Cross-sector point of view: ELTIF, the retail route for alternatives?

The review of the ELTIF Regulation has generated growing interest in this investment structure. How will the proposed reforms impact the various financial services sectors and what is the outlook for Luxembourg?

To date, only 84 alternative investment funds (AIFs) with relatively modest assets under management (AuM) have been authorized as European long-term investment funds (ELTIF) across four jurisdictions, namely Italy, France, Spain and Luxembourg¹.  Take up of the ELTIF has been hindered by overly complex and restrictive rules, notably in terms of portfolio composition and distribution. The review of the ELTIF Regulation has, however, generated growing interest for this structure with many asset managers welcoming the revision of the regime to unlock the full potential of ELTIFs.

The reforms to the ELTIF Regulation, adopted by the European Parliament on 15 February 2023, fit well with political objectives linked to the Capital Markets Union, Sustainable Finance Strategy and COVID-19 recovery plan. The ambition of this update is to enhance the attractiveness of ELTIFs as go-to vehicles for investment into infrastructure, real estate and small and medium enterprise financing across Europe at a time when there is growing appetite for private equity/debt investments from both institutional and retail investors into these assets.

The Regulation was published in the Official Journal on 20 March 2023 and will become applicable on 10 January 2024. ELTIF 2 introduces more flexibility of the vehicle with respect to eligible assets, portfolio composition, distribution and authorization, as well as further relaxed requirements for ELTIFs solely marketed to professional investors.

Advantages of the ELTIF for investors

The current ELTIF regime already comes with some distinctive advantages which have not been fully leveraged by sponsors. ELTIFs can be marketed to both institutional and retail clients, such as private wealth investors. ELTIFs can be a safer pathway for investors interested in private market investments as they present a lower risk profile than other pure private market funds. Their default closed-end nature and long-term orientation can help investors withstand market volatility, while also providing investors with opportunities for diversification and potentially higher returns through exposure to non-traditional assets. As a regulated vehicle tailor-made for investment in long-term, illiquid and real assets, it is therefore well suited to such clients. 

Compared to AIFs, ELTIFs can also be distributed across the EU with a passport to both professional and retail investors, without being subject to additional national requirements. It is interesting to note that out of the 41 ELTIFs currently registered for marketing in one country only, 21 are distributed in Italy and this is mainly due to national incentives granted to Italian investors.

While the tax treatment depends on the regulatory regime applicable to the AIF set-up as an ELTIF and to the eligibility to double tax treaties, certain jurisdictions – such as Italy – already provide tax incentives for ELTIF investors, i.e., an exemption of capital gains tax, under certain conditions, for private individuals holding shares/units of ELTIFs.

Insurance wrappers’ national investment compliance rules may also enable investment in ELTIFs under certain conditions. This is the case in France, for example, where retail investors can already invest up to 10% of units of their contract in an ELTIF while professional investors can invest up to 50% of their contract, within the limit of 10% of their wealth. The application of the regulation in France also opened up a breach in the banking monopoly, allowing loan origination by ELTIFs.

As a result of these favourable developments, Italy and France have historically been the main placement markets for ELTIFs, but recent activity shows increasing interest in other jurisdictions, such as Germany. The preferred domicile is Luxembourg, however, as it combines a flexible regulatory environment and vehicle toolbox, strong relationships with target markets as well as significant capabilities to administer both regulated products and alternative assets. 

Following an amendment to Solvency II by Commission Delegated Regulation (EU) 2016/467, ELTIFs can also benefit from the same capital charges as equities traded on regulated markets which is lower than other equities.

The reforms to the ELTIF regime build on these strengths by providing additional flexibility for sponsors. This should enhance the attractiveness of the ELTIF in a context of COVID-19 recovery, market volatility affecting traditional financial instruments and growing appetite for alternative and sustainable strategies amongst retail and institutional investors. By providing a more attractive channel for retail savings to finance productive investment, the ELTIF is also likely to become a pillar of the Capital Markets Union.

