The European Parliament voted on 15 February 2023 in favour of a major update to the EU’s regulation for long-term investment funds (ELTIFs), also known as ELTIF 2.0, applies as from 10 January 2024. ELTIF 2.0 forms part of the EU’s wider Capital Markets Union (CMU) initiative that aims to develop the EU’s capital markets.
1. Background to ELTIF 2.0
The initial ELTIF Regulation entered into force on 19 May 2015 (ELTIF 1.0) with the objective of boosting European long-term investments in the real economy, in line with the EU wider objective of smart, sustainable and inclusive growth. Albeit receiving a lot of attention, especially given the introduction of a marketing passport for “retail investors”, it became clear, over time, that the ELTIF regulation did not scale up as expected.
Further to the initial ELTIF Regulation’s review clause, the European Commission identified a number of shortcomings that have been addressed in ELTIF 2.0 to serve as an impetus for its use.
We have summarised the key changes introduced by the Regulation and the ELTIF 2.0 RTS recently proposed in a final report by ESMA (ELTIF 2.0 RTS), which will be relevant for Alternative Investment Fund Managers (AIFMs).
2. Broader scope of eligible assets & investments
ELTIF 2.0 significantly widens the scope of eligible investment assets.
In the first place, promoters may thus under ELTIF 2.0 pursue a global investment strategy, as the regulation allows (a majority of) eligible assets and investments to be located in third countries.
Another change widely applauded by the industry is that the definition of “real asset” is revised. The revised definition captures any asset that has intrinsic value due to their substance and properties. The purpose of this revision is to broaden the scope of the real asset investment strategies that ELTIF managers can pursue. Furthermore, ELTIF 2.0 abolishes the minimum investment threshold of EUR 10 million and it is also no longer required that real assets are owned directly or via an “indirect holding” of qualifying portfolio undertakings.
The scope of eligible assets for ELTIFs is, in addition, extended with certain securitised assets with a “STS-label” under Regulation (EU) 2017/2402 and green bonds that are issued by “qualifying portfolio undertakings” under the EU legislation on environmentally sustainable bonds.
Furthermore, the market capitalisation threshold for listed “qualifying portfolio undertakings” has been raised from EUR 500 million to EUR 1.5 billion to provide ELTIFs with a better liquidity profile.
Lastly, the lowering of the eligible investment asset threshold from 70% of its capital down to 55% of its net asset value enables ELTIF managers to better manage the liquidity of ELTIFs and makes the ELTIF regulatory framework more appealing for both asset managers and investors.
3. More attractive for professional investors
The ELTIF 1.0 framework was too rigid for AIFs that were only marketed to professional investors. ELTIF 2.0 has been made more attractive for professional investors by disapplying portfolio composition, diversification and concentration rules altogether for ELTIFs that are only marketed to professional investors.
The leverage limitation in the original regulation was 30% of the fund’s capital, whereas ELTIF 2.0 has raised this to 100% for ELTIFs marketed solely to professional investors. In addition, lending ELTIFs are under the revised version of the regulation also allowed to use leverage to finance loans.
Conflict of interest rules have also been softened. In particular, the ban on (minority) co-investments has been levied. ELTIF 2.0 now allows AIFMs managing ELTIFs and other funds to co-invest so long as any conflicts are identified and appropriately managed.
4. Lighter retail investor requirements
In line with the retailisation trend, ELTIF 2.0 also contains a number of amendments that are very favourable for ELTIFs marketed to retail investors. Not only has the scope of eligible assets and investments been widened, but also the diversification, concentration and borrowing rules have been made more flexible for retail ELTIFs. Borrowing limits have been raised up to 50% of the ELTIF’s net asset value. The raising of the diversification requirement from, for example, 10% to 20% allows also for greater flexibility, as the previous requirement meant that an ELTIF had to hold, at least, seven equally sized investments alongside a liquidity pocket. This was challenging in practice.
Other welcome developments, particularly, concern the distribution of retail ELTIFs. The mandatory investment advice to be obtained prior to investing in an ELTIF has been abolished that, in practice, means that AIFMs directly marketing ELTIFs to retail investors do not need a “MiFID II top-up” anymore. In line with this, the 10% cap on a portfolio’s exposure to the ELTIF for retail investors with a total portfolio smaller than EUR 500,000, as well as the minimum entry ticket of EUR 10,000 have been abolished. Lastly, the alignment with the MiFID II requirements in terms of product governance and the suitability test also means that relationships between AIFMs and distributors in the ELTIF domain are expected to be smoother under the ELTIF 2.0 framework.
5. ELTIF master-feeder & fund-of-funds
ELTIF 2.0 has also introduced master-feeder structures and a flexible legal framework for fund-of-fund structures (FoF ELTIFs). FoF ELTIFs may now invest in target funds that are not restricted to only ELTIFs, EuSEFs or EuVECAs, which are rare occurrences in the market anyway, but also, under certain conditions, in other AIFs.
