ELTIF 2.0: retailization of private funds – the gateway to heaven or a storm in a teacup? | Dechert LLP

ELTIF 2.0: retailization of private funds – the gateway to heaven or a storm in a teacup? | Dechert LLP

Key takeaways:

  • Since Regulation (EU) 2015/760 of the European Parliament and of the Council of 29 April 2015 on European long term investment funds (ELTIF Regulation) was adopted, only a few European long-term investment funds (ELTIFs) have been launched.
  • The ELTIF Regulation is being revised in an effort to channel more investments into businesses in need of capital and into long-term investment projects.
  • The proposed revised ELTIF Regulation will differentiate between ELTIFs marketed to professional investors and those ELTIFs marketed to retail investors – with professional investor ELTIFs facing fewer restrictions, – for example in terms of diversification requirements, leverage, and being permitted to make investments in other funds. There are also changes proposed to make it easier for retail investors to access ELTIFs by removing minimum investment requirements and limitations on aggregate investments.
  • The proposed revised ELTIF Regulation has not been without criticism, as discussed below.
  • The ELTIF is the sole non-sector specific European-wide fund product which can be marketed to retail investors in Europe under a specific marketing passport regime. It will therefore arguably form a key tool in progressing the retailization of private funds in the European Economic Area (EEA).1
  • The current expectation is that the revised ELTIF Regulation (ELTIF 2.0) will enter into force in Q1 2023 and its provisions will apply nine months later, i.e. most likely from early 2024.

Latest update on ELTIF 2.0

Following informal negotiations between representatives of the European Council (Council), the European Commission (Commission) and European Parliament (Parliament), on 7 December 2022 the Council published a note2 indicating that it would adopt the current text of the proposed revision of the ELTIF Regulation agreed between the Council and the European Parliament (Parliament) in October 2022, provided that the Parliament also agreed to adopt the same text. The text of the overall compromise package is included as an annex to the Council’s note. The next step is for the Council and the Parliament to formally adopt the revised ELTIF Regulation. On 12 January 2022, as part of the ongoing European legislative process, the Parliament’s Committee on Economic and Monetary Affairs (ECON) approved the text of ELTIF 2.0.3

In this OnPoint, we look at main amendments that have been proposed to the ELTIF Regulation and their impact on the European investment funds’ market.

For ease of reference, we have also created a marked-up version of the original ELTIF Regulation against ELTIF 2.0, showing the changes proposed to be made and which is accessible here.

Please note: This mark-up of the original ELTIF Regulation is provided for reference only. Dechert does not assume any liability for its contents or accuracy. The authentic versions of the relevant current and draft legislation, including their preambles, are those published in the Official Journal of the European Union.

Background to ELTIF 2.0

The original ELTIF Regulation entered into force on 19 May 2015 with the objective of raising and channelling capital towards European long-term investments in the real economy, in line with the EU wider objective of smart, sustainable and inclusive growth.4 The ELTIF framework initially received considerable attention, in particular given that the ELTIF Regulation provided that funds qualifying as ELTIFs could be marketed to retail investors on the basis of an EEA-wide passport, similar to the marketing passport available to professional investors under the Alternative Investment Fund Managers Directive (AIFMD).5

However, over time, it has become clear that the original ELTIF Regulation has not achieved the desired success. As of December 2022, only 81 ELTIFs have been registered in the entire EEA (45 in Luxembourg, 21 in France, 13 in Italy and two in Spain), with only a single-digit figure in billion under management. In terms of number of funds, this is still extremely low compared for example with the Luxembourg (national) Reserved Alternative Investment Fund (RAIF)6 regime introduced just a year later, which by September 2022, had seen 1686 RAIFs established.7 The European legislative institutions were acutely aware of the shortcomings of the ELTIF Regulation, as is evident from the following recital to ELTIF 2.0:

Certain characteristics of the ELTIF market, including the low number of funds, the small net asset size, the low number of jurisdictions in which ELTIFs are domiciled, and a portfolio composition that is skewed towards certain eligible investment categories, demonstrate the concentrated nature of that market, both geographically and in terms of investment type. Moreover, it appears that there is a lack of awareness and financial literacy, but most importantly a low level of trust and reliability in the finance industry, that should be overcome to make ELTIFs more accessible and popular among individual investors. It is therefore necessary to review the functioning of the ELTIF legal framework to ensure that more investments are channeled to businesses in need of capital and to long-term investment projects”.8

The ELTIF Regulation included a review clause9 stipulating that certain provisions should be assessed and reviewed by the Commission no later than 9 June 2019. Following a public consultation process, on 25 November 2021 the Commission published its proposal for ELTIF 2.0 to address what were perceived as the main shortcomings of the original ELTIF Regulation.

ELTIF 2.0 has been discussed and amended by the Parliament and the Council in accordance with the European ordinary legislative procedure and political agreement on all major items was reached between the Parliament and the Council in October 2022. On 7 December 2022, the Council published an information note indicating that it would adopt the current form of ELTIF 2.0 if the Parliament also approves it.

This new legislative impetus is also reflected in a recent increase in the number of ELTIFs being registered (from 57 ELTIF on 25 November 2021 to 82 ELTIFs in the EU/EEA as of December 2022, an increase of approximately 30 percent within one year).10

What are the main changes proposed in ELTIF 2.0 compared to the original ELTIF Regulation?

We have set out below a non-exhaustive overview of the main changes to the ELTIF Regulation (based on the proposed version of ELTIF 2.0 as attached to the informative note sent by Council on 7 December 2022):

1. Eligible Investments (Note that ELTIF 2.0 distinguishes between funds marketed to retail investors and those marketed to professional investors. These additional differences are discussed in point 2 below).

a. Definition of real asset

Article 10(e) of the original ELTIF Regulation stipulated that a real asset must have a value of at least EUR 10 million or its equivalent in the relevant local currency. Under ELTIF 2.0, this threshold will be lowered to EUR 1 million. In addition, the definition of “real asset” has been simplified and now reads that a “real asset” is “an asset that has an intrinsic value due to its substance and properties” rather than the more restrictive provision included in the original ELTIF Regulation.

b. Market Capitalization Threshold

Article 11(b)(ii) of the original ELTIF Regulation stipulated that any undertaking admitted to trading on a regulated market or on a multilateral trading facility shall not have a market capitalization of more than EUR 500 million. Such threshold is increased to EUR 1.5 billion under ELTIF 2.0.

c. Portfolio Composition

Article 13(1) of the original ELTIF Regulation required an ELTIF to invest at least 70 percent of its assets in ELTIF eligible investments. This threshold has been lowered to 55 percent in ELTIF 2.0.

d. Diversification Limits

The 10 percent diversification requirement for investments in each underlying asset or portfolio undertaking per Article 13(2) of the original ELTIF Regulation has been increased to 20 percent in ELTIF 2.0. In addition, ELTIF 2.0 has increased the investment limit from five percent to 10 percent for investments in each underlying UCITS fund. This means that under the ELTIF 2.0 framework, ELTIFs will have the flexibility to pursue more concentrated investment strategies and be exposed to fewer eligible assets.

e. Concentration Limit

The 25 percent concentration limit in eligible underlying funds provided for by Article 15(1) of the original ELTIF Regulation has been increased to 30 percent under ELTIF 2.0]. More significantly, ELTIF 2.0 includes a new provision that the concentration limits shall not apply where ELTIFs are marketed solely to professional investors.

f. Possibility to invest in financial undertakings (to a limited extent)

The original ELTIF Regulation contained an outright prohibition on investing in financial undertakings such as credit institutions or credit firms. Pursuant to ELTIF 2.0, this prohibition no longer applies to a financial undertaking that is a financial holding company or a mixed-activity holding company, which has been authorized or registered less than five years prior to the date of the investment. The effect of this is that under ELTIF 2.0, it is possible for ELTIFs to invest in innovative new financial undertakings such as fintech companies.

g. Investments in non-EU Assets

Article 1(2) of the original ELTIF Regulation stated, relatively restrictively, that its objective was “to raise and channel capital towards European long-term investments in the real economy”. The objective of ELTIF 2.0 is now substantially wider, being to “facilitate the raising and channeling of capital towards long-term investments in the real economy, including towards investments that promote the European Green Deal and other priority areas, in line with the Union objective of smart, sustainable and inclusive growth.