Distinguishing between retail and institutional clients

ELTIF 2 recognizes that retail and institutional investors have “different time horizons, risk tolerances, investment needs and capabilities to analyse investment opportunities” ² and provides for different rules for ELTIFs marketed to retail and institutional clients in the following areas:

• The diversification and composition of the portfolio
• The concentration limits
• The borrowing of cash

A one-size-fits-all fund regime for all alternative assets?

Eligible assets and portfolio composition 

Under the revised regime, eligible long-term assets will comprise:

• Quasi equity, debt instruments, green bonds issued by or loans granted to a qualifying portfolio undertaking 
• Undertakings for collective investment (UCIs) such as other ELTIFs, EuVECAs, EuSEFs, UCITS and EU AIFs managed by an EU AIFM
• Real assets
• Simple, transparent and standardised securitisations (STS)

In terms of portfolio composition, the requirement for an ELTIF to invest 70% of its capital in long-term eligible assets has been lowered to 55%. It is worth noting that a look-through approach is required for the purposes of complying with this limit as well as diversification and borrowing limits. The remainder of the capital should be invested in UCITS eligible assets, up to 10% in assets issued by any single body and provided that UCITS Directive concentration limits are complied with. UCITS eligible assets include listed transferrable securities and money market instruments, recently issued transferrable securities, UCITS and other UCIs, deposits with credit institutions, derivatives and non-listed money market instruments. ELTIFs are not allowed to enter short sales, take direct or indirect exposure to commodities and use derivatives, except for hedging purpose.

The revised investment rules have been adjusted according to specific needs voiced by the fund management community. While most asset-side amendments bring significant flexibility across all strategies it is worth highlighting certain key changes in the context of specific asset classes. 

It must be reminded that diversification and concentration limits mentioned below only apply to ELTIFs marketed to retail investors.

Real estate

While ELTIFs have not been a successful vehicle for real estate, recent activity demonstrates increasing interest from sponsors. This trend is set to be confirmed by the revision of the scope of eligible real assets which will capture any assets that have intrinsic value due to their substance and properties. This definition significantly broadens the scope of eligible assets, including those assets that cannot be easily quantified, for instance, those based on a discounted cash flow or comparison valuation method. ELTIFs can invest in commercial property and industrial facilities, but also housing, including in senior residents and social housing.

ELTIFs will also be able to invest in real assets irrespective of the investment value of such assets (minimum of  EUR 10,000,000 under the current regime). This should enable asset managers to capture a broader range of potential real assets investment strategies, contribute to diversification and consequently reduce risks.  It will also no longer be required for real assets to be owned directly or via indirect holding through qualifying portfolio undertakings.

While current diversification thresholds may be challenging to comply with for real estate funds, the increase from 10 to 20% of the maximum capital allocated to financing of a single real asset should also provide more flexibility to hold larger indivisible assets. 

Infrastructure

ELTIFs can invest in communication, environment, energy or transport infrastructures, social infrastructure (e.g., retirement homes or hospital), infrastructures and installations for education, sport, health and welfare, counselling, research and development and more broadly infrastructures that give rise to economic or social benefit. 

The removal of the aggregate limit of 20% applicable to investments in target funds opens up the possibility to pursue a fund of funds (FoF) strategy. The eligible target funds universe will be significantly extended, notably to UCITS and EU AIFs managed by EU AIFMs, in addition to ELTIFs, EuVECAs2 and EuSEFs, provided they invest in eligible investments. ELTIFs will be able to invest up to 20% of their capital in a single target fund instead of the current 10%. Concentration limits will be set at 30% of the units or shares of a single target fund. Appropriate cooperation arrangements with the target funds will be required in order to perform quarterly look-through. With those changes, infrastructure FoF ELTIFs should notably attract investors in the early stages of building out an exposure to this asset class. 

