ELTIFs - a long term answer for European investors?

This note examines the European Commission's proposal for a new investment vehicle, the European Long-term Investment Fund or ELTIF. The ELTIF vehicle would be available for marketing to all types of investors -- including retail - across the European Economic Area (EEA).

The Commission's proposal is now being considered by the Council of the EU (the Council) and the European Parliament (the Parliament) and an agreed text is likely to be finalised either in late 2014 or Q1 2015. The Regulation would then be translated into the official languages of the EU before being published in the Official Journal and entering into force 20 days later.

This note considers, in turn:

A. Overview of the proposed regime

B. Key provisions in the Proposal

1. Authorisation
2. Investment policies
3. Redemption, disposal and distribution
4. Transparency
5. Marketing
6. Review

C. The key battlegrounds between the Council, European Parliament and Commission

D. Where we are in the legislative process and next steps

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A. Overview of the proposed regime

On 26 June 2013, the European Commission (the Commission) adopted a proposal for a Regulation on European Long-term Investment Funds (the Proposal). This followed a public consultation by the Commission (the UCITS VI Consultation), which ran from 26 July to 18 October 2012, and which formed part of the review of possible changes to the UCITS regime.

The UCITS VI Consultation considered, among other things, how best to foster a culture of long-term investment in the EEA and whether the creation of a regime centred around long-term investments suitable for retail investors would be better achieved through amendments to the UCITS regime or through a separate, standalone legislative initiative. The Commission decided on the latter route and the ELTIF regime was born.

The intention behind the Proposal is to enable EU-based managers, authorised as alternative investment fund managers (AIFMs) of EU-based alternative investment funds (AIFs) under the EU's Alternative Investment Fund Managers Directive (AIFMD), to market long-term investment funds, 'ELTIFs', to all types of investors, including retail investors, across the EEA.

To achieve this, the Proposal sets out rules and restrictions on the authorisation, investment policies, and operating conditions of EU AIFs that may be marketed as ELTIFs. In order to qualify as an ELTIF, a fund must (among other things):

• invest at least 70% of its of its capital in eligible investment assets 
• not engage in short selling 
• observe strict limitations on its use of leverage and derivatives 
• be a closed-ended fund, and 
• be managed by an authorised AIFM.

The Commission's Proposal is currently under review by the Council and the Parliament. These institutions each have their own amendments, which they would wish to see incorporated into a final text of the Regulation. The Parliament is set to reconsider its amendments, following the European elections in May 2014, in the Autumn of 2014 while the Council will also hold further working group meetings during October 2014.

Although the Commission had intended the Regulation to enter into force early in 2015, this timing has now slipped. Negotiations (or trilogues) between the Council, Parliament and Commission are likely to start in Q4 2014 and may result in a political agreement for a final text of the Regulation either late in 2014 or in Q1 2015.

B. Key provisions in the Proposal

Note: The provisions set out below are those contained in the Commission's Proposal. These may well change (in some cases, perhaps significantly) between now the Commission, Council and Parliament reaching a final political agreement.

1. Authorisation (Articles 3 to 6 of the Proposal)

Only an EU AIF may be authorised as an ELTIF and only an authorised ELTIF may be marketed as an ELTIF in the EEA.

The ELTIF must apply for authorisation to its home state regulator. An EU AIFM wishing to manage an ELTIF must, in turn, apply to the ELTIF's home regulator for authority to do so. The Proposal specifies certain information, which must accompany each application (for example, the fund's instruments of incorporation, a written agreement with the fund's depositary and information on delegation arrangements concerning portfolio and risk management and administration).

The Proposal envisages the authorisation process taking no more than two months. Both the ELTIF and its manager must comply with the provisions of both the ELTIF Regulation and AIFMD.

2. Investment policies (Articles 7 to 15 of the Proposal)

An ELTIF is restricted to investing only in (a) eligible investment assets (see below) or (b) assets referred to in Article 50(1) of the UCITS Directive (UCITS assets) and must also comply with the diversification requirements set out below.

