Understanding the Rules on Transfer Matching under ELTIF 2 RTS
- The final draft of the ELTIF 2 RTS is now out. Just on time for the official entry into force of the revised regulation in 2024. The transfer matching mechanism is covered under the package of second level rules just issued. Whilst at local level in Europe there are examples of transfer matching already used for certain types of closed ended funds, it is the first time that the transfer matching is regulated at European level.
- Transfer matching is a systematic transfer of ELTIF shares between existing investors and potential new investors. As the term suggests, there is no liquidity event as such taking place at the time of the transfer matching. Also, no underlying investments of the ELTIF are divested. The transfer matching is in essence similar to a private transfer of shares between parties. The only difference lies in that the transfer can happen only under certain conditions and is not guaranteed.
- Appropriate disclosure of the transfer matching mechanism is of paramount importance. This is because the transfer mechanism could be misinterpreted or misunderstood. The offer of an early exit for a long-term investment is an interesting addition. One that can significantly minimize the perception risks associated with investing in long-term funds. At the same time, there are risks of misrepresentation which would have a ripple effect on the growing ELTIF industry in Europe.
The legislative process in the ecosystem of European financial services is made of different levels of rules. Directives or regulations constitute the basic laws, or level one. They set out the foundation principles. With the support of various consultative bodies, the European Commission adopts second level regulation, containing technical measures to facilitate the implementation of the main rules. This approach allows the European Council and Parliament to concentrate on the fundamental political decisions whilst leaving the technical details to the European Commission.
Second level regulation can sometime be highly technical in nature and require intervention of supervisory experts. In these cases, it takes the form of technical standards. These are adopted by the European Commission based on drafts developed by supervisory authorities.
The ELTIF 2 RTS Are Now Out
The ELTIF 2 regulation contains a specific mandate for ESMA to develop draft regulatory technical standards – RTS in jargon – on a series of related implementation aspects. After a consultation period of six months or so, the ELTIF 2 RTS are now out. Amongst the various aspects covered, the ELTIF 2 RTS contain principles-based guidance on the use of the matching mechanism for transfer requests from existing ELTIF investors and the circumstances under which it can be deployed.
Albeit regulated already at local level in certain European member states and for specific closed-ended structures, the matching mechanism is an entirely new concept at European level. In the initial consultation on the ELTIF 2 RTS, ESMA proposed to adopt a principle-based approach on the matching mechanism as opposed to a highly prescriptive one. In the eyes of ESMA, this approach would suit better situations where, with minimal exceptions, European fund managers don’t have the necessary prior experience to be able to assess more prescriptive requirements. At the same time, for the lack of equivalent rules at European level, ESMA believed that the introduction of more detailed requirements might have generated cognitive bias induced adjustments to the requirements at local law level across Europe.
What is the Transfer Matching Mechanism and Why Was It Introduced
The main Achilles’ heel of the entire retail long-term investment fund proposition has always been represented by the substantial illiquidity of ELTIFs underling investments. Illiquidity of underlying investments created perception issues from the outset. Retail investors can and did struggle conceptually to commit to longer-term horizon investments. Introduced as part of the proposal for the ELTIF 2 regulation, the matching mechanism represents an optional liquidity window. Subject to a series of conditions being met, it provides investors with an early exit from their investment before the end of the life of the ELTIF.
Matching is a mechanism different from redemption at various levels. Redemptions are in essence legal claims granted to investors to redeem or liquidate their participation at specific points in time during the lifecycle of an ELTIF. From an operational perspective, managers meet redemptions requests by either disbursing liquidity or else selling underlying assets. As the term itself implies, transfer matching is a completely different mechanism. Here requests to transfer participations of existing investors are matched with requests of new investors willing to subscribe into an ELTIF. As part of the matching process, no new shares are created, no liquidity disbursed or any underlying assets divested. Existing investors willing to exit the ELTIF will be paid with the proceeds received by newly entrant investors, hence avoiding liquidity mismatches or other liquidity stress conditions of sort. Matching is nothing more than a systematic transfer of shares between existing and new investors, which can be provided for under the terms of an ELTIF. Where transfer matching facilities are indeed provided, these remains voluntary and subject in principle to the existence of a sufficient number of requests from newly entrant investors.
Qualifying the Transfer Matching Mechanism
Transfer of shares within ELTIFs, same as other funds, are not prohibited in principle. In these cases, transfers amount to private deeds between the interested parties. Considering that the ownership of shares in an ELTIF, same as any other fund, is recorded at centralised level on the register held by the administrator or transfer agent, any transfer of ownership ensuing a private deed between the parties shall be recorded on that same centralised ledger.
The transfer matching mechanism as a concept is essentially a transfer of shares in an ELTIF organised and carried out in a systematic manner. The ELTIF manager and the administrator are the main actors of this process. Matching can happen under certain predefined circumstances and the related process is overseen by the ELTIF manager.
Whilst it has been clarified that the activities involved in executing the matching process will not amount to the operation of a multilateral trading facility under MiFID, there are other considerations to make on the regulatory qualification of the transfer matching mechanism. Any communications and related activities affecting shares in ELTIFs for the purposes of matching might be construed as marketing of the specific ELTIF. The definition of marketing under AIFMD, per se very broad and applicable also to ELTIFs, also covers the placement of existing shares in an alternative investment fund for matching purposes.
