I did then what I knew how to do, Now I know better, I do better
There has been a lot of industry chatter regarding the democratization of regulated, illiquid funds by making them available to a wider spectrum of eligible investors. While it has become a global theme, the real action was in Europe where both the European Long-Term Investment Fund (ELTIF) and the U.K.’s Long-Term Asset Fund (LTAF) caught the attention of policymakers, investors, and asset managers alike.
Since inception, the ELTIF has not captured investment flows as intended for a variety of reasons, including an eligible asset universe generally considered to be too narrow. Evidence of this opinion may be found in the lack of ELTIFs since its launch in 2015 and the ones that have launched were both small and comprised mainly of local investments and investors in a handful of EU countries (e.g. France, Italy, Spain). Only around 28 ELTIFs have been established, with a low asset base (below €2 billion).1
ELTIF has become more popular and there was discernible growth in 2021 with asset managers launching usually in partnership with a private bank or wealth manager. With that said, for now ELTIFs remain a small corner of the EU regulated funds market. However, with sizeable revisions to its rule-set imminent, are the fortunes of the ELTIF about to change?
The European Commission (EC) has removed many of the suggested barriers to ELTIFs’ success to make ELTIF 2.0 more attractive for asset managers. The proposed revisions make both portfolio composition and the distribution to a broad range of investor types easier and more attractive. The ELTIF changes form a sub-set of a range of policy measures which underpin a more general makeover of the EU’s Capital Markets Union and an overarching desire to diversify the financing to Europe’s real economy beyond bank lending.
ELTIF’s future success is not guaranteed. However, this revamp greatly enhances the structure’s attractiveness to product manufacturers, distributors and ultimately investors. So there is rightly some genuine enthusiasm mobilizing around ELTIF and hope that at the second time around, it may act as a legitimate third option within the EU regulated funds landscape to compliment the highly successful Undertakings for the Collective Investment in Transferable Securities (UCITS) and the Alternative Investment Fund Managers Directive (AIFMD) frameworks.
Here’s a brief walk through of the latest ELTIF revisions which could mean that the second time’s a charm for ELTIF 2.0.
1. Wider Range of Eligible Assets
Several changes to the ELTIF eligible asset rules significantly widen its investment opportunities and attractiveness, including:
- Global Investments
There is explicit clarification that ELTIFs may invest freely in non-EU (“third country”) exposures. Previously ELTIFs were designed as a means of channeling investment into EU industries primarily and non-EU investments had additional conditions ascribed. That constrained investment opportunities and was cited as slightly protectionist. The clarification now allows for a far more diverse range of investment opportunities.
- Real Asset Definition
A revised definition of “real asset” now includes any asset with “intrinsic value” rather than one that can provide “investment returns” or “predictable cashflow” – this change shows that the devil is always in the detail when framing a fund structure’s ruleset.
- Real Asset Threshold
The minimum investment in a real asset by an ELTIF is also lowered from €10 million to €1 million making real asset investments much more accessible.
- Listed Assets Threshold
The market capitalization threshold for permitted listed investments is raised from €500 million to €1 billion (at time of initial purchase).
- Other investment funds
ELTIFs may now invest in Alternative Investment Funds (AIFs) who themselves invest in eligible assets on a “look through basis”; previously an ELTIF could only invest in other ELTIFs, European Venture Capital Funds (EUVECA) or European Social Entrepreneurship Funds (EUSEF) structures.
ELTIFs may now invest in eligible se-curitizations which include mortgage-backed securities, commercial, residential, and corporate loans, as well as trade receivables.
- Minority Co-investments
Another notable revision to allowable investment permissions is that an ELTIF can now make a minority co-investment directly or through investment conduits but doesn’t need to be owned directly or via a “majority owned” subsidiary. When twinned with the allowable investments in other eligible fund structures, the ELTIF now has the type of investment flexibility usually found in other similar regulated fund structures seeking exposure to private market investments and allows for the implementation of indirect investment strategies.