ELTIF managers will also be able to invest in the same target asset through different vehicles they manage (parallel structures), provided that proper organizational and administrative arrangements have been made to identify, prevent, manage and monitor conflicts of interest and provided that such conflicts of interest are adequately disclosed.

Since infrastructure assets generate relatively stable cash flows providing comfort to lenders, managers should also be able to take advantage of debt financing and leverage increasing from 30% to 50% for ELTIFs marketed to retail investors and 100% for ELTIFs reserved for professional investors. The 30% limit applicable to encumbrance of assets, which is currently limiting further down borrowing, will also be removed.

Other real assets strategies

Beyond real estate and infrastructure, ELTIFs can also invest in other real assets such as vessels, aircraft, equipment, machinery or rolling stock. The regulation also specifically permits investments in certain types of intangible assets, such as intellectual property, water rights, forest rights, building rights and mineral rights.

Private equity (PE)

The reforms also amend the calculation basis for determining the borrowing limits: while this threshold is currently determined by reference to the capital of the ELTIF, future calculation will use the net asset value (NAV) of the ELTIF.  Even if leverage is typically applied to each portfolio company individually, PE funds will be able to increase their capability to finance their best-performing investments when the overall NAV will increase during the holding period. This is a useful feature where hybrid financing is needed to avoid equity dilution in later investment stages. In order to avoid an overestimation of the actual leverage level, the new regime also clarifies that borrowing arrangements that are fully covered by investors’ capital commitments are not considered as borrowing. 

An ELTIF will be permitted to invest in a financial undertaking, other than a financial holding company or a mixed-activity holding company, that has been authorized or registered within five years of the date of the investment. This should notably facilitate investments in fintech and provide certainty on the use of special purpose vehicles. The investment universe will also be broadened by the possibility to make minority co-investments.

The possibility to set up parallel structures and pursue FoF strategies will enable sponsors to reconcile requirements from different investors established in different jurisdictions, target a larger investor base and achieve efficient management of larger investment pools. It will also be possible to set up a master-feeder structure but since the master fund must be an ELTIF, opportunities seem more limited.

Private debt

While subscription lines bridging investors’ commitments are not considered as leverage, lending ELTIFs will also be allowed to use NAV-based leverage to finance loans in order to  increase their returns in a market becoming more competitive.

Private debt ELTIFs will also be able to grant up to 20% of committed capital to a single qualifying portfolio undertaking.

The scope of eligible assets has been further broadened to encompass STS, up to an aggregate limit of 20% of the ELTIF’s capital, provided that the underlying assets are either: 

• Residential mortgage-backed securities
  
• Commercial loans that are secured by one or more mortgages on commercial immovable property 
• Credit facilities, including loans and leases, provided to any type of enterprise or corporation
• Corporate loans (including loans granted to small and medium enterprises)
• Trade receivables or other underlying exposures that the originator considers to constitute a distinct asset type, provided that the proceeds from securitizing these trade receivables or other underlying exposures are used for financing or refinancing long-term investments

Green bonds

Bonds issued by a qualifying portfolio undertaking under EU legislative framework on environmentally sustainable bonds will become eligible investments.

Small caps

The maximum market capitalization threshold defining an eligible small and medium-sized enterprise equity or debt issuer has been raised to EUR 1,500,000,000 (up from EUR 500,000,000) which is more aligned with the average capitalization of small cap index constituents. This capitalization threshold will only be applicable at the time of the initial investment so as not to create a cliff edge where ELTIFs would need to divest from growing companies.

The reforms also clarify that ELTIFs do not have to invest specifically in European eligible assets. This should facilitate implementation of global or non-EU small cap strategies considering that the majority of the assets of the ELTIF or the main source of revenue or profit of such assets may be located in a third country. However, third countries where qualifying portfolio undertakings are located must not be included in the list of non-cooperative jurisdictions for tax purposes or be identified as high-risk countries pursuant to the 4th AML Directive. It should also be noted that ELTIFs will also no longer be required to borrow in the currency of the asset which is being financed and will therefore be able to take advantage of lower interest rates.

