Patient Capital: The Retailization of Illiquid Funds

June 26, 2020

I recently had the pleasure of virtually meeting with Lora Froud, Partner at Macfarlanes, to discuss the growing focus in asset management on retail investor access to less liquid alternative investment funds. What follows is some highlights and key considerations arising from that conversation.

Adrian Whelan: Why is the concept of retailization of illiquid funds in such sharp industry focus right now?

Lora Froud: Investors want to put their pension money to work effectively. As it is likely to be invested for, say, 20 or 30 years, they recognise the benefits of accessing a diversified portfolio, which would ideally include some longer term, less liquid, asset classes with the corresponding potential for higher returns. Pension investors do not need daily access to their investments and there is therefore no sound reason for their portfolios to be limited to liquid listed equities and bonds.  

To date, illiquid asset classes have typically been held in fund vehicles which cannot be accessed by retail investors. There is now increasing demand from defined contribution (DC) schemes and wealth managers (in respect of their “mass affluent” clients) to access illiquid assets as part of a more diversified portfolio.

Retailization also represents an opportunity for an alternative source of investment in the economy. This is something the Government has recognised for some time now, as evidenced through its work on “Patient Capital.” This need, however, has been further highlighted as a result of the desire to increase investment in the economy following the damaging effects of COVID-19. Infrastructure projects and unlisted companies are two examples of illiquid assets that desperately need to source additional funding options. Frequently, long term investment projects have an ESG angle, which is also desirable. 

There are ways of retail investors gaining access to long-term investments now, through investment trusts, non-UCITS retail schemes (NURS), and European Long-Term Investment Funds (ELTIF). These vehicles work to a greater or lesser extent for some types of investors, but they are not fit for purpose for all. The industry needs to ensure it delivers access to these investments in a way that works for all investors.

Clearly the retailization of illiquid funds must be done prudently, particularly given the widespread impact of the liquidity issues faced by the Woodford funds. A key way to achieve this is to ensure dealing frequency matches the liquidity of the underlying portfolio.

Adrian Whelan: In the UK, recently the Investment Asscoiation (IA) has advocated strongly for the Long Term Asset Fund (LTAF). What is the LTAF and why is it seen as important?

Lora Froud: The LTAF is a regulated, open-ended product which is fit for purpose to allow certain types of retail investors access to private market investments, e.g. private equity, private debt, infrastructure and real estate.

The blueprint for the LTAF was developed by the IA in 2019 as part of the final report published by the IA UK Funds Regime Working Group (which provides a strong vision for enhancing the competitiveness of the UK investment fund industry). Macfarlanes has been heavily involved in the LTAF working group.

The LTAF is a “flavor” of NURS which also draws on aspects of the closed-ended world:

Flexible investment and borrowing powers: The LTAF would have more flexible investment restrictions than a NURS and be able to invest directly in limited partnerships and more freely in unlisted securities. The LTAF would also have the ability to borrow at the fund level or provide guarantees in order to assist with making investments and bridging redemptions. These extended borrowing powers may include the ability to lend or originate loans.

Open-ended vehicle with flexible dealing frequency: The manager of an LTAF could structure the redemption opportunities to match the liquidity profile of the LTAF’s underlying assets. For example, by offering a dealing frequency of anything between daily to annual, or even up to every two years.  

Available to ‘semi-professional’ retail investors and DC market: The LTAF would be available to specific types of investors, provided they meet certain criteria. Such criteria will likely relate to their wealth and/or level of experience, and institutional investors, such as DC schemes, would be eligible.

Strong investor protections: Given the potential infrequency of redemption opportunities and the range of liquidity management tools that would be available to the manager of an LTAF, appropriate investor protection measures would be incorporated. These might include the need for investment advice to be taken prior to investment and/or a limit placed on the amount of an individual’s assets/pension pot which can be invested in an LTAF.

There was traction with the FCA at the end of 2019 to consider the LTAF proposals.  Further progress was delayed due to COVID-19 but it is becoming an increasing priority again, given the potential of the LTAF to aid the post-COVID-19 recovery.

The IA is currently preparing a response to the FCA’s questions on the LTAF proposal. Timing for any further developments is unclear but the hope is that the IA will respond to the FCA later in the summer and we may hear something further from the FCA later this year.

Adrian Whelan: What does the future hold for retail access to less liquid alternative fund structures?

Lora Froud: We are hopeful the LTAF will progress in the UK, offering UK investors a new way in which to access this important asset class in a proportionate, regulated way, alongside closed ended investment trusts. It is a great way for the UK to differentiate itself and to assist with investing in the economy, post COVID-19.

We also think we will continue to see progress in the EU in this space. For example, the review of the ELTIF Regulation is all about fixing some of the issues with the ELTIF and making it more fit for purpose.

This is a worldwide project, though. The US, for example, has to date been behind the curve on this but just last week the US Department of Labor released new guidance to facilitate the inclusion of private equity exposure in defined contribution plans subject to ERISA. This was apparently in direct response to Trump’s executive order in May to remove barriers to economic prosperity in order to overcome the effects COVID-19 has had on the economy.

Far from COVID-19 stifling global developments in this space, we think it will ultimately accelerate them. The views expressed in this material are those of the author as of [date] and may or may not be consistent with the views of Brown Brothers Harriman & Co. and its subsidiaries and affiliates (“BBH”), and are intended for informational purposes only. Neither, Brown Brothers Harriman, its affiliates, nor its financial professionals, render tax or legal advice. Please consult with attorney, accountant, and/or tax advisor for advice concerning your particular circumstances. BBH is not affiliated with Lora Froud.

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