The CSSF, (the Luxembourg regulator) has in practice permitted ELTIFs to have up to 50 percent of their portfolio exposed to non-European assets, ELTIF 2.0 introduces changes. ELTIF 2.0 amends Article 11(c)(ii) of the original ELTIF Regulation to provide that investments in qualifying portfolio undertakings based in non-cooperative jurisdictions for tax purposes will not be permitted. The original ELTIF Regulation provided that qualifying portfolio undertakings needed to be based in a jurisdiction that had entered into an agreement for the sharing of tax information with the home Member State of the ELTIF and any other Member State in which the relevant ELTIF is marketed. The ELTIF 2.0 framework is much less restrictive in terms of where portfolio undertakings can be based.

h. Master-Feeder Structures

The limit on an ELTIF being able to invest only 20 percent of its assets in other ELTIFs, EuVECAs11 or EUSEFs12 in Article 13(3) of the original ELTIF Regulation has been seen as a significant reason for the lack of ELTIF uptake. ELTIF 2.0 has removed this restriction, de facto allowing for master-feeder structures. Although, a master-feeder structure will be allowed, unfortunately it is limited to instances where both the master and the feeder are ELTIFs. Several disclosure obligations (in particular disclosure of fee arrangements at master-fund level) have been included in ELTIF 2.0 to ensure adequate investor protection).13 There are also some material additional obligations in new Articles 29(6) and 29(7) of ELTIF 2.0 which require information sharing agreements to be in place where the master ELTIF and the feeder ELTIF have different management companies or depositaries.

i. Fund-of-fund structures

The addition of the ability to invest into other EU AIFs as provided for in Article 10 (1)(d) of ELTIF 2.0 will14 permit ELTIFs to be structured as fund-of-funds vehicles. Such a structure was not possible under the original ELTIF Regulation. This is one of the long-awaited amendments to the original framework which has been positively received by investment funds managers.

j. Securitizations

ELTIF 2.0 enables an ELTIF to invest in underlying securitizations, including mortgage-backed securities, commercial, resi­dential, and corporate loans, as well as trade receivables – something that was not possible under the original ELTIF Regulation. Per Article 8(3) of ELTIF 2.0, such securitization investments may amount to up to 20 percent of the capital value of the relevant ELTIF.

k. Minority co-investments

The revisions to Article 10(a)(iii) under ELTIF 2.0 will enable ELTIFs to hold minority co-investment participations in qualifying portfolio undertakings which, under the original ELTIF Regulation, was only possible if the relevant ELTIF held a majority of the units, shares or interests of the relevant qualifying portfolio undertaking. This is another amendment that has been welcomed by the investment fund industry because it will create additional flexibility in the structuring of investments by the ELTIF, rendering it much more similar to other alternative fund vehicles such as the RAIF.

2. Retail investors

a. Differentiation between retail and professional investors

The EU legislators recognize that retail investors and professional investors have different time horizons, risk tolerances, investment needs and capabilities. In light of this ELTIF 2.0 provides specific rules for ELTIFs that are destined to be marketed specifically to professional investors.

ELTIF 2.0 stipulates that certain requirements in relation to the diversification and composition of the portfolio, the minimum threshold for eligible assets, the concentration limits and the borrowing of cash that previously applied to all ELTIFs under the original ELTIF Regulation shall no longer apply to ELTIFs that are exclusively marketed to professional investors.

