The EU's New Regulation on European Long-Term Investment Funds

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By Tara Doyle, Michelle Ridge and Oisín McClenaghan, of Matheson, Dublin.

The European Union's new Regulation on European Long-Term Investment Funds (ELTIF Regulation), which entered into effect on December 9, 2015, introduces a new type of EU investment fund vehicle.

The ELTIF Regulation, which is directly applicable throughout the 28 EU member states, implements harmonised EU rules relating to the authorisation, investment policies and operating conditions for ELTIFs.

ELTIFs are a new regulated EU fund brand designed for investing in companies and projects that need long-term capital. They offer investment for both retail and non-retail investors and are permitted to operate a cross-border EU sales passport.

The European Commission (Commission) estimates that between 1.5 trillion euros (U.S.$1.6 trillion) and 2 trillion euros (U.S.$2.2 trillion) will be required in order to finance infrastructure projects in the European Union up to 2030.

A key impetus for the introduction of the ELTIF is to create a source of funding for these infrastructure and other long-term projects as an alternative to bank lending or raising capital on the stock exchange, and ultimately to promote EU economic growth. Supporting the take-up of ELTIFs has been identified by the Commission as a priority work area within the Capital Markets Union project.

It is anticipated that ELTIFs will be particularly attractive to pension funds, large insurance companies and other entities which have longer-term liabilities and, accordingly, are seeking to generate long-term returns within a regulated fund structure.

ELTIFs also represent an investment opportunity for affluent retail investors who are willing to “lock up” their investment in the long term.

One of the key benefits of an ELTIF is that it can avail of a pan-EU marketing passport, for marketing to both retail and professional investors, in contrast to the marketing of EU alternative investment funds, which may be marketed only to professional investors.

Under the EU's Solvency II Directive, which creates a fully harmonised regime for the prudential regulation of insurance and reinsurance business in the EU, insurance undertakings' investments in ELTIFs will be subject to beneficial capital treatment. Equities held by insurance undertakings within ELTIFs will be considered Type I equities attracting a lower risk factor under the standard formula for the solvency capital requirement. Due to this beneficial treatment, investment managers and promoters are showing considerable interest in establishing ELTIFs specifically targeting insurance undertaking investors.

It is anticipated that ELTIFs will be particularly attractive to pension funds, large insurance companies and other entities which have longer-term liabilities and, accordingly, are seeking to generate long-term returns within a regulated fund structure.

Structure and Authorisation

An ELTIF may be marketed in the EU only when it has been authorised under the ELTIF Regulation. Only EU alternative investment funds (AIFs) are eligible to apply for authorisation as an ELTIF, and an ELTIF manager will have to comply with the requirements of the EU Alternative Investment Fund Managers Directive (AIFMD). A key distinction between the AIFMD and the ELTIF frameworks is that, unlike AIFs managed by alternative investment fund managers (AIFMs), ELTIFs may be marketed to retail investors using a pan-EU passport.

ELTIFs are, in principle, closed-ended investment vehicles. As a general rule, an ELTIF is not permitted to offer investors the ability to redeem their investment before the end of the life of the fund, which should be clearly stipulated in the ELTIF's constitutional document and disclosed to investors. The life of the ELTIF must be consistent with its long-term nature and must be sufficient in length to cover the life-cycle of each of its individual investments. However, early redemption rights can be made available under certain conditions, to incentivise investors who may not be willing to lock their capital up for a long period of time (see further below under the section on Redemption and Disposal of Shares).

An ELTIF must apply for authorisation to its home member state and, as part of its application, must submit:

• its constitutional documentation;

• information on the identity of the proposed manager and depositary; and

• a description of the information to be made available to investors.

 

The proposed manager of an ELTIF must also apply to the home member state of the ELTIF for approval to manage the ELTIF. The application for approval of the ELTIF manager must include:

• a written agreement with the depositary;

• information on the delegation arrangements regarding portfolio and risk management and administration; and

• information about the investment strategies, risk profile and other characteristics of AIFs which the EU AIFM is authorised to manage.