(a) Eligible investment assets

The Proposal defines eligible investment assets as being:

• equity or quasi-equity instruments that have been:
  • issued by a qualifying portfolio undertaking and acquired directly by the ELTIF from the qualifying portfolio undertaking (see below)
  • issued by a qualifying portfolio undertaking in exchange for an equity instrument previously acquired directly by the ELTIF from the qualifying portfolio undertaking, or
  • issued by an undertaking of which the qualifying portfolio undertaking is a majority-owned subsidiary, in exchange for an equity instrument acquired in accordance with points (i) or (ii) above by the ELTIF from the qualifying portfolio undertaking.
• debt instruments issued by a qualifying portfolio undertaking
• loans granted by the ELTIF to a qualifying portfolio undertaking
• units or shares of one or several other ELTIFs, European Venture Capital Funds (EuVECAs) and European Social Entrepreneurship Funds (EuSEFs), provided that those ELTIFs, EuVECAs and EuSEFs have not themselves invested more than 10% of their capital in ELTIFs, and
• direct holdings of individual real estate assets that require upfront capital expenditure of at least EUR10 million or its equivalent in the currency, and at the time, in which the expenditure is incurred.

(b) Qualifying portfolio undertaking

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

• is not a financial undertaking as defined in Article 2 of the Proposal (i.e., it is not a credit institution, a MiFID investment firm, an insurance undertaking or a financial holding company or mixed-activity holding company as defined in the Capital Requirements Directive)
• is not admitted to a regulated market, an Multilateral Trading Facility (MTF) or an Organised Trading Facility (OTF) as defined in MiFID/MiFIR
• is established in an EU Member State or in a third country which
  • is not a high risk and non co-operative jurisdiction as identified by the Financial Action Task Force, and
  • has signed an OECD Model Tax Convention in Income and on Capital agreement with the ELTIF manager's home Member State and with each other Member State in which the units or shares of the ELTIF are intended to be marketed

Notwithstanding point (a) above, a qualifying portfolio undertaking may be a financial undertaking provided that it exclusively finances qualifying portfolio undertakings in the meaning of the ELTIF Regulation and in real estate.

(c) Diversification provisions

An ELTIF must invest at least 70% of its capital in eligible investment assets as set out above.

It must not, however, invest more than:

• 10% of its capital in assets issued by any single qualifying portfolio undertaking
• 10% of its capital in an individual real asset
• 10% of its capital in units or shares of any single ELTIF, EuVECA or EuSEF, or
• 5% its capital in UCITS assets where those assets have been issued by any single body.

In addition:

• the figures of 10% referred to in bullets (a) and (b) above can be raised to 20% provided that the aggregate value of assets held by the ELTIF in qualifying investment portfolios and individual real assets in which it invests more than 10% of its capital does not exceed 40% of the value of its capital
• the aggregate value of units or shares of ELTIFs, EuVECAs and EuSEFs in an ELTIF portfolio cannot exceed 20% of the value of the ELTIF's capital
• the aggregate risk exposure to a counterparty of the ELTIF stemming from OTC derivative transactions or reverse repurchase agreements must not exceed 5% of the ELTIF's capital
• the ELTIF cannot acquire more than 25% of the units or shares of a single ELTIF, EuVECA or EuSEF, or 
• the ELTIF cannot invest in an eligible investment asset in which the manager has a direct or indirect interest, other than holding units or shares of the ELTIF it manages.

(d) Investment restrictions

An ELTIF cannot: 

• engage in short selling 
• take direct or indirect exposure to commodities 
• enter into securities lending and borrowing agreements or any other agreement that would encumber the assets of the ELTIF, or 
• use financial derivative instruments (except where the underlying instrument consists of interest rates or currencies and it solely serves the purpose of hedging the duration and exchange risks inherent to other investments of the ELTIF).

(e) Borrowing restrictions

An ELTIF may only borrow cash provided that it:

• represents no more than 30% of the capital of the ELTIF
• is used to acquire participation in eligible investment assets 
• is in the same currency as the assets to be acquired with it 
• does not hinder the realisation of any asset held in the ELTIF's portfolio, and 
• does not encumber the assets held in the ELTIF's portfolio.

3. Redemption, disposal and distribution (Articles 16 to 20 of the Proposal)

Investors in an ELTIF will not be able to redeem their units or shares before the end of life of the fund. This is a specific date, which must be clearly disclosed to investors and indicated in the ELTIF's rules or instruments of incorporation.

The life of an ELTIF must be sufficiently long to cover the life-cycle of each of the fund's individual assets, measured according to its 'illiquidity profile and economic life-style' as well as to the stated investment objective of the ELTIF.

Redemption to investors must commence on the day following the end of the ELTIF's life and investors must always have the option to be repaid in cash

The ELTIF's constitutional documents must not prevent shares or units in the ELTIF from either being admitted to trading on a regulated market, MTF or OTF, or from being freely transferred by investors to third parties.

