Client memorandum | March 2, 2023
Authors: Gregg Beechey, Zac Mellor-Clark, and Nishkaam Paul
Regulation (EU) 2015/760 of the European Parliament and of the Council of 29 April 2015 on European long-term investment funds (the “ELTIF Regulation”), which has applied since 9 December 2015, established a type of collective investment vehicle called an ‘ELTIF’ which seeks to facilitate investment in companies and projects requiring long-term or ‘patient’ capital, such as infrastructure, education and research and development, whilst offering investors stable returns. The ELTIF Regulation builds on the AIFMD, with only EU AIFs being eligible for authorisation as ELTIFs and each ELTIF needing to be managed by an authorised EU AIFM.
While the ELTIF regime launched with great fanfare, in particular due to its status as the sole non-sector specific fund product which could be offered to retail investors in the EU under a marketing passport similar to that offered in respect of professional investors under the AIFMD, it saw limited take up in the market. As of the end of 2021, only 57 ELTIFs had been established across the European Union when compared with over 1500 Luxembourg Reserved Alternative Investment Funds or RAIFs, which offer access primarily to the retail market in Luxembourg.
While there was a notable uptick in the number of ELTIFs established in 2022 as part of a broader ‘retailisation’ of the private funds market, the Commission acknowledged the lack of success of the regime when undertaking its legislatively-mandated review. The Commission’s review and a subsequent public consultation culminated in the publication of a legislative proposal in November 2021. Political agreement was reached on the legislation in October 2022 and the European Parliament approved the revised ELTIF Regulations (“ELTIF 2.0”) on 15 February 2023.
The revised regulation is expected to be published in the Official Journal of the EU in March 2023, entering into application nine months later in Q1 2024.
In order to address perceived shortcomings of and lack of market engagement with the current regime, the European legislative authorities have agreed the following updates:
I. Wider Pool of Potential Investments
In order to enhance the flow of private capital towards growth-inducing, long-term investments and to address, in the words of the Commission, the skew ‘towards certain eligible investment categories’, ELTIF 2.0 will significantly widen the universe of potential investments that are available to an ELTIF.
- ELTIFs will be able to invest in all real assets, whether directly or indirectly, irrespective of their value, whereas they are currently restricted to investing in real assets with a minimum value of EUR 10 million or more. A ‘real asset’ will be defined as any asset having an ‘intrinsic value due to its substance and properties’ and the concept will encompass immovable property, IP and rolling stock as well as investments in water, forest, building and mineral rights.
- ELTIFs are currently prohibited from investing in credit institutions, investment firms, insurance undertakings and other financial undertakings but will now be able to invest in such undertakings provided that they were authorised or registered within 5 years of the date of the investment. This update seeks to direct capital towards innovative and dynamic undertakings, such as those in the FinTech space, in the belief that they contribute to the digital transition and lead to efficiencies in regulatory, supervisory and oversight functions across financial and non-financial institutions.
- ELTIFs are currently only able to invest in equity or quasi-equity in listed undertakings which have a market capitalisation of EUR 500 million or less but this threshold will be increased to EUR 1.5 billion. This change is being effected in order to allow ELTIFs to avail of the greater liquidity offered by larger listings, in particular due to the possibility of semi-open-ended ELTIFs being established under ELTIF 2.0 (see ‘Redemptions and Liquidity’ below).
- The legislative authorities have also recognised that investments in long-term projects, assets and infrastructure in third-countries can indirectly have tangible benefits for the EU, not least by bringing capital to ELTIFs, and restrictions on investing in third country undertakings have been significantly loosened.
- ELTIFs will be able to invest in simple, transparent and standardised securitisations (as defined in the Securitisation Regulation) and green bonds.
II. Reduced Diversification Requirements
The European legislative authorities acknowledged that the restrictive diversification requirements in the current regime, which were designed to ensure that ELTIFs could weather adverse market circumstances, have ‘proven to be too burdensome’ and that it was necessary to adjust these without materially affecting the ability of these vehicles to withstand market volatility.
- ELTIFs are currently required to invest at least 70% of their assets in ‘eligible investment assets’ (see ‘Wider Pool of Potential Investments’ above) but this will be reduced to 55%.
- ELTIFs are currently (subject to certain derogations) prohibited from investing more than 10% in a single investment, i.e. a single qualifying portfolio undertaking, a single real asset, a single collective investment undertaking, but this will be increased to 20% (subject to the exclusion in respect of ELTIFs marketed to exclusively to professional investors as described in ‘Introducing a Retail/Professional Distinction’ below)
III. Borrowings and Leverage
The recitals to the amending regulation note the key role that leverage plays in the day-to-day operations of an ELTIF and the fact that moderate amounts of leverage coupled with appropriate controls can serve to amplify returns without exacerbating the risks to investors. With this in mind, ELTIF 2.0 will allow ELTIF managers to access greater levels of leverage and to employ this leverage for wider purposes, while aligning the management of such techniques with the AIFMD.
In particular, leverage limits in respect of ELTIFs which are marketed to retail investors will be increased from ‘30% of capital’ to 50% of net asset value (a higher 100% limit will apply in respect of ELTIFs marketed exclusively to professional investors, see ‘‘Introducing a Retail/Professional Distinction’ below). The amending regulation also clarifies the manner in which this leverage should be calculated, with borrowing which is fully covered by the capital commitments of investors to be excluded from the calculation of these limits and the borrowing limits to apply from a date specified in the prospectus of the ELTIF, in each case in a manner similar to the AIFMD.
IV. Introducing a Retail/Professional Distinction
The current regime applies almost identically to ELTIFs irrespective of whether they are marketed to retail investors or not, including with respect to leverage limits, diversification requirements and eligible investments. This approach does not take into account the higher risk tolerance, more sophisticated due diligence processes and differing time horizons of professional investors and has effectively stymied the establishment of ELTIFs tailored to professional investors.