The FoF ELTIF changes are widely applauded in the industry and allow sponsors to grant retail investors indirect exposure to (a number of) funds that were previously only reserved to professionals or not available at all in the EU market. Unlike FoF ELTIFs, master-feeder structures are restricted to “master ELTIFs” only and are not expected to gain as much traction as FoF ELTIFs.
6. Open-ended ELTIFs
Under ELTIF 2.0, ELTIFs can only be structured as limited-duration funds and, therefore, they cannot be “true” evergreen funds. Despite this, ELTIFs can be structured as “de facto” open-ended funds. In this respect, ELTIF 2.0 has eased the “redemption regime” for ELTIFs. So far, investors were mandatorily locked-up until the end of the ELTIF ramp-up period. Under ELTIF 2.0, the lock-up may be decoupled from the ramp-up period. Furthermore, investors may under ELTIF 2.0 not request the winding down of an ELTIF anymore if their redemption requests have not been satisfied within one year.
However, ELTIF 2.0 contains a provision in which ESMA is required to develop regulatory technical standards that specify the ELTIF redemption regime in more detail. In this respect, ESMA published its final report on the 19 December 2023 that has been submitted to the European Commission for endorsement and final approval. In general, the ELTIF 2.0 RTS are well-received. This being said, while most concerns raised during the consultation period have been addressed by ESMA in its final report, there is, however, one item in relation to the redemption policy which makes it difficult to operate open-ended ELTIFs. Indeed, the ELTIF 2.0 RTS require a minimum notice period of 12 months for investors and those open-ended ELTIFs that wish to implement a shorter notice period are required to hold a minimum liquidity pocket that, depending upon the notice period in place, may be up to 40% of the ELTIF’s portfolio. This has raised concerns in the market, as those proposed minimum standards with respect to liquidity pockets are clearly too restrictive and not in line at all with the current market and regulatory practice for (semi-) open-ended funds.
Although the mentioned restrictions cause uncertainty in relation to the viability of open-ended ELTIFs in the market, it remains to be seen whether the European Commission will pick up the concerns from market players and adopt the final RTS by means of a Commission Delegated Regulation in a fashion that takes into account current concerns and answers these in a pragmatic manner.
If this mentioned point will not be addressed accordingly, many market practitioners and sponsors fear that open-ended ELTIFs will not be a viable alternative for other retail AIFs, such as the Part II UCI in Luxembourg and managers will rather opt for the national products, such as the Part II UCI, only. However, we still see an opportunity for closed-ended retail ELTIFs that would not need to comply with the ELTIF 2.0 prescribed liquidity management tools that, apart from a (long) notice period, require, at least, one anti-dilution mechanism and redemption gates to be employed.
ELTIF 2.0 namely provides for a mechanism to allow investors to dispose of their shares in a ELTIF before the end of the fund’s life on a “matched” secondary market basis to promote the secondary trading of ELTIF units/shares. This mechanism is open for both closed-ended and open-ended ELTIFs. Going forward, we see, based upon the principle-based approach in the ELTIF 2.0 RTS, at least, two ways in which closed-ended retail ELTIFs could be viably structured on the basis of this mechanism. The first viable solution would be to establish a closed-ended ELTIF with a “matched secondary market” that would operate through a digital marketing pool with thousands of investors. The matching mechanism would work in a very simple manner: new investors indicate to the ELTIF manager or the fund administrator on behalf of the ELTIF manager their interest to invest. Conversely, investors willing to step out of the fund would indicate their interest in a selling notice and the price would be fixed based upon the NAV or a bid/ask mechanism.
By absence of a digital marketing pool that would generate sufficient (secondary market) liquidity opportunities for retail investors, fund promoters could establish periodic liquidity windows in which a sponsor-led or external affiliated secondaries fund could offer retail investors periodically to step out of the fund based upon the price fixed on the NAV. For this to effectively and fairly function, however, strict valuation and NAV calculation, as well as conflicts of interest policies/procedures need to be put in place. Layers of protection which make these solutions, in our view, viable is that the “matched secondary market mechanism” is required to be described in detail in the ELTIF’s prospectus and fund documentation which are both subject to the review and approval of the responsible local regulator. Furthermore, ELTIF managers and/or distributors would have the responsibility in taking into account the liquidity profile of the ELTIF when retail investors invest in the product and to properly assess whether this matches their risk profile and appetite.
Albeit these both sound as viable solutions, none of these mechanisms have been “tried and tested” on a large scale. We will, thus, need to await how such mechanisms might eventually work in practice in a retail context.
7. Application and transitional phase
Although ELTIF 2.0 applies as from 10 January 2024, it provides for a transitional regime.
Open-ended and closed-ended ELTIFs that are still being marketed are required to comply within five years as from the mentioned date of application.
Closed-ended ELTIFs that were authorised prior to the date of application and do not raise additional capital are not required to comply with the ELTIF 2.0 amendments.
Finally, ELTIFs authorised before 10 January 2024 under the ELTIF 1.0 regime may choose to comply with ELTIF 2.0, provided that the relevant competent authority is notified thereof.
For additional information, please see ELTIF 2.0.
