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AIFMD states that the employment of leverage by an AIFM may contribute to the “build-up of systemic risk” or “disorderly markets”. It defines leverage as “any method by which the AIFM increases the exposure of an AIF it manages whether through borrowing of cash securities, or leverage embedded in derivative positions or by any other means”. This definition is wide and particularly in light of the calculation methodologies required to be employed, the amount of “leverage” employed in an AIFMD sense is often far higher than borrowing limits which may otherwise be set out in fund documents from a commercial perspective.
Under AIFMD, Member States shall ensure that each authorised AIFM shall set leverage limits in respect of each AIF it manages.
AIFMD II will introduce a new definition of “leveraged AIF”, which means “an AIF whose exposures are increased by the AIFM that manages it, whether through borrowing of cash or securities, leverage embedded in derivative positions or any other means”. This is relevant for supervisory cooperation and leverage limits.
New rules relating to “loan-originating AIFs” will be introduced by AIFMD II, which include leverage limits for such AIFs. See the “Loan Origination” page for more information.
As set out in more detail here, an AIFM which is authorised under AIFMD or which markets an AIF in the EU is required to make certain disclosures to investors regarding the leverage employed on behalf of the relevant AIF.
Some of these disclosures are required to be made to investors before they invest, and some are required to be made on a periodic basis.
In order for the home regulator to identify the extent to which the use of leverage contributes to the build-up of systemic risk in the financial system or risks disorderly markets, Article 24(4) AIFMD requires that an AIFM which is fully authorised under AIFMD and that manages an AIF employing leverage on a “substantial basis” is required to make available to its home regulator information about:
The Level 2 Regulations state that leverage shall be considered to be employed on a substantial basis when the exposure of an AIF calculated according to the Commitment Method (as described below) exceeds three times its net asset value.
The home regulator shall also ensure that such information is made available to other relevant EU regulators, ESMA and ESRB. In exceptional circumstances, ESMA may request that home regulators impose additional reporting requirements.
These rules also apply to AIFMs that market AIFs in accordance with the marketing rules contained in AIFMD.
AIFMD II will amend the reporting information required by Article 24(2)(c) to specify that, when reporting on the AIF’s current risk profile, an AIFM must, for each EU AIF it manages and for each AIF it markets in the EU, provide detail about the total amount of leverage employed by the AIF to its home regulator.
The power noted above for ESMA to require additional reporting requirements in exceptional circumstances will be amended to make clear that it could do so only after consulting the ESRB.
AIFMD II introduces a requirement for ESMA to develop draft Regulatory Technical Standards and Implementing Technical Standards on the detailed reporting requirements by 16 April 2027.
In order to limit the extent to which leverage contributes to the build-up of systemic risk in the financial system or risks disorderly markets, the home regulator is permitted to impose its own limits on the level of leverage an AIFM may employ or other restrictions on management (after having notified ESMA and ESRB).
In addition, after taking into account the advice of ESRB, if ESMA makes a determination that the leverage employed by an AIFM poses a substantial risk to the stability and integrity of the financial system, it may specify remedial measures to be taken by the home regulators, which include limits on the degree of leverage which the AIFM may employ.
Article 112 of the Level 2 Regulations sets out principles that competent authorities should take into account in determining whether to exercise their power to impose leverage limits or other restrictions on AIFMs. In December 2020, ESMA published guidelines addressing the framework that competent authorities should use to identify AIFs or groups of AIFs whose use of leverage poses risks to the financial system, and considerations that they should take into account in determining what leverage limits or other restrictions they should impose on such AIFs.
The leverage rules in AIFMD are essentially aimed at leverage employed at the level of the AIF. Exposure which is contained in any financial or legal structures controlled by the relevant AIF must be included in the calculation of the exposure where those structures have been specifically set up to increase, directly or indirectly, the exposure of the AIF. However, for the purpose of calculating leverage for private equity funds for example, any exposure that exists at the level of either the relevant financial structure or investee companies should be excluded where the AIF’s or the AIFM’s exposure is limited to its investment in such financial structure or such companies (as applicable).For more detail, see ESMA’s guidance on calculation of leverage here under Section VII of the AIFMD Q&A.
Additionally, temporary borrowing should be excluded where it is fully covered by capital commitments from investors. It may be worth noting that revolving credit facilities could give rise to borrowing which is not temporary in nature, particularly if utilised on a continually rolling basis.
In calculating leverage, the Level 2 Regulations require:
When calculating an AIF’s exposure using the Gross Method, AIFMs should:
When calculating an AIF’s exposure using the Commitment Method, AIFMs should:
Financial derivatives instruments do not need to be taken into account where they do not provide incremental exposure or leverage. By way of example, where an AIF that invests in an index futures contracts and holds a cash position equal to the total underlying market value of such contract, its exposure is deemed to be equivalent to its exposure resulting from a direct investment in the index shares. On that basis, using such a futures contract does not create any incremental exposure.
The Luxembourg rules on maximum leverage limits are set out in the Luxembourg AIFM Law (articles 15(4) and 23(3))
The Luxembourg rules on investor disclosure rules are contained in the Luxembourg AIFM Law (article 21.(5)), while the rules on reporting on leverage are set out in article 22(4).
In addition, the CSSF’s powers to impose its own limits on the level of leverage an AIFM may employ are set out in article 23 of the Luxembourg AIFM Law.
The FCA’s rules on maximum leverage limits are set out in the FCA Handbook (FUND 3.7.7 to 3.7.9) and require an AIFM which is fully authorised by the FCA.
The FCA’s rules on investor disclosure rules are contained in the FCA Handbook (FUND 3.2.1(1) and FUND 3.2.6) and the rules on FCA reporting on leverage are set out in FUND 3.4.5.
Finally, the FCA’s powers to impose its own limits on the level of leverage an AIFM may employ or other restrictions on management are set out in Regulation 68 of the UK Regulations.
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