ELTIFs for everyone?
Luxembourg-based Arendt & Medernach lawyer Stefan Staedter discusses the success of the European long-term investment fund and its upcoming review
With the launch of a recent public consultation on the EU rules governing European long-term investment funds (ELTIFs), the European Commission has stoked discussions about the current features and the framework for ELTIFs under statute.
These are: Regulation (EU) 2015/760 of the European Parliament and of the Council of April 2015 on European long-term investment funds, and Commission Delegated Regulation (EU) 2018/480 of December 2017 supplementing Regulation (EU) 2015/760 of the European Parliament and of the Council. The latter refers to regulatory technical standards on financial derivative instruments solely serving hedging purposes, sufficient length of the life of the European long-term investment funds, assessment criteria for the market for potential buyers and valuation of the assets to be divested, and the types and characteristics of the facilities available to retail investors.
This discussion has become more important as the number of ELTIFs in EU member states has risen (and will continue to rise, given that there are several authorisations pending).
This discussion has become more important as the number of ELTIFs in EU member states has risen
From the central public register for ELTIFs maintained by the European Securities and Market Authority (Esma), we know that as of October 15 2020, 28 ELTIFs had been set up in the EU. The ELTIF register shows France, Italy, Spain and Luxembourg to be the most active jurisdictions for ELTIFs, with the most vehicles and the greatest development of relevant expertise on the part of supervisory authorities. Based on discussions with several asset managers, the number of Luxembourg ELTIFs (nine) is soon expected to double, with 10 new funds currently in the pipeline. It is expected that this trend will also continue in France, Italy and Spain.
The ELTIF register lists the largest asset managers down to medium-sized from the EU and the US, including, inter alia, (in alphabetical order) Amundi, BlackRock, Eurizon, Kairos, Intesa, Partners Group, and Tikehau. While the first generation of ELTIFs seems to have focused on equity investments, the pool is now more diversified, and also includes real assets (real estate and infrastructure), debt/loan strategies, and private equity strategies.
In Luxembourg, ELTIFs are typically structured as alternative investment funds (or sub-funds thereof) subject to Part II of the Luxembourg law of December 2010 on undertakings for collective investment where true retail distribution of the shares/units is desired. Where intended for marketing to well-informed investors alone, ELTIFs are typically structured as specialised investment funds subject to the Luxembourg law of February 2007 relating to specialised investment funds, or as reserved alternative investment funds subject to the Luxembourg law of July 2016 on reserved alternative investment funds.
Key features of ELTIFs
In a nutshell, ELTIFs are designed to attract investors seeking opportunities for long-term investments in companies and ventures. Only EU alternative investment funds (AIFs) or sub-funds thereof are eligible to be authorised as ELTIFs. ELTIFs have a hybrid nature combining features of undertakings for collective investment in transferable securities (UCITS), such as the risk diversification rules, applicable investment limits, and the option to market to retail investors, with features of AIFs, such as the appointment of an AIFM and a depositary, diversity of asset classes, and structural flexibility.
An ELTIF must invest at least 70% of its capital in eligible investment assets, and no more than 30% of the capital of an ELTIF may be invested in assets which are deemed eligible under Article 50(1) of Directive 2009/65/EC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities.
Article 10 of the ELTIF Regulation qualifies the following assets as ELTIF-eligible: (i) equity or quasi-equity instruments, (ii) debt instruments, (iii) loans granted by the ELTIF, (iv) units/shares of one or more other ELTIFs, EuVECAs and EuSEFs and/or (v) real assets of a certain size. The relevant asset class must be linked to (i.e., invested in, issued by, granted to or held via) a qualifying portfolio undertaking. The features of a qualifying portfolio undertaking are set out in Article 11 of the ELTIF regulation. Inter alia, such undertakings are required (i) not to qualify as collective investment undertakings, (ii) not to be financial undertakings (such as credit institutions or insurance companies) and (iii) either not to be admitted to trading on a regulated market or multilateral trading facility, or where they are, not to have a market capitalisation exceeding €500 million ($587 million). The qualifying portfolio undertaking may be established either in a member state or in a third country, provided the third country complies with Article 11(1)(c) of the ELTIF Regulation.