 

Where the home member state of the ELTIF is the same as that of the EU AIFM being appointed as manager, an application for approval of the manager may refer to the documentation submitted for authorisation under the AIFMD.

One of the key benefits of an ELTIF is that it can avail of a pan-EU marketing passport, for marketing to both retail and professional investors, in contrast to the marketing of EU alternative investment funds, which may be marketed only to professional investors.

Similar to the AIFMD, the ELTIF Regulation provides that an ELTIF may be internally managed and choose not to appoint an external manager. In such a case, the EU AIF must apply simultaneously for authorisation as an ELTIF under the ELTIF Regulation and as an AIFM under the AIFMD.

The ELTIF Regulation provides that the home state regulator has a period of two months during which to consider an application for the authorisation of an ELTIF, such time limit being extended to three months in the case of an internally managed ELTIF.

The manager of an ELTIF is responsible for ensuring compliance with the ELTIF Regulation, and may be liable for losses or damages resulting from non-compliance under both the ELTIF Regulation and the AIFMD.

Investment Policies and Eligible Assets

The ELTIF Regulation facilitates a wide range of eligible assets for investment, including property, loans, aircraft, vessels, social infrastructure, equity and debt instruments and intellectual property. Pursuant to the ELTIF Regulation, an ELTIF may invest in 1) eligible investment assets and 2) the UCITS (undertakings for collective investment in transferable securities) eligible assets specified in the EU UCITS Directive.

“Eligible investment assets” are defined as:

• equity or quasi-equity instruments which are issued by a qualifying portfolio undertaking or the parent of a qualifying portfolio undertaking which is a majority owner of the qualifying portfolio undertaking;

• debt instruments issued by a qualifying portfolio undertaking;

• loans granted by the ELTIF to a qualifying portfolio undertaking which mature within the life of the ELTIF;

• units or shares of one or several ELTIFs, European Venture Capital Funds (EuVECAs) and European Social Entrepreneurship Funds (EuSEFs), provided that those funds have not themselves invested more than 10 percent of their capital in ELTIFs; and

• direct or indirect holdings via qualifying portfolio undertakings of individual real assets with a minimum value of 10 million euros (U.S.$10.9 million) or the equivalent in another currency.

 

A qualifying portfolio undertaking is an undertaking, other than a collective investment undertaking, which:

• is not a “financial undertaking” as defined in the ELTIF Regulation, meaning it is not a credit institution, an EU Markets in Financial Instruments Directive (MiFID) investment firm, an insurance undertaking, a financial holding company, a mixed-activity holding company, a UCITS management company or an AIFM. A financial undertaking is permitted where it exclusively finances qualifying portfolio undertakings or real assets;

• is unlisted, or is listed with a market capitalisation not exceeding 500 million euros (U.S.$546.7 million); and

• is established in an EU member state, or in a third country, provided that the third country is not a high-risk non-cooperative jurisdiction identified by the Financial Action Task Force and has signed a tax information exchange agreement with the home member state of the ELTIF manager and with every member state where it is intended to market the ELTIF.

 

Investment Restrictions

The ELTIF Regulation provides that an ELTIF may not:

• engage in short selling;

• take direct or indirect exposure to commodities, including via financial derivative instruments, certificates representing them, indices based on them or any other means or instrument that would give an exposure to them;

• enter into securities lending, securities borrowing, repurchase transactions, or any other agreement that has an equivalent economic effect and poses similar risks, if more than 10 percent of the assets of the ELTIF are affected; or

• use financial derivative instruments, except where the use of such instruments solely serves the purpose of hedging the risk inherent in other investments of the ELTIF.

 

In relation to the final point, the European Securities and Markets Authority (ESMA) is required to develop draft regulatory technical standards (RTS) specifying the criteria for establishing the circumstances in which the use of financial derivative instruments solely serves the purpose of hedging the risks inherent in other investments of the ELTIF.

Portfolio Composition and Diversification

The ELTIF Regulation requires that an ELTIF invests at least 70 percent of its capital in eligible investment assets. This investment limit applies from the date specified in the ELTIF's constitutional documents, which must be no later than five years after the date of authorisation as an ELTIF, or half the life of the fund, whichever is earlier. The investment limit will cease to apply once the ELTIF starts to sell assets in the lead-up to the closure of the ELTIF, and may be temporarily suspended during the life of ELTIF for up to 12 months.

