The European Commission published its draft proposal of a regulation regarding European long-term investment funds (“Draft Proposal”) on June 26, 2013, heralding the creation of a new type of fund with a long-term investment horizon. The ELTIF regime is intended to address specific needs of investors (such as insurance companies and pension funds) that commonly invest on a long-term basis. The asset classes in which ELTIFs are permitted to invest are expected to provide investors with long-term, stable returns. By permitting the marketing of ELTIFs to retail, as well as institutional, investors, the Draft Proposal offers retail investors the opportunity to gain exposure to long-term capital appreciation. The creation of ELTIFs aims to strengthen Europe’s “real” economy – the access to patient (non-bank) “capital” to finance long-term projects (especially tangible assets and infrastructure projects with long lives) is to be eased for businesses.
Authorized Investment Assets
The Draft Proposal requires an ELTIF to adhere to strict investment rules. First, it may invest only in so-called “eligible investment assets” – these are the assets in which an ELTIF may invest all of its capital. Second, except for “real assets,” an ELTIF may invest only in instruments issued by a so-called “qualifying portfolio undertaking.” However, a difficulty is presented in that the Draft Proposal contains no definition of the term “real assets” – even the recitals provide only a few references to the term (referring to “real estate and other real assets” in one section, to “companies not listed on the stock exchange and comparable real assets” in another and expressly mentioning real estate, vessels and aircraft in a third). Given the enormous significance of the term, a legislative clarification will doubtless need to be included in the final regulations.
“Eligible investment assets” are, subject to the concentration limits discussed below, essentially: (i) equity or quasi-equity instruments; (ii) debt instruments; (iii) loans granted by an ELTIF (however, loans themselves may not be acquired); (iv) investments in other ELTIFs; and (v) direct holdings of individual real assets that require an up-front capital expenditure of at least €10 million.
A “qualifying portfolio undertaking” is defined as an undertaking that: (i) is established in an EU member state or a third country that meets specific requirements (e.g., compliance with the standards laid down in Article 26 of the OECD Model Tax Convention); (ii) is not a company listed on a regulated market or multilateral trading facility within the meaning of MiFID;1 and (iii) is not a financial undertaking. Therefore, an ELTIF may not invest in financial undertakings (i.e., credit institutions, MiFID investment firms, insurance companies, and financial holding companies) – in line with the objective of the Draft Proposal to strengthen the financial base of the “real” economy. However, the Draft Proposal provides for an exception if the financial institution itself exclusively finances “qualifying portfolio undertakings” or the above-mentioned real assets.
Above and beyond the eligible investment assets, the Draft Proposal grants the manager of an ELTIF the ability to permanently invest up to 30% of the ELTIF’s capital (determined on a committed capital basis) in liquid assets (primarily securities, bank deposits, money market instruments and UCITS) to enable the manager to manage the ELTIF’s liquidity and cash flows in the phase of building the portfolio of long-term assets. Under certain circumstances (e.g., with additional capital call-ins), the ELTIF is also allowed to temporarily invest a higher proportion of its capital in such liquid assets.
The Draft Proposal prohibits investments in assets that could lead to a conflict of interest between the manager of, and the investors in, the ELTIF. Accordingly, an ELTIF is not allowed to invest in assets in which the manager has a direct or indirect interest, nor can the ELTIF effect short sales, or gain direct or indirect exposure to commodities.2
Diversification, Issuer Limits and Borrowing
Because the nature of long-term investments makes the risks arising from concentration in a few assets rather difficult to manage, the Draft Proposal sets forth specific diversification rules. For example, no more than 10% of the capital of the ELTIF may be invested in: (i) assets issued by the same qualifying portfolio undertaking; (ii) an individual real asset; or (iii) the interests of any single ELTIF. The investment restrictions stated in (i) and (ii) may be raised to 20%, provided that the aggregate value of the ELTIF’s investments in qualifying portfolio undertakings and in individual real assets that account for more than 10% of the ELTIF’s capital does not exceed 40% of the value of its capital.
The Draft Proposal does not stipulate issuer limits in regards to qualifying portfolio undertakings or real assets, although those set out in the UCITS Directive will apply in relation to the above-mentioned liquid assets. In addition, an ELTIF is not allowed to acquire more than 25% of the interests of a single ELTIF.
Pursuant to the Draft Proposal, ELTIFs may borrow in an amount up to 30% of their capital, provided that, among other things, the borrowed cash is used for the acquisition of eligible investment assets and the credit agreement is denominated in the same currency as the assets to be acquired with the cash raised.
Management and Approval of ELTIFs
Due to the limited nature of the assets in which an ELTIF may invest, the ELTIF does not qualify as an undertaking for collective investments in transferable securities (“UCITS”). Rather, an ELTIF is subject to the AIFM Directive.3 Consequently, ELTIFs may be managed only by companies that are properly authorized as alternative investment fund managers (“AIFMs”) in accordance with the AIFM Directive, and also that must be established within the European Union. In addition to the authorization requirement under the AIFM Directive, the Draft Proposal requires the manager of an ELTIF to obtain an explicit authorization to manage ELTIFs, which will be granted only if the manager complies with all the requirements of the ELTIF regulation. A separate authorization is required for the management of each ELTIF, which arguably means that a manager can manage both ELTIFs and non-ELTIFs.