A new paragraph in Article 13(8) in ELTIF 2.0 provides that the single asset limitation, the percentage limitation on investments into underlying securitizations and the counterparty exposure limit do not apply to an ELTIF that is solely marketed to professional investors. Another instance of differentiation between ELTIFs marketed to retail investors and those marketed solely to professional investors is in the amendment to Article 16(1)(i)(a) of ELTIF 2.0 which stipulates a borrowing limit of 50 percent of net asset value (NAV) where the ELTIF is marketed to retail investors in comparison to a borrowing limit of 100 percent of NAV where the ELTIF is marketed solely to professional investors.

b. Assessment of suitability

Article 30(3) of the original ELTIF Regulation included a cumbersome, double-layered assessment of suitability for retail investors (a minimum of EUR 10,000 investment but no more than 10 percent of a retail investor’s financial instrument portfolio in any one ELTIF). ELTIF 2.0 has removed these requirements and the suitability assessment has been streamlined to take into account developments under MiFID II15 as well as retail investor -specific requirements. In addition, ELTIF 2.0 no longer requires the manager of an ELTIF or relevant distributor to provide “investment advice” to retail investors (as was required under Article 30(1) of the original ELTIF Regulation). This is a welcome move as the concept of “investment advice” was not quite clearly set out in the original ELTIF Regulation.

c. Additional retail investor protection mechanisms

Article 30 of ELTIF 2.0 includes specific requirements concerning the distribution and marketing of ELTIFs to retail investors that are intended to increase investor protection. This includes an obligation on the ELTIF manager to provide for clear written alerts where the ELTIF has a lifetime of more than ten (10) years or where the rules or instruments of incorporation of an ELTIF provide for the possibility a matching mechanism as further described in point 4. below. In addition, a retail investor is required to give its explicit consent where it wishes to invest into an ELTIF notwithstanding a negative sustainability assessment in relation to the specific ELTIF.

d. Removal of need for local facilities in country where ELTIF is marketed to retail investors

Article 26 of the original ELTIF Regulation has been deleted, meaning that there is no longer a requirement to put in place local facilities in each EU Member State where the ELTIF is marketed to retail investors. This could potentially significantly reduce the cost burden on ELTIF managers.

e. Distribution rules

In addition to the suitability assessment modifications as described above, Articles 27 to 31 of the original ELTIF Regulation have been modified or deleted in ELTIF 2.0 to align the requirements with those with the that are already well established under MiFID II.

3. Manager authorization

Article 5 of the original ELTIF Regulation has been amended to provide that only the ELTIF itself is subject to regulatory authorization. ELTIF 2.0 no longer subjects EU AIFMs to an “additional” ELTIF management authorization. The rationale behind this amendment is to promote cross-border ELTIF set-ups (where the ELTIF and the EU AIFM can be domiciled in different EU Member States).

4. Redemptions / liquidity window

Whilst ELTIF 2.0 makes minor modifications to Article 18 of the original ELTIF Regulation, the rules on redemptions remain relatively stringent. This makes making the ELTIF more suitable for closed-ended funds than for open-ended or semi-liquid fund structures.

ELTIF 2.0 does foresee a new and, as far as funds legislation at European level is concerned, unique matching mechanism for transfers of the relevant ELTIFs shares or units under Article 19(2)(a). This matching mechanism states that the rules or instruments of incorporation of the ELTIF may provide for the possibility of full or partial matching, during the life of the ELTIF, of transfer requests of units or shares of the ELTIF by exiting ELTIF investors with transfer requests by potential investors, provided that specific conditions are fulfilled. This matching mechanism could be used to generate liquidity in these otherwise very illiquid investment structures.

5. Borrowing

Article 16(1)(a) of the original ELTIF Regulation limited any borrowing to 30 percent of the value of the capital of the relevant ELTIF. In ELTIF 2.0, this limit has been replaced with a two-tiered borrowing limitation of 50 percent of NAV of the relevant ELTIF for ELTIFs marketed to retail investors, and 100 percent of the NAV of the relevant ELTIF for ELTIFs marketed to professional investors only. In addition, Article 16(1)(c) of ELTIF 2.0 will allow for borrowings in a currency other than the currency in which a relevant asset is to be acquired, as long as appropriate currency hedging arrangements are in place.