As indicated above, ELTIFs must diversify their risks. Article 13 of the ELTIF Regulation provides detailed diversification rules with respect to eligible investments. In the event of a passive breach of these diversification requirements, the AIFM of the ELTIF must take the measures necessary to rectify the position, taking due account of the interests of the ELTIF's investors. Note that Article 17 of the ELTIF Regulation allows for derogation from the portfolio composition rules during the ramp-up period.
Retail marketing is, by the testimony of a number of asset management industry representatives, the key driver for setting up an ELTIF
Due to its long-term nature, an ELTIF must not, inter alia, short-sell its assets or take any direct or indirect exposure to commodities; furthermore, ELTIFs may make use of derivative instruments only to hedge risks inherent to their other investments. The ELTIF Regulation also sets out conditions and limits for cash borrowing: inter alia, Article 16 of the ELTIF Regulation restricts borrowing and the encumbrance of assets to 30% of the ELTIF's capital, and provides that borrowing must be contracted in the same currency as the assets to be acquired with the borrowed cash.
If ELTIF shares or units are to be marketed to retail investors under the marketing passport of the AIFM, additional requirements apply. For the purposes of the ELTIF Regulation, retail investors are nonprofessional investors with substantial financial assets (of at least €100,000) including both cash deposits and financial instruments not given as collateral.
Note that a retail investor must not invest an aggregate amount exceeding 10% of their financial instrument portfolio, and that the initial amount they invest in one or more ELTIFs must be at least €10,000. Articles 26 et seq. of the ELTIF Regulation set out retail protection provisions, such as the retail assessment process, the equal treatment of investors, or the special withdrawal right for a period of two weeks from the date of subscriptions for ELTIF shares/units. A typical ELTIF life cycle begins with an investment period, including a certain ramp-up period in which the portfolio is built up. This is followed by a holding period.
Finally, the date of the end of the life of the ELTIF kicks off with the exit strategy and culminates in the liquidation of the ELTIF. As ELTIFs are closed-end funds, their investors must not be allowed to request the redemption of their shares/units before the end of the ELTIF's life. By way of derogation, however, redemptions prior to the end of the life of the ELTIF may be permitted under the conditions of Article 18 of the ELTIF Regulation.
Optimisation suggestions for the ELTIF framework
As recently highlighted by the high-level forum on the Capital Markets Union, initial take-up of the ELTIF has been slow, with only a limited number launched to date due to their stringent legal requirements. For this reason, the High-Level Forum has recommended (i) that the European Commission propose targeted amendments to the ELTIF framework and (ii) that member states simplify the tax rules applicable to ELTIFs and/or grant them preferential tax treatment.
Further to the High-Level Forum's recommendations, the European Commission has commenced a review of the ELTIF framework by running an inception impact assessment. The inception impact assessment focuses on (i) the investment horizon (including broadening the category of eligible investment assets and modifying the borrowing limits) and (ii) reducing barriers for investors.
On October 19 2020, the European Commission launched a public consultation until January 19 2021. The public consultation questionnaire is available as a short version with six questions or a full version with 42 detailed questions, dealing with several aspects of the ELTIF framework and addressing the recommendations of the High-Level Forum and the different points raised by stakeholders (including asset managers and investment associations). The below analysis of the public consultation focuses on a few discussion points that several asset managers have characterised as posing a particular challenge when setting up an ELTIF. These items concern both the investment universe and the investor side.
With respect to the investment universe, a number of asset managers wish for more flexibility when it comes to fund-of-fund strategies. Under Article 11 of the ELTIF Regulation, a qualifying portfolio undertaking must not be a collective investment undertaking. This essentially excludes fund-of-fund strategies (except for EuVECAs, EuSEFs and other ELTIFs for the illiquid pocket and UCITS for the liquid pocket). Particularly in the context of fully paid-in capital structures, granting accessibility to fund-of-fund strategies would mean that asset managers could invest on a broader basis in other funds, allowing for faster deployment of capital.
