When it is obvious that the goals cannot be reached, don’t adjust the goals, adjust the action steps
One of the purported benefits of the U.K. leaving the European Union was that it would have autonomy and flexibility to frame regulations outside of the large EU policy making machine. An acid test of this newly found policy freedom was the Long-Term Asset Fund (LTAF), the U.K.’s initiative to create a new authorized fund structure to house less liquid investments for U.K. investors. The Chancellor of the Exchequer, Rishi Sunak, claimed that it was his ambition that the LTAF would be launched by the end of 2021 and given the Financial Conduct Authority (FCA) publicly consulted on the LTAF ruleset in May 2021, and the final rules were published in October 2021, it can be said that in terms of speed of movement it has passed that test.
The LTAF became officially available on November 15, 2021. However, as the Regulatory Field Guide went to press none had yet been approved by the FCA.
The intention behind the creation of the LTAF is to provide the U.K. with an open-ended fund structure that allows investment in long term less liquid asset classes while also offering robust structural and governance safeguards. The governance framework is particularly important given the LTAF concept is largely a reaction to certain high-profile negative liquidity events found in other U.K. structures in recent years. While fund liquidity events are not unique to the U.K. market, certain sensitivities remain particularly acute within the FCA given the widespread impact of the liquidity issues faced by the Woodford funds1 and certain authorized open-ended property funds matters that continues to rumble on.
Weighed against that backdrop, there was also great appetite within the U.K. to create a newly authorized fund vehicle to make it easier for defined contribution (DC) pension schemes, and professional, sophisticated and high net worth investors to access alternative and illiquid assets through an open-ended fund structure. Historically, U.K. investors would invest in long-term assets through closed ended structures such as limited partnerships, or investment trusts with a relatively narrow band of eligible investors granted access. It was agreed that the LTAF must be supported by strong levels of transparency, governance, and investor protection given its target investor base.
In addition to helping DC pensions with increasing exposure to higher returning long term assets with a view to bridging the widening pensions funding gaps, another touted positive knock-on effect of LTAF is its ability to act as a conduit to channel private finance towards a range of UK private market opportunities and boost the so called “real economy”.
Predominantly, the U.K. asset management industry participants were pleased with the final LTAF rules, considering the FCA accommodated many of the points raised through the mid-2021 consultation. However, there are some challenges and items which need to be addressed in practical terms before asset managers can truly be up and running successfully on LTAF asset gathering. While the LTAF is technically “live,” there remain crucial wrinkles to be ironed out before we see growth in the market. But what is certain is that investor appetite and latent demand is high and now the U.K. has a fit-for-purpose fund structure to cater for investors who want long term exposures, flexible redemption terms and a high level of governance oversight on their fund investments. 2022 will be a big year for LTAFs in the U.K.
Let’s assess the top 10 LTAF points of interest:
1. Redemption Terms
The LTAF is an open-ended fund structure. Redemptions must not be available more frequently than monthly and a minimum notice period of 90 days to redeem also applies. The notice period makes sense in terms of alleviating some of the liquidity mismatch issues previously experienced. However, in practical terms it raises operational issues for the U.K. market. The LTAF is primarily targeted at DC pension schemes and wealth management segments each of whom typically access their investments through investment platforms. Platforms generally operate on daily dealing life cycles and their operational models are largely hard coded for daily dealing and therefore might not be operationally ready to accommodate these notice periods in the short term. With the LTAF potential opportunity evident, it is hoped that the requisite investments are made to accommodate this new operational reality.
2. Structuring and Distribution
The LTAF may be established as a unit trust, open ended investment company (OEIC) or an Authorized Contractual Scheme (ACS). The FCA considers that the principal target market for the LTAF is professional investors and in particular DC pension schemes, as well as sophisticated retail investors. LTAF comes under the definition of a non-mainstream pooled investment (NMPI) rather than a non-UCITS retail scheme (NURS). However, the FCA has at the same time tweaked its NMPI rules to specifically allow the LTAF to be sold to certificated high net worth investors as part of a diversified portfolio. Therefore, LTAFs will be sold through wealth management channels to eligible investors providing a more diversified source of inflows beyond merely the DC pension market. The FCA is also making technical changes to the permitted links rules to help DC pension schemes accommodate illiquid assets more easily within their portfolios via the LTAF. And finally, consultation in 2022 will consider further broadening LTAF access among retail investors.
3. Investment and Borrowing Powers
The FCA expects an LTAF to invest at least 50% of its assets in unlisted securities and other long-term assets such as interests in immovables or other funds investing in such assets. This confirms an LTAF can be comprised of a mix of unlisted assets, listed but illiquid assets and investment in other illiquid funds (both regulated and unregulated, including limited partnerships). Further, there is no requirement to ensure the underlying Collective Investment Scheme (CIS) does not invest more than 15% in other CIS, which is welcome since it allows investment into “funds of funds”. There are also specific initial and ongoing due diligence requirements where an LTAF invests more than 20% in unregulated funds or other LTAFs. Investment in intermediate holding vehicles, domestic and overseas is permitted. The final rules also relax some of the originally proposed restrictions in respect of the LTAF investing in loans, which will be of interest to credit managers.
Another useful outcome from the consultation is that the FCA has clarified that the LTAF should be generally invested in long term assets as a strategy and is not specifically applicable to any point-in-time snapshot of the LTAF’s holdings. This gives LTAF managers increased flexibility, particularly immediately after launch when scaling up investments or in the case of significant redemptions where assets are sold off to fund redemption proceeds.
