and so the picture for loan originating AIFs is still a developing one.”

Open or closed?

All loan-originating AIFs are encouraged to be closed-ended, but they can be open-ended if the manager is able to demonstrate to the regulator that the fund’s demonstrate to its home regulator that the AIF’s liquidity management system is compatible with its investment strategy and redemption policy.

ESMA is required to develop draft regulatory technical standards within 12 months, after the new Directive is introduced. These will determine the requirements that a loan-originating AIF must comply with, in order to maintain an open-ended structure.

These requirements will include a robust liquidity management system, the availability of liquid assets and stress testing, as well as an appropriate redemption policy given the liquidity profile of the loan originating AIF, and take due account of the underlying loan exposures, the average repayment time of the loans and the overall granularity and composition of the portfolios.

Investor disclosures

Funds will now need to make a full list of fees, charges and expenses available to investors before they invest.

Additionally, fund managers will need to periodically report to investors on the composition of the loan portfolio.

They will also need to report annually to investors on any fees and charges, and on any parent company or subsidiary utilised in relation to an AIF’s investments by or on behalf of the fund manager.

ESMA is going to produce a report within 18 months of the new Directive coming into force, to assess the costs charged by fund managers to their investors.

This process aligns with the wider regulatory examination of the fair treatment of customers within the retail investment sector in both the UK and EU.

Timeline

The new rules are expected to enter the EU’s official journal by April and be adopted in national laws within two years, according to EU officials cited by Bloomberg.

Funds would then have a further year to meet the additional data reporting requirements.

UK funds

The EU rule changes will not automatically impact UK fund managers. However, the Financial Conduct Authority (FCA) is consulting on amending the UK AIFMD and is re-evaluating the rules for non-UCITS retail funds in 2024, and will review the regulatory reporting regime in 2025.

“The FCA would like to use a set of consistent rules across all managers of alternative funds,” Linklaters said. “Rather than having two different categories of manager (i.e. above and below an AuM threshold) and applying different rules to each, it is exploring ways to ensure the regime operates proportionately depending on the nature and scale of a firm’s business.

“The FCA will work with the Treasury to explore how to make regulation work better for ‘small registered’, ‘small authorised’, and ‘full scope’ managers.”

Respondents to the FCA’s May 2023 discussion paper on updating the UK regime for asset management, highlighted that AIFMD prevents full-scope AIFMs from carrying out other activities within the same legal entity. The FCA is considering modifications in this area.

Rules and risks

The $1.7tn (£1.3tn) private credit industry is predicted to grow to $2.8tn by 2028, according to data provider Preqin.

The fast growth of the sector has prompted concerns from authorities worldwide about whether it presents a risk to financial stability, due to a lack of data transparency, the underlying illiquidity of the assets and the impact of high interest rates on defaults.

Oliver Gajda, executive director of the European Crowdfunding Network, welcomed the new EU rules but called for them to go further to protect retail investors.

“As institutional investors increasingly dominate private credit markets, there’s a risk of systemic fallout,” he said. “Tighter regulatory oversight is crucial for market stability. The entry of traditional investors into this space suggests a demand partly driven by regulatory arbitrage, with fund managers and institutional investors finding the risk profiles appealing.

“However, it’s crucial to strike a balance in regulatory approaches to address challenges stemming from banks’ retreat from the credit market. In this context, the EU proposal is a relevant step towards maintaining market integrity and mitigating systemic risks.

“Unclear are the motivations of European regulatory limitations excluding retail investors, notably through the Consumer Credit Directive, and the continued exclusion of consumer protection in direct private credit for retail investors by the European law makers.”