Fund-of-fund strategies are also a common and effective way of rapidly obtaining exposure to illiquid assets (especially real assets). The public consultation addresses this discussion point, requesting feedback (i) on whether there is a need to expand the scope of eligible investment assets and the ELTIF investment universe to other areas and asset classes, and (ii) on the limitation of eligible investment assets to shares/units in EuVECAs, EuSEFs and other ELTIFs versus other potential fund categories.
The review will only be truly successful if the ELTIF framework strengthens product flexibility based on retail versus professional
With respect to real assets, the public consultation requests feedback (i) on real estate assets, including commercial and residential real estate without a perceived economic or social benefit under the EU's energy, regional and cohesion policies and (ii) on the need for clarification and practical guidance on eligibility requirements, particularly in relation to investments in real assets.
Several asset managers in the real estate industry have mentioned that when it comes to real assets, and particularly real estate strategies in the ELTIF context, there is a perceived lack of clarity and guidance, notably for investments which serve the purpose of contributing to smart, sustainable and inclusive growth or to the union's energy, regional and cohesion policies. They assert that these uncertainties make it difficult to design and pursue a real (estate) asset strategy.
Another key topic for asset managers is the features of qualifying portfolio undertakings which impact the options for portfolio structuring and the use of co-investment strategies. The public consultation requests feedback on each feature, including inter alia (i) the inability to invest in a financial undertaking, (ii) the push to raise the maximum market capitalisation threshold of €500 million when investing in listed companies, and (iii) the rules for investments in third-country undertakings. Based on discussions with several asset managers, (i) raising the maximum market capitalisation threshold to €1 billion may grant more flexibility for portfolio composition and (ii) pruning the list of entities considered as financial undertakings in Article 2 of the ELTIF Regulation will promote investments in the fintech sector.
The practical modus operandi of funds set up in the ELTIF context has also raised questions about the borrowing conditions and limitations under Article 16 of the ELTIF Regulation and the compliance with the specific conflict of interest provision in Article 12 of the ELTIF Regulation. With respect to the borrowing limitations, the European Commission requests stakeholder feedback on, inter alia, the optimal maximum allowed net leverage, and the appropriateness of the legal mechanisms differentiating marketing to retail versus professional investors. In this section of the public consultation, several asset managers will have the opportunity to elaborate on their demand for flexibility in the currency of borrowed cash, which must currently be the same as that of the assets to be acquired, and to request a derogation from the cash borrowing rules during the ramp-up period.
The conflict of interest provision is typically discussed in the context of parallel fund setups and co-investment strategies. Because Article 12 of the ELTIF Regulation can be interpreted in different ways, some uncertainty remains with respect to the scope of prohibited investments, making actors reluctant to implement these fund setups and strategies. Now stakeholders can suggest amendments, including the addition of a mitigation mechanism for when a potential conflict of interest is identified. On the investment universe side, stakeholders can also recommend amending the current rules on portfolio composition, diversification and redemption, and the life of ELTIFs.
As for the investor side, the consultation paper kicks off the discussion by asking which limitations imposed by the ELTIF framework reduce the attractiveness of the ELTIF fund structure or of cross-border marketing and distribution across the European Union. This broad opening question helps address several concerns of the asset management industry. On the one hand, stakeholders can expand on their experiences with the reportedly cumbersome mechanisms for assessment and control that must be applied when marketing to retail investors; in particular, this concerns Articles 26 et seq. of the ELTIF Regulation. On the other, stakeholders can give feedback on the need for reform with respect to distribution to employees of the initiator, who are technically considered retail investors.