The European legislative authorities acknowledged this and have sought to lighten the administrative burden and costs incumbent upon ELTIFs marketed exclusively to professional investors:
- ELTIFs marketed exclusively to professional investors will not be subject to the single investment diversification requirements (see ‘Reduced Diversification Requirements’ above)
- ELTIFs marketed exclusively to professional investors will be subject to a higher leverage limit of 100% of the net asset value of the ELTIF (see ‘Borrowing and leverage’ above)
- ELTIFs marketed exclusively to professional investors will not be subject to the restriction prohibiting an ELTIF from holding more than 30% of the interests of a collective investment undertaking
Note that the distinction between retail and professional ELTIFs is based on whether the fund is marketed to retail investors in addition to professional investors and it should still be possible to admit retail investors into a professional ELTIF without engaging the more restrictive regime.
Notwithstanding the foregoing, given the primary driver for sponsors seeking to raise ELTIFs is typically to access capital from retail investors, it remains to be seen just how successful the professional investor only ELTIF model will be.
V. Master-Feeder Structures and Funds-of-Funds
The current ELTIF regime imposes restrictions on the level of investment that an ELTIF can hold in other collective investment undertakings, effectively restricting fund-of-funds strategies pursued by ELTIFs to investments in ELTIFs, EuVECAs and EuSEFs.
Under ELTIF 2.0, fund-of-funds strategies are recognised as a common and effective method of obtaining exposure to illiquid assets and are broadened to permit investments in UCITS and EU AIFs. This is likely to be a significant market development, as ELTIFs employing such an investment strategy would give retail investors exposure to certain alternative investments that have hitherto been difficult to access.
Similarly, ELTIF 2.0 permits the establishment of a master-feeder ELTIF structure with the definitions of a ‘master ELTIF’ and ‘feeder ELTIF’ aligning with the corresponding definitions under the AIFMD (i.e. based on a 85% exposure threshold). In order to ensure that retail investors are provided with sufficient detail to assess the potential benefits and risks of an investment in such a structure, the prospectus of a feeder ELTIF will need to include detailed disclosure on the master ELTIF and description of all costs borne directly and indirectly by investors. A particular focus of the European legislative authorities is to ensure that investors are protected against unjustified additional costs as a result of subscription and redemption fees by the master ELTIF. The application for authorisation of a feeder ELTIF, submitted to the competent authority of the home state of the ELTIF, will also need to include detailed information regarding the master.
VI. Conflicts and Co-Investments
In order to exclude certain conflicts of interest on the part of ELTIF managers, the current ELTIF regime prohibits ELTIFs from investing in assets that are related to the manager. ELTIF 2.0 explicitly contemplates investments in an ELTIF’s portfolio investments by employees in the manager’s group, subject to the application of arrangements to manage conflicts of interest that are equivalent to the requirements set out in the AIFMD.
VII. Redemptions and Liquidity
The ability of investors to request the winding down of an ELTIF where redemption requests are not satisfied within one year will be removed. This should offer managers greater comfort and stability in applying the long-term investment strategies typical of ELTIFs.
While this aspect of ELTIF 2.0 remains subject to the drawing up of detailed technical standards by the European Securities and Markets Authority, ELTIFs may now provide for a liquidity window during which transfer requests by investors may be fully or partially matched. In order to offer this form of liquidity, managers will be required to draw up a detailed policy setting out the transfer process, relevant time periods, pricing, etc.
VIII. Marketing and Distribution
ELTIF 2.0 seeks to streamline the requirements incumbent on managers and distributors marketing ELTIFs to retail investors, in particular with respect to certain requirements under the current regime which are duplicative of or similar to requirements imposed by MiFID II. For example, the suitability assessment required to be carried out is now aligned with that required under MiFID II and it is clarified that such an assessment need not be carried out in respect of investments by employees of the ELTIF manager’s group.
While managers/distributors will no longer be subject to the challenging requirement to ensure that retail investors make a EUR 10,000 minimum subscription and that their investment in ELTIFs does not exceed 10% of their financial portfolio, retail investor protection is enhanced by a requirement to provide investors with a client alert prior to their investment and by affording such investors a two week cooling off period following the signing of subscription documents (consistent with the EU Distance Marketing Directive).
A number of the updates described above seek to align requirements incumbent on ELTIFs with those applying to AIFs more broadly under the AIFMD. ELTIF managers should therefore also take note of the proposals to revise the AIFMD regime which are currently in trilogue stage [as referenced here] and which may indirectly impact ELTIF 2.0. Though the enhancement of the ELTIF Regulation is likely to prove attractive at a time when many managers are exploring ways of accessing capital from retail investors, should the “professional investor” concept embedded within AIFMD be extended to capture so-called semi-professional investors as part of the AIFMD review (as has been previously proposed), this may undermine the success of ELTIF 2.0.
ELTIF 2.0 includes a transitional mechanism by which existing ELTIFs will be deemed to be compliant with the revised regime for 5 years following the effective date of these revisions (i.e. up to Q1 2029 base on the currently expected timeline). ELTIFs which are no longer raising capital as of that point in time will continue to be deemed to apply with ELTIF 2.0. Note that ELTIF managers may choose to opt-in to the new regime notwithstanding the above transitional arrangements.
However, given the long-term nature of ELTIFs, managers and sponsors of existing ELTIFs will likely need to consider the impacts of the new regime sooner rather than later.
This communication is for general information only. It is not intended, nor should it be relied upon, as legal advice. In some jurisdictions, this may be considered attorney advertising. Please refer to the firm’s data policy page for further information.