The ELTIF must adopt an itemised schedule for the orderly disposal of its assets to redeem investors at its life's end -- the details that such a schedule must contain will be developed by the Commission as a level two measure.

Income generated by the assets in an ELTIF's portfolio must be regularly distributed to investors, unless it is required for future commitments of the ELTIF. The ELTIF must set out its distribution policy in its fund rules.

4. Transparency (Articles 21 and 22 of the Proposal)

An ELTIF cannot be marketed in the EEA unless a prospectus has previously been published, complying with the requirements of the Prospectus Directive as well as the further information specified under Article 21 of the Proposal (such as a statement setting out how the ELTIF's investment objectives and strategy for achieving these objectives qualify the fund as being long-term in nature).

Furthermore, no marketing of an ELTIF can be made to retail investors unless a Key Information Document (KID) has previously been published, which complies with the requirements of the proposed PRIIPS Regulation. (This Regulation will introduce a new pan-European pre-contractual product disclosure document for packaged retail investment products.)

The prospectus, KID and other marketing documents must, in particular, prominently notify investors of the illiquid nature of the ELTIF. Such documents must also clearly inform investors of other matters, including the date of the end of life of the ELTIF, whether the ELTIF is intended to be marketed to retail investors and the fact that investors have no right to redeem their investment until the end of the ELTIF's life.

In addition, the prospectus must prominently inform investors of the level of different costs which the investor will bear, either directly or indirectly, grouped under the following headings:

• Costs of set-up
• Costs related to acquisition of assets 
• Management costs 
• Distribution costs
• Other costs (eg, administrative, regulatory, custodial and audit costs).

5. Marketing (Articles 23 to 25 of the Proposal)

To market an ELTIF to professional and retail investors in the home Member State of the ELTIF, the manager must notify the home state regulator in accordance with Article 31 of the AIFMD.

The Proposal also contains a passporting regime, whereby the manager of an ELTIF can market a fund to professional and retail investors in Member States other than the ELTIF's home Member State, provided it has notified its home regulator in accordance with the process set out in Article 32 of the AIFMD, supplemented by the additional requirements of Article 25 of the Proposal (including, for example, providing the regulator with the ELTIF's prospectus and, where it is marketing to retail customers, its KID). It must inform the regulator, in respect of each ELTIF it intends to market, whether it will market to retail investors

The manager of an ELTIF must have facilities in place in each Member State in which it intends to market its ELTIFs, such facilities being available for making subscriptions, making payments to investors, repurchasing or redeeming units or shares and making available the prescribed information which the ELTIF and/or the manager must provide

Additional requirements apply where the ELTIF is to be marketed to retail investors:

• the ELTIF's constitutional documents must provide that all investors benefit from equal treatment and that no preferential treatment (such as side letters) or specific economic benefits are granted to individual investors or groups of investors
• the fund must not be structured as a partnership, and
• retail investors must be allowed a cooling off period during the subscription period and for at least two weeks after subscription, in which to cancel their subscription without charge.

6. Review (Article 30 of the Proposal)

Within three years of entry into force of the ELTIF Regulation, the Commission must start a review of its application, including, in particular:

• the impact of the restriction on investors from redeeming their units or shares before the end of the ELTIF's life
• an assessment of whether exempting a limited number of retail investors from the rule in (a) above would increase demand for ELTIFs among retail investors
• the impact on asset diversification of the 70% minimum threshold referred to above, and
• whether AIFMs falling beneath the threshold set out in Article 3(2) of AIFMD should be able to market ELTIFs in the EU.

C. The key battlegrounds between the Council, European Parliament and Commission

The amendments which the Parliament and by the Council wish to see made to the Commission's Proposal (see section D below) allow us to identify where differences exist between the three EU institutions as they prepare for trilogues. These negotiations will lead to a political compromise, which will be the basis of the final Regulation.

Clearly, where the Council and Parliament are in agreement on an issue, the likelihood is that this position will prevail and be adopted in the final text.

As set out in section D below, both Parliament and Council are continuing to review the Proposal despite having effectively reached their starting positions for trilogues. On the assumption that neither will make any significant alteration to their current position, among the key points to note are the following (references below to Articles are to those in the Proposal):

Authorisation (Article 4)

• The Parliament would require the manager of an ELTIF to make a simplified application, making reference to the application and information then submitted, in its application for authorisation under the AIFMD. 
• The Council would wish to see the authorisation process including provision for internally managed ELTIFs.