The investor side also collects stakeholder feedback (i) on the application of the principle of equal treatment (including a potential clarification that equal treatment applies at share/unit class level) and (ii) on whether the ELTIF framework is rendered less effective by national legislation or existing market practices. This includes national tax regimes which may reduce the attractiveness of ELTIFs, such as gold-plating or misapplication of the EU acquis. Although the potential use of gold-plating practices has been pointed out by several asset managers in the past, it will be interesting to find out to what extent stakeholders will disclose these practices to the European Commission.
Under miscellaneous, the European Commission notably invites stakeholders to make additional comments and to consent to a direct follow-up request from the European Commission. As the public consultation indicates, it will also take into account parallel consultations and review processes of the other EU financial acquis, such as that of the AIFMD and of Mifid II/Mifir, irrespective of timing.
ELTIFs in the context of the European Green Deal and Covid-19
The public consultation also makes it clear that the ELTIF label can serve as an important conduit for investments to support the European Green Deal. A preliminary roadmap detailed in European Commission communication COM(2019) 640 final, the European Green Deal reaffirms the Commission's commitment to tackling climate and environment-related challenges. ELTIFs could contribute to the long-term financing needs of the green transition in both the public and the private sectors, and such financing opportunities for green projects could even be leveraged if the European Investment Bank or the European Investment Fund were to support the ELTIF label by investing systematically in ELTIFs.
The public consultation highlights the importance of the ELTIF in implementing the European Green Deal, requesting feedback on sustainability and the EU taxonomy for sustainable activities in the ELTIF context. As the ELTIF framework aims to develop alternative financing streams alongside the traditional banking market in order to close the financial gap for the real economy and, in particular, for small and medium-sized companies, the public consultation also polls stakeholders on the extent to which they feel ELTIFs will invest in recovery projects post-Covid-19. The pandemic has had a severe impact, creating demand for financing. As ELTIFs may invest in equity/debt instruments or grant loans to the real economy, they may prove to be a suitable alternative financing tool to help the European economy recover by investing in distressed assets or alongside European Guarantee Funds.
What it means for retail
As highlighted by the High-Level Forum, the ELTIF was created as a suitable investment vehicle for bringing alternative investments to a sophisticated segment of Europe's retail investor base. Retail marketing is, by the testimony of a number of asset management industry representatives, the key driver for setting up an ELTIF. Therefore, the retail appetite for ELTIFs will further increase when coupled with national tax incentives, or when national pension plan criteria are aligned with the ELTIF framework (as is the case in Italy with the PIR regime, for instance). Diversity of asset classes and flexibility in structuring make the ELTIF a promising vehicle that, according to the High-Level Forum, "could encourage the growth of market-based lending entities analogous to US Business Development Companies (BDCs), which play a notable role in real economy financing in the US, especially to many SMEs".
Where the asset management industry is able to make strong arguments in response to the public consultation, it is highly likely that the European Commission will suggest amendments to the ELTIF Regulation. This initiative could, in turn, accelerate the takeup by retail investors, and thus increase the total number of ELTIFs and the net assets under management. However, the review will only be truly successful if the ELTIF framework strengthens product flexibility based on retail versus professional distribution. This is because a wider institutional takeup will help (i) to promote investor perception of the ELTIF label as pan-European quality label for AIFs and (ii) to sufficiently leverage the considerable size of these funds.
Senior associate, Arendt & Medernach
T: +352 40 78 78 5352
Stefan Staedter is a senior associate in the investment management practice of Arendt & Medernach. He specialises in regulated and unregulated investment funds, and primarily advises clients on the structuring and setup of alternative investment funds (real estate, private equity and debt) and their respective management entities.
He has been a member of the Koblenz Bar (Germany) and Luxembourg Bar since 2015. Prior to joining Arendt & Medernach, he worked for a number of international law firms across Europe.
He studied in Potsdam and Paris. He holds a Master's degree in law from the University of Paris-X, a German first and second state exam in law, and a German doctorate. He is also a member of the ELTIF Working Group of both ALFI and Invest Europe.