ELTIF 2.0 amends Article 16(1)(e) in a manner that will allow all assets to be fully pledged or encumbered. This is expected to make lending arrangements for ELTIFs easier than under the current limitation whereby the pledge was limited to 30 percent of the capital value of the assets of the respective ELTIF.

6. ELTIF Register

Article 3(3) of the original ELTIF Regulation required the European Securities and Markets Authority (ESMA) to keep a central public register of ELTIFs. ELTIF 2.0 expands on the original provisions and requires much more granular detail to be provided to ESMA. For example, ESMA is to be provided with the Legal Entity Identifier (LEI) and the national code identifier of the ELTIF, the name, address and the LEI of the ELTIF manager, the International Securities Identification Numbers (ISIN) codes of the ELTIF and of each separate share or unit class, the competent authority of the ELTIF and the home Member State of that ELTIF, the Member States where the ELTIF is marketed, whether the ELTIF can be marketed to retail investors or can solely be marketed to professional investors, the date of the authorization of the ELTIF, and the date on which the marketing of the ELTIF has commenced.

7. Equal treatment

A new Article 30(6) has been included in ELTIF 2.0 requiring that all retail investors benefit from equal treatment and that no preferential treatment or specific economic benefit is granted to individual investors or groups of investors within the same class or classes. This amendment is intended to create greater legal security for carried interest structures or other differentiations that may otherwise occur between classes of shares.

8. Conflict-of-interest provisions and co-investments

Article 12 of the original ELTIF Regulation is amended to allow co-investments by the ELTIF manager and the relevant staff directly with or in the relevant ELTIF provided that any conflicts of interest that arise from such co-investment are properly dealt with and disclosed. Co-investment is commonly seen in other fund structures to ensure some “skin in the game” and “alignment of interest” as well as investment opportunities for fund managers in their own products so this amendment will align ELTIF 2.0 with market expectations for private asset vehicles.

ELTIF 2.0 is not perfect……

There are two main criticisms that have been levelled against ELTIF 2.0 by industry bodies representing market participants and by other discussion fora:

  • The amendments are being perceived as too modest and not sufficiently ambitious.

Some commentators are of the view that the amendments proposed by ELTIF 2.0 are insufficient to create a truly attractive pan-European fund product for retail investors that could rival the UCITS. In particular, the fact that an open-ended ELTIF is only possible when respecting fairly limiting redemption rules during the ELTIF’s term may be perceived as an obstacle by or for retail investors who may not want or may not be able to lock in their liquidity for a substantial amount of time.

Another area where market participants think that ELTIF 2.0 could have broadened its appeal is with regards to the proposals for master-feeder structures. Creating a double layer of ELTIFs (i.e. both the feeder and the master need to qualify as ELTIFs), is seen by some as unduly burdensome and restrictive without clearly adding investor protection. From a Luxembourg perspective, this seems rather restrictive as, for example, a RAIF could invest in an underlying master fund not qualifying as a RAIF provided that the relevant diversification limits and investment restrictions are contractually applied by the underlying master fund. It is also worth noting that the Commission’s original proposal for a green ELTIF has been dropped, based on the argument that the Sustainable Finance Disclosure Regulation16 applies to an ELTIF, and therefore there is no need for additional ELTIF-specific sustainability rules. Article 37(a) of ELTIF 2.0 does however provide for this to be considered as part of the review process.

  • The amendments may have less impact due to the on-going AIFMD review.

At the same time as the proposals for reform of the ELTIF Regulation were launched, the Commission also set out its proposals to make significant amendments to the AIFMD framework. From a loan origination perspective, in certain countries, ELTIFs are the only fund vehicles that are permitted to originate loans alongside banks or other licensed professionals. The discussed reform of AIFMD as regards the “loan originating funds” and the potential possibility to passport the “loan originating” activity by the AIFMs across the EEA could reduce the attractiveness of the ELTIF vehicle, even following its reform.

ELTIF is unlikely to become a vehicle of choice for “all investors” as, even under the ELTIF 2.0 framework, there are still elements that are not attractive to institutional investors. Compared to other regimes, such as RAIFs or fully unregulated vehicles, ELTIF 2.0 is still a relatively restrictive regime and institutional investors may not want to invest in parallel with a multitude of smaller retail investors.