Derivatives and efficient portfolio management

The aggregate risk exposure to a counterparty of the ELTIF stemming from OTC derivative transactions, repurchase agreements, or reverse repurchase agreements should not exceed 10% of the value of the capital of the ELTIF.

Efficient portfolio management techniques (securities lending and borrowing, repurchase transactions or any other agreement which has an equivalent economic effect and poses similar risks) cannot represent more than 10 % of the assets of the ELTIF affected.

ELTIF, the retail route for alternatives?

There are different frontiers and ways to address them to respond to individual investors’ growing appetite for alternative strategies and alternative asset classes. UCITS with alternative strategies, listed real estate or private equity funds, and evergreen funds stand as possible options since liquidity, transparency and investor protection safeguards remain key drivers of retail participation while sponsors strive for flexibility and simplicity.

Keeping these conditions for success in mind, policymakers have looked at alleviating certain barriers and cumbersome requirements hindering distribution.

Facilities

ELTIF managers will no longer be required to have facilities in place in the Member State where the retail investors targeted are located for the purpose of making subscriptions, payments, repurchasing shares and making information available.

Suitability test

The revised ELTIF Regulation now cross-references the suitability assessment in line with the MiFID II provisions for ELTIF managers and distributors when directly offering or placing ELTIFs. This removes the duplication of suitability tests and collection of information – on retail investors’ knowledge, experience, financial situations and objectives – that existed within the ELTIF Regulation. In instances where retail investors receive a negative result on the suitability assessment but still wish to proceed with the transaction, the ELTIF manager is permitted to do so provided they obtain the explicit consent of the retail investor.

Equal treatment

Investors benefit from equal treatment and no preferential treatment or specific economic benefits should be granted to individual investors or groups of investors at a share class level.

Subscription amounts

The reforms remove the minimum entry ticket of EUR 10,000 and the 10% aggregate threshold for retail investors whose financial portfolios do not exceed EUR 500,000. In practice, private asset pure players typically set closed-ended funds with a minimum investment amount. However, allowing investors to commit lower amounts should appeal to those multi-asset managers coming from the liquid world who want to attract a larger investor base and have the capability to administer large volumes of subscriptions. The removal of the 10%/EUR 500,000 threshold should also bring more comfort to distributors who do not always have a comprehensive view over all investor’s individual holdings due to the extensive use of wrappers in the retail space.

Structuration and liquidity

ELTIFs cannot be structured as genuine evergreen funds since they need to have a maturity date. Rules or instruments of incorporation of the ELTIF should clearly indicate a specific date for the end of the life of the ELTIF, but may provide for the right to temporarily extend the life of the ELTIF and the conditions for exercising such a right. 

In practice, ELTIFs can be set up with an extended lifetime but also to provide for the possibility of redemptions during the life of the ELTIF provided that, inter alia:

• The manager of the ELTIF is able to demonstrate to the competent authority that the ELTIF has an appropriate redemption policy and liquidity management tools, which are compatible with the long-term investment strategy of the ELTIF
  
• The provisions on liquidity risk management and liquidity management tools set out in the AIFMD are complied with
• The redemption policy of the ELTIF:
  • Clearly indicates the procedures and conditions for redemptions 
  • Ensures that redemptions are limited to a percentage of the share of UCITS eligible assets owned by the ELTIF
  • Ensures that investors are treated fairly and redemptions are granted on a pro rata basis if the requests for redemptions exceed the limit provided for in the policy

The reforms also permit to set a lock-up period (minimum holding period) which is shorter than the ramp-up period and remove the option for an investor to request the winding down of an ELTIF if their redemption request, made in accordance with the redemption policy, has not been satisfied within one year from the date on which they were made.

The reforms also allow that ELTIF managers provide for a secondary market that would allow full or partial matching of transfer requests of units or shares of the ELTIF by exiting ELTIF investors with subscription requests by new investors during the life of the ELTIF.

