Martin Mager and other Luxembourg stakeholders are calling for changes to the review of the Alternative Investment Fund Managers’ Directive Linklaters

Martin Mager and other Luxembourg stakeholders are calling for changes to the review of the Alternative Investment Fund Managers’ Directive Linklaters

Private debt, an exciting alternative asset class growing in size and maturity in Luxembourg is under threat from new EU legislation which could clip its wings -- with consequences not just for Luxembourg but for rebuilding the European economy. Martin Mager, partner at Linklaters, Luxembourg, explains a little about how this critical source of financing for small businesses could inadvertently become collateral damage of the European Union’s Alternative Investment Fund Managers’ Directive review.

“The EU proposals are well designed to manage risk in alternative assets,” Mager says. “However, they need some revisions in order to avoid negatively impacting the environment for private debt in Luxembourg.”

Private debt, which refers to loan-originating funds that provide financing for small businesses whose model or growth requirements mean they cannot access a bank loan, falls under the umbrella of alternative assets and therefore the AIFMD. However, there are some key tenets of the proposed amendments of the legislation that could inadvertently harm the flourishing private debt market in Europe, and particularly in Luxembourg, home to 35% of Europe’s private debt funds.

“Debt funds are a very important source of financing for the real economy,” says Mager. In fact, the market has grown rapidly since the retrenchment of banks during the 2008 financial crisis, and even more since the covid pandemic, leaping 40.6% to €181.7 billion in assets under management in Luxembourg the past year alone as an important complementary source of financing to public funding and bank loans, according to KPMG and the Association of the Luxembourg Fund Industry figures.

Until recently, Luxembourg has provided a liberal regime for these loan funds. However, this could change, cautions Mager. “Certain aspects of the AIFMD would hinder the effective management of these funds, and others would actively reduce the launch of such structures and deprive the real economy from the benefits of loan funds.”

Restrictions on loan origination

The AIFMD is designed to protect investors in alternative investment funds by providing a supervisory framework for alternative investment fund managers. In 2021, some tweaks to the original text were proposed by the European commission, particularly targeting alternative investment funds that issue loans.

According to Mager, the new proposals contain two principal elements that would be harmful to private debt funds. The first is a new stipulation that if 60% of alternative investment fund assets are originated assets, then the fund must be closed-ended. The idea is to avoid any maturity mismatches that may present themselves in an open-ended fund, but this inadvertently impacts private debt funds which typically have a shorter-than-average holding period than the more illiquid alternative asset funds the 60% rule is designed to target, says Mager.

“Private debt funds typically grant loans or other debt instruments to a diversified range of businesses for limited holding periods of around two to three years. For this they often use open-ended fund vehicles. An open-ended structure gives the investor regular redemption rights which is attractive to both institutional and retail investors,” he says. “We have noticed growing interest from well-established fund managers for open-ended loan originating structures in private debt. Limitations such as the 60% limitation would actively reduce the launch of such structures and deprive the real economy from the benefits of loan funds.”

A more efficient way to manage maturities and liquidity windows could be through robust risk management governance of the AIFM, says Mager. “We are unaware of any inability to manage maturity mismatches in loan origination funds but if this arose it would in our view be a governance issue and not a portfolio management issue,” he says.

A second proposal in the revised text requires that fund managers, as a risk-retention measure, retain 5% of the value of loan if they sell it. Although the risk retention requirement is designed to address potential moral hazard concerns and promote sound credit underwriting and due diligence practices, it poses some adverse consequences to private debt in its current form, says Mager.

“Selling loans is often part of the normal exit strategy of a loan fund,” explains Mager. In fact, “there are many legitimate reasons why credit fund managers may sell a loan that they have originated. In particular, to perform portfolio allocation and rebalancing in line with their mandate and in order to achieve the desired returns.”

He suggests instead that there could be a more general requirement to prohibit private debt funds from originating loans with the sole purpose of transferring those loans to third parties or to limit the risk retention to a short time period following the origination.

Impact for Luxembourg and European small businesses

Given that a significant chunk of Europe’s private debt is domiciled in Luxembourg, ALFI and a number of other stakeholders are in consultation with the commission to adapt the current AIFMD proposals.

“Debt funds are a very important source of financing for the real economy,” says Mager. “As such, it is critical in rebuilding the European economy and in line with the objectives of the EU’s capital markets union.”

Policy-wise, the commission itself makes active use of debt funds in order to diversify sources of financing for small businesses. One example is European institution the European Investment Fund, which has invested in around 45 private debt funds across Europe in order to support policy goals of increasing funding sources for small businesses. In fact, “a considerable number of open-ended loan funds are those sponsored by government entities to help finance the real economy,” says Mager.

Additionally, around 33% of private debt funds are classed as article 8 under sustainable finance disclosure regulation, meaning that they promote environmental and social governance characteristics. A further 6% fall under article 9, which means that they actively take sustainable investment as their objective and measure its performance in relation to ESG.

Mager is at pains to point out that the AIFM directive is in general supportive of the management of alternative assets in Europe. In fact, one particular feature of the new proposals will improve cross-border loan issuance for private debt funds.

“The new proposals allow alternative investment funds to extend loans anywhere in the European Union – something we welcome because it allows the origination of loans irrespective of local banking regulation and will create a level playing field in private debt,” he says.

The outstanding issues with the proposals arise from a common misconception that private debt funds, due to their illiquidity, will all be closed-ended. “They often are not,” he argues. Flagging this misconception as part of the consultation is a step in the right direction for preserving a welcoming regime for private debt under the AIFMD, he adds.

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