2. More Flexible Concentration and Diversification Limits
The other criticism of ELTIF was that the portfolio diversification parameters were overly rigid and too narrow to allow for flexible portfolio composition for illiquid strategies. As such, there are substantial proposed changes to a range of investment permissions and restrictions to allow for a much wider investment universe for ELTIFs, including:
- Maximum allowable amount that may be invested in other funds such as other ELTIFs, UCITS or AIFMD funds is raised from 10% to 20% of capital
- Maximum allowable amount that may be invested in a single real asset is raised from 10% to 20% of capital
- Also, the maximum aggregate value of units or shares of other funds such as Alternative Investment Funds (AIFs), UCITS or other ELTIFs is also increased from 20% to 40% of capital
- An ELTIF may also now own 30% of units or shares outstanding of another ELTIF, EU EUVECA or EUSEF funds
- The maximum aggregate amount of securitizations an ELTIF may invest in is now 20% of the total value of the ELTIF
- The maximum amount of capital that must be invested in eligible investments is lowered from 70% to 60% of capital
3. Increased Leverage
Another element of long-term funds that was overly restricted and hence made ELTIFs less attractive was the ability to finance investments by way of borrowing or provision of leverage. This has been addressed to bring ELTIFs more in line with similar fund vehicles elsewhere. Among the changes in this regard are:
- The cash borrowing limit is raised from 30% to 50% of ELTIF value for retail ELTIFs and 100% of ELTIF value for ELTIFs solely marketed to professional investors
- The cash borrowing no longer must be in the same currency as the currency the ELTIF buys its assets, so long as it is hedged
- The fund may encumber its assets to implement its borrowing strategy – previously there was a fixed 30% encumbrance limitation, this meant it was difficult to secure borrowing as liens and pledges of portfolio assets were difficult for ELTIFs and not attractive to lenders
4. Differentiation Between ELTIFs Marketed to Retail and Professional Investors
ELTIF 2.0 formally recognizes that the ELTIF might be sold to distinct constituents and is not exclusively a retail eligible vehicle. In particular, much lighter investment strategy and borrowing requirements now apply to ELTIFs solely marketed to professional investors.
Amendments have been made to make it clear that the two-week withdrawal period applies only to retail investors and can only be effective during the two weeks following effective date of the commitment or subscription agreement.
Distribution and Structuring Enhancements
ELTIFs can be distributed across the EU with a passport to both professional and retail investors. Some positive changes have been made to streamline the authorization of ELTIFs under new proposals. The National Competent Authority (NCA) responsible for authorizing the ELTIF will be solely responsible for the authorization of an ELTIF and will not be involved in the additional authorization or ‘approval’ of the EU Alternative Investment Fund Manager (AIFM). The new rules also clarify that an ELTIF doesn’t need to be managed by an AIFM in the same domicile.
There is the removal of duplication in the retail investor suitability tests and alignment of ELTIF to Markets in Financial Instruments Directive (MiFID) point of sale rules. This ties with the deletion of the minimum-entry ticket (€10,000), replaced with €1,000 minimum and the 10% aggregate threshold for retail investors whose financial portfolios do not exceed €500,000. ELTIFs also retain favorable capital charges under Solvency II rules, which introduce prudential requirements tailored to the specific risks which each insurer bears, so distribution to the EU insurance and pensions segment remains attractive.
Under ELTIF 2.0, retail investors may cancel their subscription and have the money returned without penalty. The two-week withdrawal period is only effective during the two weeks following effective date of the commitment or subscription agreement. The national investor facilities requirements for retail investors are also deleted to facilitate the cross-border marketing of ELTIFs and align with the new rules on Cross Border Distribution Directive (CBDD).
Second Time’s a Charm
In combination, these ELTIF 2.0 revisions remove many regulatory and structural impediments managers face. Initially they have been broadly welcomed since they address many concerns market participants have with the current rules.
It is hoped that ELTIF 2.0 when applied makes the European Long-Term Investment Fund a viable investment structure for many alternatives managers to the extent they can construct a portfolio that falls within the eligible investment criteria. It sits neatly into the EU regulated fund structure toolkit between UCITS and AIFMD funds. It has a cross border marketing passport and affords opportunity to target a wide range of investor types with diversified illiquid exposures all with a robust regulatory wrapper. Owing to increasing demand from European private bank and wealth management networks, the latest proposals serve to magnify expectations of more ELTIFs in the future. While the EU approval process means that ELTIF 2.0 would become effective six months and one year after coming into force respectively, so by 2024, market participants who begin to work on their strategies now stand to be on the front foot of the charm offensive.
Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners.© Brown Brothers Harriman & Co. 2022. All rights reserved. IS-07852-2021-12-23