Diversification requirements apply so that the ELTIF may invest no more than:

• 10 percent of its capital in instruments issued by, or loans granted to, any single qualifying portfolio undertaking;

• 10 percent of its capital directly or indirectly in a single real asset;

• 10 percent of its capital in units or shares of any single ELTIF, EuVECA or EuSEF; or

• 5 percent of capital in UCITS eligible assets where those assets have been issued by any single body.

 

The aggregate value of units or shares of ELTIFs, EuVECAs and EuSEFs in an ELTIF portfolio may not exceed 20 percent of the value of the capital of the ELTIF. The aggregate risk exposure to a counterparty stemming from over-the-counter derivative transactions, repurchase agreements or reverse repurchase agreements may not exceed 5 percent of the value of the ELTIF's capital.

The 10 percent limit applicable to investments in instruments issued by, or loans granted to, any single qualifying portfolio undertaking, or in any single real asset, can be raised to 20 percent provided the aggregate value of those investments in which the ELTIF holds more than 10 percent of its capital does not exceed 40 percent of the value of the ELTIF's capital. The 5 percent limit applicable to investments in UCITS eligible assets may be increased to 25 percent where bonds are issued by a credit institution which has its registered office in a member state and is subject by law to special public supervision designed to protect bondholders.

Investment managers and promoters are showing considerable interest in establishing ELTIFs specifically targeting insurance undertaking investors.

Concentration and Borrowing Limits

No more than 25 percent of the units or shares of a single ELTIF, EuVECA or EuSEF can be acquired by an ELTIF. Where an ELTIF invests in UCITS eligible assets, the concentration limits in the UCITS Directive apply.

The ELTIF Regulation also imposes restrictions on an ELTIF's ability to borrow, with leverage of only 30 percent of the assets of the ELTIF permitted. The borrowing must be for the purpose of investing in eligible investment assets, with the exception that borrowed cash may not be used for granting loans to qualifying portfolio undertakings. It must be contracted in the same currency as the assets to be acquired with the borrowed cash, and it must have a maturity no longer than the life of the ELTIF. The ELTIF's prospectus must disclose whether the ELTIF manager intends to borrow cash as part of its investment strategy.

Redemption and Disposal of Shares

As ELTIFs are closed-ended funds, investors in an ELTIF are not ordinarily permitted to request the redemption of their units or shares before the end of the life of the ELTIF. However, one of the most significant amendments introduced during the political negotiation of the ELTIF Regulation is the inclusion of a provision which allows redemptions before the end of the life of the ELTIF, subject to the following conditions:

• redemptions are not granted before the 70 percent “eligible investment assets” investment limit becomes applicable;

• at the time of the authorisation of the ELTIF and throughout its life, the manager of the ELTIF can demonstrate that it has appropriate procedures and systems in place to manage the liquidity of the ELTIF and to monitor liquidity risk which are compatible with the long-term investment strategy of the ELTIF and the proposed redemption policy;

• there is a defined redemption policy in place which clearly indicates the redemption periods;

• the redemption policy of the ELTIF ensures that the overall amount of redemptions within any period is limited to a percentage of the ELTIF's assets invested in UCITS eligible assets and that this percentage is in line with the liquidity management and investment strategy of the ELTIF's manager; and

• the redemption policy of the ELTIF ensures the fair treatment of investors with redemption requests being processed on a pro rata basis if the percentage outlined above is exceeded.

 

While the ELTIF Regulation does contain significant limits on redemptions, it also provides that units or shares of an ELTIF may be listed and traded on a regulated market and may also be transferred to third parties other than the ELTIF manager. Therefore, investors may be in a position to dispose of any units or shares, within a reasonable period of time, should they so require.

One of the most significant amendments introduced during the political negotiation of the ELTIF Regulation is the inclusion of a provision which allows redemptions before the end of the life of the ELTIF, subject to certain conditions.

