ELTIF II Regulation Enhancing Long-Term Investments with Enhanced Demand and Supply Solutions
- The ELTIF II Regulation will be applicable as of January 2024 and comes with the promise of having resolved the demand and supply constraints identified in its first iteration. Success of ELTIF II is also dependent on a better understanding of long-term investments by retail investors.
- Constraints on the demand for ELTIF are resolved by removing some unnecessary requirements for both suitability assessments and investment limits for retail investors. A lighter regime for professional investors is also one of the strong points of the reform.
- ELTIF II will be allowed to invest also in opportunities located in third countries and not necessarily only in Europe. However, there should always be a link with Europe, in that investment opportunities located in third countries shall always have a link and benefit Europe and its economy.
The formal adoption by the European Council in March 2023 of the text of the ELTIF II regulation closed the legislative process for the revamp of the regime of European long-term investment funds. In mid-February 2023 the European Parliament voted on the text of the ELTIF II regulation, which was then formally adopted by the European Council. The ELTIF II Regulation is set to come into force in January 2024.
The first iteration of the ELTIF regulation showed that a market for long-term investments had developed in selected pockets of Europe. A not-at-all exorbitant number of ELTIFs were launched overall since inception of the regulation, mostly out of Luxembourg and other continental and southern European jurisdictions. Little to no pan-European distribution endeavours for these products, confirmed by the fact that the first ELTIFs were launched also in jurisdictions like France and Italy – traditionally not what we would call European gateways.
Part of the bet of the European authorities is also that times have changed and that long-term investments will be the taste for a broader retail audience now.
The Forces behind ELTIF II Regulation
From a technical standpoint, article 37 ELTIF regulation set the clock for a review of the regulation to take place by no later than June 2019. The Capital Markets Union, the European Green Deal and other Union policy initiatives, including the recovery from the recent Covid-19 pandemic, are amongst the other forces that drove the introduction of ELTIF II regulation. By the end of 2020, the European Council urged the Commission to prioritise the work on reviewing the existing ELTIF regulation to improve the framework for non-bank financing of SMEs and infrastructure. At the same time, a natural connection between ELTIF regulation and AIFMD always existed. ELTIFs are essentially AIFs, only subject to a specific regime. The AIFMD revamp is also underway and will likely be rolled out soon after the ELTIF II regulation comes into force.
The Issue of Supply and Demand
In a report on the functioning of the ELTIF framework dated November 2021, the EU Commission identified some of the key constraints for both the demand and the supply side of ELTIFs.
We take the view that part of the demand side constraints was related to investor preference. Retail investors did not have a developed understanding – a taste if you like – for long-term investment opportunities at the time when ELTIFs were first rolled out. The situation is different nowadays, where there is a clear-er case for retailisation of private markets. In its report, the EU Commission focussed on the limitations under the ELTIF regulation itself, including duplications of provisions existing already in parallel regulatory frameworks. This is where the assessment of knowledge and experience of retail investors, imposed on ELTIF managers under the first iteration of the regulation, goes away under ELTIF II regulation. This requirement duplicated the suitability assessment under MiFID as already applicable to ELTIFs. For the AIFMs managing ELTIFs very rarely wanting to get involved with retail investors, if ever, delegating this additional assessment to distributors tended to be a controversial point in related negotiations on distribution agreements.
The minimum initial investment of Euro 10 000, combined with the 10% limitation on aggregate investments for retail investors with a portfolio below Euro 500 000, did constitute a significant limitation for the masses to access ELTIFs. These limits, applied together, realistically capped the investment into ELTIF at Euro 10 000 even in cases where, based on the actual size of the portfolio of a retail investor, the 10% threshold would be much higher than Euro 10 000. At the same time distributors did not always have a clear picture of the existing portfolio of retail investors, making the upside and protection of these thresholds difficult to measure.
The issue of the supply constraints for ELTIFs is multifaceted. What seems to have emerged in the preparatory works of the ELTIF II regulation was the need for a clearer distinction between ELTIFs for professional investors and the ones for retail investors. This was one of the most significant arguments under a technical advice from ESMA issued in 2021. In essence, ESMA purported that retail and professional investors’ interests and needs are not always aligned. Considering the different characteristics of each type of investor, ELTIFs should foster participation of retail investors and at the same time meet the specific needs of professional investors. A very ambitious proposition, left at the creativity of European authorities to implement in practice.
A Clear-Cut Distinction between Professional and Retail ELTIF
Even when looking at the closest example to ELTIF under European regulation – UCITS – we don’t see a set of different rules applicable depending on whether professional or retail investors will be the target market for these products. The approach adopted under ELTIF II regulation is so far unique in that it creates a clear-cut distinction. The rules surrounding portfolio diversification and composition as well as limits on eligible assets are indeed a good example. In the ELTIF II regulation, no more than 20% will be investable in instruments or securities issued by a single qualifying portfolio undertaking, single real asset, single other ELTIF, EuVECA, EuSEF, UCITS, EU AIF or single securitisation. These rules do not apply to ELTIFs that will be marketed solely to professional investors. The same goes for concentration limits, where ELTIFs may not acquire more than 30% of the units of a single other ELTIF, EuVECA, EuSEF, UCITS, EU AIF, but this limit will not apply to ELTIFs that are marketed only to professional investors.
