The European Long-Term Investment Funds Regulation

Harmonised rules have now taken effect across the EU

MICHELLE RIDGE AND DARYL O’BRIEN, MATHESON

The introduction of European Long Term Investment Funds (ELTIFs) provides for a new type of investment fund, available to both retail and professional investors. Regulation (EU) 2015/760 on European long-term investment funds (the ELTIF Regulation) took effect on 9 December 2015 and implements harmonised EU rules relating to the authorisation, investment policies and operating conditions for ELTIFs.  

The European Commission estimates that between €1.5 to €2 trillion will be required in order to finance infrastructure projects in Europe 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 European economic growth. Supporting the take-up of ELTIFs has been identified by the Commission as a priority work area within the Capital Markets Union (CMU) project.

It is anticipated that ELTIFs will be attractive to pension funds, large insurance companies and other entities which have longer-term liabilities that are seeking to generate long-term returns within a regulated fund structure. They also represent an investment opportunity for affluent retail investors who are willing to “lock up” their investment in the long term. Under Solvency II, insurance undertakings’ investments in ELTIFs will be subject to beneficial capital treatment. Accordingly, investment managers and promoters are showing considerable interest in establishing ELTIFs specifically targeting insurance undertaking investors.

The purpose of this article is to provide an overview of the ELTIF structure and the investment policies, eligible assets, investment restrictions and diversification requirements contained in the ELTIF Regulation.

Structure
An ELTIF may only be marketed in the EU 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 Alternative Investment Fund Managers Directive (Directive 2011/61/EU) (as amended) (AIFMD). The main distinction between the AIFMD and the ELTIF frameworks is that, unlike AIFs managed by AIFMs, ELTIFs may be marketed to retail investors using a pan-European passport.

ELTIFs will in principle be closed-ended investment vehicles. As a general rule, an ELTIF will not be 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. Early redemption rights may be made available in certain circumstances, to incentivise investors who may not be willing to lock their capital up for a long period of time (see further below under Redemption and disposal of shares).

The manager of an ELTIF will be 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 (a) eligible investment assets and (b) the UCITS eligible assets specified in the UCITS IV Directive. The broad spectrum of eligible assets reflects the need for alternative sourcing of funding for infrastructure projects across Europe.

“Eligible investment assets” are defined as:  

  • Equity or quasi-equity instruments which are issued by a “qualifying portfolio undertaking” (broadly speaking, unlisted companies or listed companies with market capitalisation of less than €500 million) 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% 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 or the equivalent in another currency.

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 (FDI), 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 with an equivalent economic effect and which poses similar risks, if more than 10% of the assets of the ELTIF are affected; or
  • Use FDI, 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 FDI 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% 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% of its capital in instruments issued by, or loans granted to, any single qualifying portfolio undertaking;
  • 10% of its capital directly or indirectly in a single real asset;
  • 10% of its capital in units or shares of any single ELTIF, EuVECA or EuSEF;
  • 5% 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% of the value of the capital of the ELTIF. The aggregate risk exposure to a counterparty stemming from OTC derivative transactions, repurchase agreements or reverse repurchase agreements may not exceed 5% of the value of the ELTIF’s capital.

The 10% 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% provided the aggregate value of those investments in which the ELTIF holds more than 10% of its capital does not exceed 40% of the value of the ELTIF’s capital. The 5% limit applicable to investments in UCITS eligible assets may be increased to 25% 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.

Concentration and borrowing limits
No more than 25% of the units or shares of a single ELTIF, EuVECA or EuSEF can be acquired by an ELTIF. The ELTIF Regulation also imposes restrictions on an ELTIF’s ability to borrow, with leverage of only 30% 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. 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 a closed-ended fund, investors in an ELTIF will not ordinarily be 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% “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. Investors may therefore be in a position to dispose of any units or shares, within a reasonable period of time, should they so require.

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 AIFMD and for closed-ended funds under the 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.  

Marketing to retail investors
As noted above, the ELTIF can avail of a pan-European 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 will therefore 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 31 December 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 intends to market the ELTIF. The types of facilities to be provided will be set out in ESMA’s RTS.

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.

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 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% of the retail investor’s portfolio in the ELTIF and that the initial minimum amount invested in one or more ELTIFs is €10,000. 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.

Conclusion
As outlined above, the ELTIF Regulation has been directly applicable since 9 December 2015. From an Irish perspective, the Minister for Finance has also signed the European Union (European long-term investment funds) Regulations 2015 into effect to facilitate the establishment of ELTIFs in Ireland. The relevant ELTIF application forms are also expected to be available from the Central Bank of Ireland shortly. There is ongoing engagement between industry and the Central Bank in relation to the authorisation of ELTIFs in Ireland. The consultation in respect of ESMA’s RTS closed on 14 October 2015 and, once published, the RTS will provide further detail and clarity in relation to various ELTIF requirements.

There is a considerable drive by the Commission to make the ELTIF a success and stimulate growth, with this new fund product seen as a key source of non-bank finance in line with the CMU project. This political support may create sufficient impetus to encourage the establishment of ELTIFs, and together with various incentives including the proposed amendments to Solvency II (which will grant a more favourable treatment to ELTIF investments), may also prove attractive. Fund managers may also be awaiting further clarity from ESMA and perhaps the uptake of the ELTIF regime will increase significantly after the release of ESMA’s RTS, but only time will tell.

Michelle Ridge is a partner in the Asset Management and Investment Funds Group of Matheson, which is the number one ranked funds practice in Ireland, Ridge has extensive experience in advising the world's leading financial institutions, investment banks, asset managers and service providers on the structuring, establishment and sale of alternative fund and UCITS investment vehicles and products.

Daryl O'Brien is an associate in the Asset Management and Investment Funds Group of Matheson, O'Brien has broad experience advising on the establishment, authorisation and operation of various types of UCITS and alternative funds.