Disclosure Requirements

The ELTIF Regulation specifies certain information that must be contained in the ELTIF's prospectus, in addition to the disclosures required for EU AIFs under the AIFMD and for closed-ended funds under the EU Prospectus Directive. The disclosure obligations include a requirement to prominently notify investors of the illiquid and closed-ended nature of the ELTIF and the date of the end of the life of the ELTIF, as well as the option to extend the life of the ELTIF where this has been provided for in its constitutional documents. The prospectus should also state whether the ELTIF is intended to be marketed to retail investors and advise all investors that only a small proportion of their overall investment portfolio should be invested in an ELTIF. The risks related to investing in real assets, including infrastructure, must be disclosed.

The prospectus must also contain information on the level of the different costs borne directly or indirectly by investors, including the cost of establishment, costs related to the acquisition of assets, management and performance related fees, distribution costs and other costs, including an overall ratio of the costs to the capital of the ELTIF.

Marketing to Retail Investors

As noted above, the ELTIF can avail of a pan-EU marketing passport. When marketing to retail investors, ELTIFs will be subject to the regulation on key information documents for packaged retail investment and insurance products (PRIIPs Regulation), and therefore will be required to provide investors with a Key Information Document (KID) prior to their investment. While the PRIIPs Regulation will not become directly applicable until December 31, 2016, asset managers who wish to market an ELTIF to retail investors should be cognisant of these requirements.

Safeguards

A number of safeguards are required to be put in place where it is intended to market the units or shares of an ELTIF to retail investors. These include the requirement to appoint a facilities agent in each member state in which it is intended to market the ELTIF. The types of facilities to be provided will be set out in regulatory technical standards. It is expected that the requirements in this respect will be substantially the same as the requirements imposed under the UCITS Directive.

The manager of an ELTIF is required to establish internal assessment processes in order to determine whether the ELTIF is suitable for marketing to retail investors, taking into account the proposed duration of the ELTIF and its intended investment strategy. In addition, when offering units or shares of an ELTIF to a retail investor, the ELTIF manager is required to obtain information in relation to the retail investor's experience of investing and financial situation, and the manager or distributor must provide the retail investor with appropriate investment advice. Where the life of an ELTIF that is marketed to retail investors exceeds 10 years, the manager or distributor must issue a clear written alert that the ELTIF product may not be suitable for retail investors.

The ELTIF Regulation imposes requirements in relation to the marketing of ELTIFs to retail investors who have an investment portfolio which does not exceed 500,000 euros (U.S.$546,700) in value. In such a situation, and after carrying out the required suitability assessment and providing the retail investor with appropriate investment advice, the ELTIF manager (or any appointed distributor) is required to ensure that the retail investor does not invest an aggregate amount exceeding 10 percent of the retail investor's portfolio in the ELTIF and that the initial minimum amount invested in one or more ELTIFs is 10,000 euros (U.S.$10,934). A two-week cooling-off period is provided for during which retail investors can cancel their investment in the ELTIF.

Depositary Provisions

Where ELTIFs are marketed to retail investors, the depositary of the ELTIF may not discharge itself of liability in the event of a loss of financial instruments held in custody by a delegate. In addition, such a depositary may not re-use the assets of the ELTIF for its own account.

Next Steps

As outlined above, the ELTIF Regulation applies from December 9, 2015. The consultation in respect of the ESMA RTS closed on October 14, 2015, and, once published, the RTS will provide further detail in relation to various ELTIF requirements.

The Irish Funds industry actively participated in the RTS consultation process and submitted a response containing a number of recommendations and points for clarification in respect of certain aspects of the ELTIF regime.

The Irish Minister for Finance, Michael Noonan, signed the European Union (European long-term investment funds) Regulations 2015 into law on December 9, 2015, to facilitate the establishment of ELTIFs in Ireland. ELTIF application forms are now available from the Central Bank of Ireland.

The EU Regulation on European Long-Term Investment Funds is available at http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32015R0760.

Tara Doyle is a Partner and Michelle Ridge and Oisín McClenaghan are Senior Associates at Matheson, Dublin. They may be contacted at tara.doyle@matheson.com, michelle.ridge@matheson.com and oisin.mcclenaghan@matheson.com.