What’s next?

The expectation is that the legislative procedure will be finalized by early March 2023 resulting in the formal entry into force of ELTIF 2.0 around that time. Based on previous experience, it is likely that the final approved text would be published in the Official Journal of the EU at the end of March or early April 2023, with its provisions entering into effect nine (9) months thereafter (i.e. January/February 2024).

It is worth noting that ELTIF 2.0 includes ‘“grandfathering’” for existing ELTIFs. Under the ELTIF 2.0 proposals, an existing ELTIF that complies with the current ELTIF Regulation will be deemed compliant (i.e. grandfathered) for five years following the date of the entry into application of ELTIF 2.0. However, ELTIFs that are authorized under the current ELTIF Regulation, but that wish to make use of the terms of the new ELTIF 2.0 rules, can simply notify their national competent authority of their wish to do so.

ELTIF 2.0 provides for a review process of the regime seven years after its entry into effect.

Conclusion

ELTIF 2.0 is currently attracting a lot of interest from industry participants as it fits well with the political desire to unlock large amounts of savings from private individuals for much-needed European infrastructure and other long-term projects. ELTIF 2.0 also provides retail investors with an opportunity to invest in assets other than stock markets or UCITS funds thereby increasing diversification and risk spreading, while at the same time maintaining certain safeguards and specific protections.

The retailization of private funds has attracted considerable attention, particularly in Luxembourg where, for example, the Part II Fund17 (which can also be combined with the ELTIF regime) offers an alternative path for asset managers to grant access to private market assets for retail investors. There has been significant growth in this area over the last year with many of the major global asset managers looking at these structures. It is foreseeable that ELTIF 2.0 will continue to attract substantial interest and growth for this type of fund, specifically in Luxembourg, which is excellently placed to benefit from this new regime due to its global recognition as a safe and tried-and-tested investment fund location, its favourable local legal framework and the experience and expertise of local service providers in this area.

Footnotes

1) European venture capital funds (EuVECAs) and European social entrepreneurship funds (EUSEFs) also grant potential access for retail investors but have a specific sector focus and hence cannot be used various asset classes in comparison to the ELTIF and are also very much niche vehicles due to their limitation to venture capital, respectively social entrepreneurship, funds.

2) The 7 December 2022 note, which includes the draft overall compromise package in ELTIF 2.0, is available here.

3) ECON is a committee of the Parliament which is responsible for the regulation of financial services, the free movement of capital and payments, taxation and competition policies, oversight of the European Central Bank, and the international financial system.

4) Article 1(2) of the ELTIF Regulation.

5) Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers.

6) The RAIF is a Luxembourg investment fund that can invest in all types of assets. It qualifies as alternative investment fund (AIF). It is not itself subject to product approval by the Luxembourg regulator, the CSSF.

7) Source : Association Luxembourgeoise des Fonds d’Investissement.

8) Alinea (3) of the proposed ELTIF Regulation.

9) Article 37 of ELTIF Regulation.

10) Figures verified on 14 December 2022 on ESMA website

11) European venture capital funds under Regulation (EU) N° 345/2013 of the European Parliament and Council of 17 April 2013 on European venture capital funds.

12) European social entrepreneurship funds under Regulation (EU) N° 346/2013 of the European Parliament and Council of 17 April 2013 on European social entrepreneurship funds.

13) For example, amendments to Article 23, in particular the inclusions of a new sub-paragraph (3)(a) and a new sub-paragraph (5).

14) Together with the deletion of Article 13(3) of the original ELTIF Regulation as illustrated above.

15) Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments.

16) Regulation (EU) 2019/2088.

17) Funds which are established under Part II of the Luxembourg law of 17 December 2010 on undertakings for collective investments, as amended from time to time. The specificity of this vehicle is that it contains no restrictions in terms of eligibility of investors as it covers the same investor category as a UCITS (i.e. retail and professional investor are eligible to invest).

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