A New Dawn Breaks?
The European Long-Term Investment Fund (ELTIF) has existed since 2015. As its name suggests, ELTIF was originally framed to channel more non-bank capital into long-term investments in the real economy across the European Union. Areas identified in the original proposal included real estate, infrastructure, intellectual property opportunities, and smaller private companies that would yield investors higher returns but also require a longer-term liquidity horizon to generate these returns.
With less than 30 launched since its inception and modest asset growth, many industry commentators have written ELTIF off as an EU policy failure. Let’s be clear, for the first five years of ELTIFs existence, they have unquestionably struggled to find a large audience. For balance however, it’s also worth noting that some managers have already successfully launched ELTIFs, particularly to house a single asset class normally discretely distributed to a specific investor type usually in partnership with a private bank or wealth manager. It is also true that recently, there has been a number of new ELTIF launches by major market players triggering lively industry debate about ELTIFs future growth trajectory.
Adding to the momentum of industry dialogue, is the public consultation on ELTIF launched in October, which looks to rectify the structural issues which have somewhat constrained ELTIF growth to date. The consultation affords industry an opportunity to drive positive reform of the ELTIF framework with a view to making it fit for purpose for the broader European distribution market which has a discernible appetite for regulated products with longer investment horizons.
Industry has until January 19, 2021 to respond and influence these ELTIF Regulation reforms. The final rules are scheduled to be published in the third quarter of 2021.
With several macro-economic factors and growing investor appetite supported by unwavering political and policy support primarily expressed in the EU’s revamped Capital Markets Union (CMU), maybe a new dawn is breaking for ELTIFS?
What’s different this time?
There are several factors underpinning why the ELTIF might be primed for growth this time if it can create a more “user friendly” framework.
Negative Interest Rates
The continuing negative interest rate environment continues to eat into cash savings and prompt more and more investors, advisors, and fiduciaries to question whether they really ought to deploy this cash rather than see it continuously erode.
There have been some well documented fund liquidity events in recent years and regulators continue to scrutinize investment funds and their ability to keep their liquidity promises, even in times of extreme market stress. This is prompting product providers to seek out alternative options to daily-dealing UCITS schemes, for example, where the funds can generate certain excess returns in return for locking in the commitment for a longer investment horizon.
It is expected that less liquid private market assets generally will likely play an increasingly important role into the future. There remain high levels of capital and savings which need to be deployed to help fund the real economy, large scale infrastructure projects, and also aid the large amount of building, financing, and retrofitting needed to shift the European Union to its desired carbon-neutral economy by 2050. It is reported that the private equity industry entered the pandemic with a $2.5 trillion mountain of cash, so called “dry powder”. That’s more than twice what the industry had after the great financial crisis of 2008. The global private market industry remains bullish and fundraising continues unabated as managers and GPs continue to look at opportunistic deals, buyouts, and mergers and acquisitions remain buoyant.
Government spending programs have been heavily impacted by the onset of the COVID-19 pandemic and the stimulus necessitated by the imposed economic shutdowns required globally. This means that even with historically attractive borrowing rates for governments, the current level of expenditure is not sustainable forever. Private markets financing will play an increasingly important role in the coming years in financing public utilities such as energy and transport as well as social infrastructure such as housing, schools, and hospitals.
Democratization of Illiquid assets
Fostering greater participation with a broader investor base in less liquid investments and strategies such as private equity and debt is a growing industry theme. Currently these investments are exclusive to institutional investors for the most part, however, there is a growing call to allow a wider range of investors to benefit from the diversification and excess returns in exchange for a longer-term investment commitment. ELTIF is seen by many as the perfect solution to channel money on behalf of mass affluent investors across Europe into less liquid assets to bridge their savings and pensions gap, and in return help the EU economy funding requirements.
What needs to change?
Prior to the consultation, the European Commission (EC) tasked several industry experts as part of a High-Level Forum (HLF) to recommended changes to the ELTIF framework. The primary objective was reducing barriers to investment by investors and increasing the scope of eligible assets and investments as well as more flexible borrowing limits.
The HLF advised the EC also that the ELTIF should be mobilized to act as a significant late stage venture capital financing vehicle in much the same way that the US Business Development Companies (BDCs) have functioned very successfully in the United States. One of the underpinnings of the EC’s broader revamped Capital Markets Union is to foster more capital flow from EU citizens, households, and institutions to a broader range of companies across the economy. This has never been more required as Europe looks to mobilize capital to combat the impacts of Brexit, COVID-19, and transition to a more environmentally friendly and sustainable economic future. The ELTIF could be a useful vehicle to further promote wider investor participation in a European cross-border private equity and credit market. The EC is focusing particularly on retail investors, broadening the scope of eligible assets, and reducing the number of local member state provisions that act as barriers to cross border activity for ELTIFs.