From a regulatory perspective, dealing with transfers requests under the transfer matching mechanism will be treated in the same manner as marketing ex novo the shares in an ELTIF. Related authorisations and licenses, including the ones for marketing of the ELTIF itself, shall be in place when ELTIF managers or distributors advertise the matching of transfer requests.
Transfer Matching Rules
The ELTIF 2 RTS impose requirements on ELTIF managers to specify the procedure and the rules to follow for investors to be able to take advantage of the matching either in the instrument of incorporation or else in the prospectus.
ELTIF managers shall specify the process and the timing of the transfer matching process. The frequency or periodicity of related matching windows, duration of the window and dealing dates. ELTIF managers shall also specify the requirements and the deadlines applicable to the submission of requests, including notice periods if any, as well as the periods during which payouts will be made.
The ELTIF II RTS refer to safeguards that ELTIF managers shall put in place to protect investors interests from potential arbitrage practices due to asymmetry of information related to the matching of transfer requests. As mentioned already, the principle-based approach adopted in the ELTIF 2 RTS does not exclude that either this principle is specified at local level or else that level 3 measures could be issued to give further clarity on this.
Execution and Pro-ratio
The ELTIF 2 RTS retain optionality on ELTIF managers for the methodology to establish the execution price for matching transfer requests. In certain cases, it might be acceptable that the execution price is based on the NAV of the ELTIF. Should an ELTIF manager decide to adopt this approach, there will be implications on the allocation of matching windows. These will have to be tiered to coincide with the ELTIF valuation dates. There might be also cases where the NAV cannot be considered a reliable benchmark for the execution of the matching of transfers. In these cases, matching windows shall be divorced from valuation dates.
In a perfect world, transfer requests are always matched with an equivalent amount of purchase requests. We all know though that this is hardly the case. The rules governing the matching mechanism shall account for the real cases where mismatches exist between investors requesting to exit and the ones wanting to buy into an ELTIF.
The first scenario to deal with is the one where there are transfer requests but no requests to purchase. Here the rules shall establish whether the related exceeding orders are to be cancelled or carried over to the next available window for transfer matching.
Second realistic scenario is where there are both requests to transfer and purchase, but transfer requests exceed purchases one or vice versa. In this case, the rules shall establish the criteria according to which the exit or purchasing requests respectively are selected to be executed. At the same time, the rules shall also specify whether the orders that cannot be met at that specific window shall be carried over to the next available window or cancelled altogether.
Transfer Matching Mechanism Disclosures.
Matching is contingent in nature. Given that no new shares are created and no existing assets divested to meet matching requests, investors willing to exit an ELTIF through the transfer matching mechanism will require enough requests from new entrants to match their existing participations. Accordingly, clear disclosure shall be presented by ELTIF managers on the matching mechanism in cases where one is made available for a specific ELTIF. Where a specific ELTIF does offer a matching mechanism, that shall not be presented or purported to be a tool to provide liquidity upon request. Moreover, retail investors shall be clearly warned that even though a matching mechanism is provided for a specific ELTIF, it does not represent a guarantee that they will be able to exit or redeem their investment earlier than the life of the ELTIF itself.
The information that ELTIF managers shall disclose on the matching mechanisms can be identified as follows:
- Dealing dates and pay-out periods
- Deadlines for submission of purchase/exit forms
- Frequency of the matching mechanism
- Relation between execution price and NAV of the ELTIF and criteria other than NAV used to determine the execution price for matching requests
- Exit and/or subscription fees, as well as cost and charges involved in the matching process
- Notice periods
- Details on the actors and the timing applicable to pay-outs and transfers
- Rules on pro-rata conditions
- Differences with redemptions, where these are provided for by the ELTIF.
The above information shall be contained in the prospectus of the ELTIF. However, it is also possible that this information is provided elsewhere, like on a website or other digital repository. Should this be the case, the prospectus of the ELTIF shall contain a link to the website where this information is available. At the same time, when a KID is produced for the ELTIF, the KID shall contain a link to the website or other medium where the information on the matching mechanism is available.
The transfer matching mechanism brings advantages from different angles. In our view these are mostly perception related. The ability to purport an early exit to a long-term investment strategy is an interesting addition to ELTIFs. Likely, it would support easing some of the concerns of retail investors vis-à-vis committing to an investment opportunity for the longer term. For the transfer matching mechanism not being based on any disbursement of liquidity or else divestment of assets, it can take place also at times when redemption mechanisms would otherwise be unavailable. That is an important outlet and reason for comfort, especially at a time when the effort of European authorities is concentrated on increasing retail investor exposure to capital markets.
The transfer matching mechanism also comes with its own challenges. With certain exclusions, it is indeed a new concept in Europe. As the transfer matching should mostly benefit retail investors, it will require significant market education on their part. The ELTIF 2 RTS clearly identify the main risks linked to transfer matching mechanisms. For the sake of boosting ELTIFs sales and grow related markets across Europe, the real features of the transfer matching could be misrepresented and misunderstood by retail investors. It could be purported that, akin to redemptions, transfers matching is an avenue of guaranteed early liquidity for ELTIFs. That is potentially not only a risk for retail investors but also for the credibility of the ELTIF industry as a whole.