The ELTIF manager will be required to have a defined policy for the secondary market including information on the transfer process for both exiting and subscribing investors, the applicable time window, the execution price, the conditions for the pro-ration, disclosure requirements and the applicable fees, costs and charges.

ELTIF redemption policies and optional liquidity mechanisms will be subject to more detailed requirements developed in regulatory technical standards.

It is also possible to improve liquidity for investors through listing on a stock exchange. In case of fully closed-ended ELTIFs, prospectus regulation and transparency directive requirements will apply. 

Authorization and public register

Changes have been incorporated to streamline the authorization of the ELTIF. The reforms separate the authorization provisions that govern the authorization of the ELTIF and that of the AIFM. The national competent authority (NCA) responsible for authorising the ELTIF will be solely responsible for the authorization of an ELTIF and will not be involved in the additional authorization or ”approval” of the EU AIFM. 

The proposed Regulation also clarifies that the authorization of an ELTIF should not be subject either to a requirement that the ELTIF be managed by an AIFM having its registered office in the ELTIF home Member State or that the AIFM pursues or delegates any activities in the ELTIF Home Member State.

Disclosure requirements for master-feeder structures

A feeder ELTIF will be required to disclose in their prospectus and annual report the aggregate charges of the feeder and the master. The prospectus should also include a description of all remuneration or reimbursement of costs payable by the feeder ELTIF by virtue of its investment in units or shares of the master ELTIF.

The prospectus of feeder ELTIFs must also include:

• A declaration that it is a feeder of a particular master and that it will permanently invest at least 85% of its assets in the master ELTIF
  
• The investment objective and policy, including the risk profile and whether the performance of the feeder and the master ELTIF is identical, or to what extent and for which reasons they differ
• A brief description of the master ELTIF, its organization, its investment objective and policy, including the risk profile, and an indication of how the prospectus of the master ELTIF can be obtained
• A summary of the agreement entered into between the feeder ELTIF and the master ELTIF or of the internal rules on the conduct of business 
• How the unitholders or shareholders may obtain further information on the master ELTIF and the agreement entered into between the feeder ELTIF and the master ELTIF 

Outlook

Luxembourg can build on the local fund industry’s experience and capabilities and is ideally positioned as a domicile for setting up an ELTIF. Part II UCIs are well established vehicles which can be used for setting up retail ELTIFs while RAIFs or SIFs can be used for professional ELTIFs. 

Major private equity and private debt managers have already taken advantage of some of the features this vehicle has to offer but the whole sector should consider significant improvements brought by the regime revision which will undoubtedly make ELTIFs easier to manage, administer and distribute.

For real estate, infrastructure and other real assets managers, the opportunity to set up a fund accessible to all European investors should certainly be considered too given the extended investment universe and the growing demand for alternative products in the retail space.

How EY can help

EY Luxembourg Consulting Services

Product Design

EY can assist you during the product design and operational fund structuring phase, which will encompass a review of the key features of the ELTIFs with regards to their operational feasibility and compliance key requirements of the ELTIF regulation and AIFMD.

Definition of our ELTIF Target Operating Model

EY can assist you in defining the Target Operating Model for your ELTIFs, including selection of suitable external service providers or software for administrating semi-liquid retail AIFs. 

Competitor analysis and benchmarking

In accordance with ESMA’s requirements for costs and charges applicable to retails AIFs, EY can assist you with performing an analysis and benchmarking related to costs and charges for your ELTIF, in order to establish the appropriateness of the fees charged to the fund.

EY Luxembourg Tax Services

EY can assist you with assessing all Luxembourg direct and indirect tax considerations including the four phases of the investment structure.

To view the ELTIF article, complete with graphs and visuals, please download our Market Pulse PDF publication.
 

1. Register of authorised European long-term investment funds (ELTIFs)

2. Recital 5