The manager is responsible for ensuring that the ELTIF complies with the requirements of the ELTIF regime at all times. While the Draft Proposal states that the manager is liable for all damages and losses resulting from the failure to discharge its duties under the ELTIF regulation, it is unclear who would be entitled to such damages. Although investors would appear to be the stakeholders who might suffer loss as a result of the ELTIF manager’s failure, it is unclear whether other persons may also have a cause of action – the wording of the Draft Proposal certainly does not preclude such an interpretation.
Moreover, the Draft Proposal requires the ELTIF (which arguably means the ELTIF manager) to apply for authorization from its home regulator, using the same authorization process as under the AIFM Directive. A complete application must be considered (and either approved or rejected) within two months, and will only be granted if certain conditions are satisfied – for instance, the ELTIF must meet all requirements of the ELTIF regulations and the competent authority must approve the ELTIF’s “fund rules.” 4
Marketing of Interests
Since large infrastructure and similar projects usually require a huge amount of capital, which may not be available when raised in only one member state, the Draft Proposal allows, under certain conditions, EU-wide marketing of interests in ELTIFs to retail investors. Authorized ELTIFs may, in principle, therefore be marketed to both institutional investors and retail investors in member states other than their home member state.
In legal terms, the framework for the marketing of interests in ELTIFs builds upon the provisions of the AIFM Directive on cross-border marketing, but broadens its scope by providing for a “European passport” for marketing to retail investors.
This “European passport,” however, entails certain regulatory costs. To try and ensure the protection of retail investors, the Draft Proposal sets forth requirements, non-compliance with which can have serious consequences. For example: (i) the fund rules or the statue of the ELTIF must explicitly provide for the principle of equal treatment of all investors; (ii) the ELTIF may not be structured as a partnership; (iii) retail investors must have the right to revoke their subscriptions during the drawdown period and at least two weeks after a capital call has occurred, and to demand repayment of the amount paid. Pursuant to the wording of the Draft Proposal, a retail investor may exercise the right in (iii) even after investments have already been made (and the longer the drawdown period, the greater the risk that an investor will exercise this right). Since this has the obvious potential to lead to liquidity difficulties for the fund, it would be desirable if the Draft Proposal were revised in relation to this point.
Term of the Fund and Holding Periods for Investments
Given the inherent lack of liquidity of eligible investment assets, the Draft Proposal does not prescribe minimum investment holding periods, but instead implicitly assumes that the ELTIF manager is best suited to determine how long the ELTIF should remain invested in an asset in order to achieve the desired return.
However, with regard to the term of the ELTIF, the Draft Proposal is more stringent. While no fixed minimum term is prescribed, the term of the ELTIF must be long enough to cover the life cycle of each of its assets and to facilitate the achievement of the stated ELTIF investment goal. More detailed rules on this will follow in due course. In any event, the Draft Proposal requires that the term of the ELTIF must be clearly stated in the form of a specific date in the fund rules or in the statue of the ELTIF, and must be disclosed to the investors.
The Draft Proposal expressly provides that investors cannot redeem their interests before the end of the ELTIF’s term. Rather, redemption is permissible no earlier than the day following the end of the ELTIF’s term. The illiquid nature of the assets held by the ELTIF is one reason why early redemption is not allowed. Moreover, this limitation should also lessen potential conflicts of interest between investors wanting to exit the fund and those preferring to stay invested. For the protection of investors, the Draft Proposal requires the ELTIF to disclose the fact that early redemption is not allowed prior to the end of the ELTIF’s term, in a prominent place in the prospectus as well as in any other marketing materials.5 The purpose of this requirement is to diminish the possibility that investors have false expectations with respect to the liquidity of an investment in an ELTIF.
Finally, the Draft Proposal also requires that each ELTIF prepare a schedule – itemized by individual assets – for the orderly disposal of its assets. The Draft Proposal, however, does not stipulate the time when this must be prepared. 6
The Draft Proposal gives the ELTIF the right to make distributions of income (but only to the extent that such income is not required for future investments). This right extends to regular income and the capital appreciation realized after the disposal of an asset. The latter explicitly excludes the original capital commitments made. This means that an ELTIF may only make distributions of proceeds arising from the disposal of assets to the extent that the disposal results in a net profit. Arguably, all other proceeds are to be distributed when the ELTIF is liquidated after the end of its term.
The creation of ELTIFs is closely linked with other European initiatives in the field of investment law, such as the establishment of the European Venture Capital Fund (EuVECA) and the European Social Entrepreneurship Fund (EuSEF). For further information regarding the EuVECA and EuSEF regimes, please refer to European Fund Regulation – Just Like London Buses? in this Quarterly Report. Unlike these products, ELTIFs are not intended to facilitate the funding of specific “niches” of the EU economy (venture capital funded start-ups in the former case, and companies whose activities will have a social impact in the latter case), but to contribute to improving the financing environment for all undertakings of the real economy. Whether this goal can be achieved with the ELTIF regulation remains to be seen. From a purely legal point of view, it should be noted that many provisions of the Draft Proposal are still unclear and would benefit from guidance and revision.