Eligible investment assets (Article 9)

• The Council would delete references to an ELTIF investing in other ELTIFs, EuVECAs and EuSEFs and widen its ability to invest by replacing these references with units or shares in AIFs, subject to certain caveats, such as the need for the AIF to have a depositary and that the AIF must not invest more than 10% of its own capital in other collective investment undertakings.

Qualified portfolio undertaking (Article 10)

• Both the Council and the Parliament propose that listed SMEs should be included as qualified portfolio undertakings.

Conflicts of interest (Article 11)

• The Proposal does not allow an ELTIF to invest in assets directly or indirectly related to its manager. The Council would, however, permit an ELTIF to invest in AIFs which are managed by the ELTIF manager, while the Parliament proposes that ELTIFs should be able to invest in assets related to the manager, providing they are eligible assets under the Regulation.

Portfolio composition and diversification (Article 12)

• The Council has deleted all references to investments in units or shares of ELTIFs, EuVECAs and EuSEFs, and has replaced these with references to AIFs generally.
• All three institutions are in agreement that 70% of an ELTIF's assets should be invested in eligible investment assets. The Parliament refines this so that 60% of the ELTIF's capital should be invested in certain categories of qualified portfolio undertakings in Member States. 
• Again, all three institutions agree that investments in single funds should be limited to 10%, but can be raised if certain conditions are met. The Council also proposes that the 10% limit should be raised to 25% where the investment is in bonds issued by a credit institution of a Member State subject to public supervision. 
• The Council and the Parliament also provide provision for the manager to take remedying action when an ELTIF breaches the portfolio composition and diversification rules.

Redemption policy (Article 16)

• Both the Commission and the Council agree that ELTIFs should be closed-ended and should not allow redemptions during the life time of the fund.
• The Parliament proposes that, where retail investors are permitted to invest in an ELTIF, all investors should be granted redemption rights, subject to conditions such as appropriate liquidity reserves.

Secondary market (Article 17)

• All three institutions agree that there should be the opportunity for investors to trade shares in an ELTIF on a regulated market or MTF.
• However, unlike the Commission and Council, the Parliament does not consider that shares should be tradable on an OTF. It would also require the manager to regularly publish an explanation of any significant difference between the market value of listed shares and the manager's own estimate of net asset value.

Transparency (Article 21)

• The Council and the Parliament would both wish to see enhanced disclosure requirements to investors, including in relation to the life of the ELTIF, the investment strategy, and procedures for dealing with complaints.

Suitability of the ELTIF for retail investors (various articles)

• Both the Council and the Parliament propose further measures to be imposed on the ELTIF manager to assess the suitability of the ELTIF for retail investors.

D. Where we are in the legislative process and next steps

As mentioned above, the Commission's Proposal for a Regulation was adopted on 26 June 2013.

The Proposal is currently under review by the Council and the Parliament. These institutions have separately developed amendments, which they would wish to see incorporated into a final text of the Regulation.

Council

On 20 June 2014, the Committee of Permanent Representatives (COREPER) agreed the Council's proposed General Approach. COREPER has invited the Council, under its Italian Presidency, to enter into negotiations with the Parliament on the basis of this General Approach, in order to agree a final text.

It should, though, be noted that, on 27 June 2014, the Council published a Note which included a joint statement by the UK and Estonia. This indicated that, while both Member States support the General Approach, they remain concerned about the requirement for retail investors to commit to a minimum investment of €10,000 that has been inserted into it. Both Member States considered that this requirement would undermine the original policy intention of creating an EU regime suitable for retail investors, and that it could severely restrict uptake of the new investment vehicle. Further, both felt that basing appropriateness on an advised sale process rather than ability to meet a minimum investment would better meet the proposal's policy aim and would also provide better protection for European investors.

European Parliament

At a plenary session held on 17 April 2014, the Parliament adopted the Report prepared by its Economics and Monetary Affairs Committee (ECON), containing its suggested amendments to the Proposal. Following European elections in May 2014, the Proposal has been referred back to ECON for reconsideration, which is likely to happen in Autumn 2014. In the meantime, the Council will also hold further working group meetings during October.

Next steps

Although the Commission had intended the Regulation to enter into force early in 2015, this timing has now slipped. Negotiations (or trilogues) between the Council, Parliament and Commission are likely to start in Q4 2014 and may result in a political agreement for a final text of the Regulation either late in 2014 or in Q1 2015.

The Regulation would then be translated in the official languages of the EU before being published in the Official Journal and entering into force 20 days later.