On this point, the register held by ESMA for ELTIFs, under the second iteration of the regulation, will have a separate entry for each ELTIF to specify whether the marketing is allowed to professional investors only or also to retail. There will be of course a set of other consequences depending on whether an ELTIF can be marketed to professional investors only or also retail. The ELTIFs for professional investor will likely not be classified as PRIIPs and will not require a KID.
Delocalisation of Underlying Investment Opportunities
ELTIFs were originally conceived to become privileged tools to support the projects of the Capital Markets Union. They were envisioned to be the vehicles to channel capital to real economy and long-term investment opportunities located exclusively in Europe. That was ELTIF I regulation. One of the most important shifts taking place with the ELTIF II regulation is relative to the location of the long-term investment opportunities underlying these products. The ELTIF II regulation states that it should be allowed for the majority of the underlying investments of an ELTIF – same as the main revenue or profit generation of such assets and investments – to be located in a third country. From subsea fibre optic cables, connecting Europe with other continents, to the construction of liquefied natural gas terminals and related infrastructure, the ELTIF II regulation will maintain the proposition for ELTIFs to be the main investment vehicles for the financing of infrastructure projects.
The shift is not entirely surprising when we consider that the main concern of European Authorities with the ELTIF II regulation was to find ways to make ELTIFs more appealing from the supply side perspective. This new approach will also help solve one of the main issues that US managers had with the ELTIF, for what concerned the location of underlying investments. At the same time, ELTIFs will still be exclusively European AIFs, managed by European AIFMs. A growing ELTIF industry will mean more European jobs. At the same time, the other side of the original proposition – offering new avenues of investment to European investors – will remain untouched. There will be another upside for the European Union in that the long-term nature of the investments underlying the ELTIFs will make it an ideal choice for investment in sustainable and green projects.
Real Assets and FinTech
A new recital appears in the current version of the ELTIF II regulation, which seems to create a new link with the Digital Finance Package of the European Commission. By relaxing the prohibition to invest in credit institutions, investment firms, insurance and other financial undertakings, ELTIFs will be able to invest also in the new segment of so-called Financial Technology firms. FinTech is made an investable underlying for ELTIFs to sustain the development and offer of innovative products and services backed by technology and aimed at automating and improving existing business models, processes and applications.
Whilst some criteria and constraints are sketched in the recitals of the regulation for what concerns investable financial undertakings, it is not entirely clear whether the same location agnostic approach adopted generally under the proposal will also apply to investments in FinTech.
From the Upper Class to the Masses
We already touched upon one of the main points of the ELTIF II regulation, being the removal of the thresholds for retail investors to invest into these products. A very radical change which, in our view, will allow to democratise for real the access to long-term investment opportunities. In its first iteration, the ELTIF retail audience was a more qualified one. By way of oversimplification and analogy, the ELTIF was conceived to be an investment product for the upper class, having an investment portfolio of a certain size, which could allow for the decision to commit to an investment for the longer term. Now everyone will be able to invest into ELTIFs II.
We don’t believe there being excessive harm in opening up ELTIFs to the mass retail investor. Many and more exoteric strategies are nevertheless already available to this type of investors and the European Union needs to channel as much capital as possible to support the ambitious plans of green and digital transition in Europe. The only issue remains the one linked to the substantially illiquid nature of the investments underlying ELTIFs and how retail investors can stomach their exposure to this type of investments. Nevertheless, there has been evolution in the debate on the topic of long-term investment opportunities for retail investors and concerns over illiquidity has somehow faded. There is a perception that long-term investments might suit very well retirement/pension contribution situations better than products so far traditionally employed for this purpose. From this perspective, we believe that liquidity might become a less pressing issue.
In addition to that, ELTIF II regulation opens to the introduction of a secondary market liquidity mechanism. Before the end of the life of an ELTIF it would be possible for investors to exit their investment upon being matched with new entrant investors on a secondary market. ESMA will be releasing regulatory technical standards for this process and provide more details on how to establish in practice a secondary market.
The delocalisation of investable opportunities, from strictly Europe to also include third countries, seems to be an interesting development within the paradigm of European long-term investments. Since inception, many American managers grappled with the issue of the geographical location of underlying investment acceptable for an ELTIF.
We take the view that we need to continue to look at the ELTIF as one of the tools for growth of the European Union. The easing of the so-called constraints on the supply side with the reform of the regulation was put in place to boost this sector and channel additional capital to support the big thematic endeavours of the European Union, like green and digital transition. With this understanding, opening ELTIFs to finance infrastructure projects located in third countries can happen in our opinion where there remains a clear measurable upside and advantage for Europe and its economy. The ELTIF II would not be suitable for projects that are clearly divorced from this principle.