The consultation is very much a game of two halves. It initially asks five short high-level questions about the ELTIF framework. It then has a more detailed questionnaire comprised of 10 distinct sections, with 37 questions in total which run the spectrum of existing challenges with the ELTIF framework.
Without delving into the full detail of each area of current discussion, more broadly the industry is focused on the following parts of ELTIF which remain far from ideal from a practical perspective.
The existing rules governing the types of assets an ELTIF may invest in are overly restrictive. ELTIFs may invest in unlisted securities of any type but listed securities must have a market capitalization of less than EUR 500 million. There is a case for this to be expanded to allow a wider choice and greater investment universe to avail of. The consultation actually flags some very contemporary types of asset classes which might benefit from ELTIF investment and should be incentivized, such as any companies involved in COVID recovery, those that help deliver on the EU’s Green Plan and nascent markets such as digital assets companies. The ability to run an ELTIF as a fund of fund structure – again, another usual method of delivering private market funds – is sub optimal and must be enhanced. The consultation asks how.
Also, the prescribed borrowing and leverage limits are quite narrow and do not lend themselves to the practical requirements of many private equity or debt funds. This overly narrow ruleset means that many have been put off by ELTIF and utilized other structures instead to execute their investment thesis. The limitations also weigh on return expectations.
One of the goals of ELTIF 2.0 is to expand its distribution reach to include a wider range of prospective investors, including retail investors. The current ELTIF distribution market is primarily comprised of institutional investors and pockets of high net worth investors who purchase ELTIFs through private bank or wealth management channels. The consultation asks for suggestions on how the supply and demand of ELTIFs can improve to grow participation levels and types of investors who might find ELTIF attractive.
The current industry focus is improving the framework to allow growth of ELTIF within a range of distribution channels, however two of the primary ones are:
1. “Mass Affluent” Channels
It depends on your definition, but it is becoming increasingly clear that there is growing appetite within high net worth investors, multi-family offices, family office platforms, and across the spectrum of private bank and wealth management channels to provide regulated pool vehicles with longer investment horizons which will provide higher returns than tradition liquid vehicles. This underlying appetite has always existed, however, the spiking short term market volatility, prevailing interest rate environment means that the revamped ELTIF might now be speaking to very welcoming ears.
2. Defined Contribution Pensions
It is no secret that the convergence of macro-economic factors and demographic shifts have resulted in an ever-increasing funding gap globally. Defined Contribution (DC) schemes are beginning to take action to combat this perpetual problem. Increasingly, there is ever rising demand from DC schemes to access illiquid assets as part of a more diversified portfolio. ELTIF, if reconstituted, could become a valuable regulated vehicle to increase participation of DC schemes in diversified investment portfolios with longer time horizons to the mutual benefit of savers, pension holders, asset managers, and companies within the “real economy”.
These are two channels who might have a reasonable amount of capital to invest and can take a longer-term view. However, the ELTIF consultation looks to set the distribution groundwork for broadest participation as possible, including direct retail access, and works to enshrining the necessary safeguards, disclosures, and not-overly-risky portfolio composition which are the bedrock of any retail fund regime. It also allows for special liquidity requests such as two-week withdrawal notice periods for retail investors.
In terms of retail eligibility rules for ELTIF, the initial minimum amount invested is EUR 10,000. The ELTIF rules dictate that retail investors with a portfolio of up to EUR 500,000 shall not invest an aggregate amount exceeding 10% of their portfolio in ELTIFs.
The ELTIF investor suitability assessment is quite extensive and enquires about the prospective investors’ appetite for risk, desired liquidity profile of the fund, and incorporates sustainability risks, investment time horizon and risk-adjusted performance. This investor suitability assessment (as with any fund structure) must be considered when framing a distribution strategy.
The consultation asks whether more clarity is needed to allow for the subsequent sale of units on a secondary market and the publication of “periodic reports”. They also seek more certainty on the rules pertaining to the offer of units or shares at a price below the current NAV to external investors without the requirement to offer them first to existing investors.
There has been much talk in Europe of finding a way to direct more investment flows from a broader capital pool into long term investment vehicle, which is more evident in the US capital markets, for example. The EU’s Capital Markets Union has this as a central tenet of its ambitions. If ELTIF is recast and made “fit for purpose”, it could be the regulated fund vehicle of choice to support these ambitions. There have already been some notable recent ELTIF launches, an indication of the latent demand in the market. With evident pent up investor demand, an increase to investment and borrow permissions combined with an easier distribution framework, maybe the stars are aligning for an ELTIF revival.
The winds of change appear to be blowing in the ELTIFs favor, and maybe second time around ELTIF will find a more welcoming, larger audience than it did upon its debut.