LTAF borrowing is permitted up to 30% of the net asset value which is less than the 100% allowed for QIS, but there are no rules on aggregate borrowing of underlying investments. There is no derogation of the limit during the start-up period.
The valuation rules are largely retained and do not reflect much of the industry feedback from the consultation. This is perhaps indicative of the balancing act the FCA has to contend with given previous fund liquidity events and its desire to retain high levels of oversight while also fostering an LTAF regime flexible enough to thrive. Importantly, the final rules row back on a previous FCA suggestion to have LTAF depositaries determine “without qualification” that the LTAF manager has the necessary knowledge, skills, and experience to value the LTAF’s assets. The final rules merely require that the depositary determines that the LTAF manager has the resources and procedures for carrying out such a valuation. An LTAF manager is required to appoint an “external valuer”, unless it can demonstrate that it has the competence and experience to value the types of assets in which the LTAF invests. Valuations must be carried out monthly.
The liability standards applying to external valuers have not been amended from “simple” to “gross” negligence in valuation, and even though both the FCA and HM Treasury recognize that this acts as a significant barrier to external valuers being appointed to LTAFs (and other U.K. illiquid funds) they have committed to exploring a relaxation of some of these rules in the future.
5. Depositary Ownership of Assets
The FCA has acknowledged that the requirement to have the depositary register the title to assets in its own name, rather than the name of the fund or the manager, is not practical for all eligible assets that an LTAF might invest in. However, for now the rule is retained albeit with a carve out that LTAFs on a case by case basis can apply to the FCA to waive the Depositary registration requirements in specific instances. This is not an ideal outcome for sourcing of LTAF depositaries and it is hoped some pragmatism is shown in the case-by-case reviews but also that the consultation can look to align U.K. depositary asset registration standards with international standards such as AIFMD or UCITS.
6. Permitted Links Revisions
Given the fact that the FCA considers that the principal target market for the LTAF is the defined contribution pension market, there are some very specific rule revisions with added additional flexibility for investments in LTAFs by DC pension schemes.
These include revisions to the per mitted links rules that will make it possible for LTAFs to be part of the default arrangement of an occupational or work place DC pension scheme. The 35% limit for LTAF-linked funds that form part of the default arrangement of a pension scheme has been removed, while certain requirements remain on insurers to provide risk warnings and ensure that the fund is suitable for the ultimate investors. To ensure the proposals only apply to default arrangements, the FCA has further proposed introducing conditional permitted LTAFs and making them available only in relation to default arrangements. This carves out the LTAF from the definition of QIS for COBS 21.3 purposes, so that the LTAF would not be available for retail investors investing outside of the pension environment. With the final LTAF rules integrating into the regulatory framework for DC pension scheme investments in unit-linked long-term insurance products, this looks to be a good channel of distribution for LTAF manufacturers into the future.
7. Fee Cap
A key aspect of the commercial arrangements of any new LTAF will be the extent to which a profit allocation to the manager can be accommodated. This is an important factor both in attracting the best managers and in aligning the interests of managers and investors in most long-term asset classes. LTAF managers must disclose their performance fees/carried interest and explain to their investors how their fees work. There will be no cap on LTAF managers’ fees, although, separately, the U.K. Department of Work & Pensions is considering how to accommodate these fees within the DC charge cap to ensure the charge cap rules do not present a barrier to the success of the LTAF regime.
Rather helpfully, in its Budget on October 27, 2021, the U.K. Government flagged its intention to consult later this year on further changes to the charge cap for DC schemes, with a view to considering amendments to its scope to better accommodate performance fees. This consultation will be an important factor in shaping the commercial attractiveness of the provision of LTAFs by asset managers and is worth tracking in 2022.
Tax is always an important fund structuring consideration, particularly for illiquid asset funds. The FCA notes that the LTAF rules permit them to be established as property authorized investment funds (PAIFs), and that an LTAF could be structured as an authorized contractual scheme (ACS). The FCA worked closely with HM Treasury and HM Revenue & Customs (HMRC) throughout the development of the LTAF. However, details on the tax treatment of LTAF specifically remains scant and there is an ongoing wider review by HM Treasury of the tax regime for U.K. funds. A tax transparent ACS structure for the LTAF could be attractive, given that the tax transparent nature of the ACS should enable tax exempt investors such as registered pension schemes to preserve their tax exemptions and access to relevant double tax treaties. As always, the final tax regime applicable to LTAF will have an inevitable impact on its attractiveness to investors.
The FCA sets the bar high for LTAF ongoing governance and oversight. Managers of LTAFs must be full-scope U.K. alternative investment fund managers - firms that currently only have “managing an unauthorized AIF” as a classification will need to seek a variation of permission (which may take up to six months to obtain). Such firms will also need to appoint at least two independent directors. LTAF managers must undertake additional assessments in respect of the LTAF’s liquidity, due diligence, valuation of the assets and conflicts of interest, and may not delegate this responsibility.
10. Quarterly Investor Reporting
Due to the FCA’s desire for high levels of transparency, LTAF managers must make quarterly reports to investors, and within 20 days of the end of the quarter. The FCA suggests that infrequent trading in illiquid markets means that reporting will generally not be unduly burdensome, but it does add another regulatory report to asset manager’s inventory.
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