ELTIFs and Part II Funds: Where Alternative Meets Retail -- White Paper
Background
On 25 November 2021, the European Commission published a proposal for amending the regulation of European Long Term Investment Funds (“ELTIF”) aiming to make the ELTIF regime more attractive. The proposed amendment is expected to come into force at the beginning of 2025 and crystallizes the EU’s political objectives linked to the Capital Markets Union, the Sustainable Finance Strategy and COVID-19 recovery plan with the ambition of enhancing the attractiveness of ELTIFs as the go-to vehicle for private market financing in the context of a growing appetite for real estate, infrastructure and private equity/debt investments from retail investors.
Originally launched in 2015, the ELTIF regime has so far not reached its intended success. To this date, only 68 alternative investment funds (“AIFs”) with relatively modest assets under management have been authorized across four jurisdictions, namely Italy, France, Spain and Luxembourg. The regime has been hindered by overly complex and restrictive rules, notably in terms of portfolio composition and distribution. Recently however, there has been a growing interest in this structure and the revised regime could yet unlock the full potential of ELTIFs.
As the other investment vehicle in focus of this paper, a fund set up under Part II of the Luxembourg Law of 17 December 2010 on undertakings for collective investment (UCIs) is an investment fund that can invest in all types of assets. It qualifies as alternative investment fund (AIF) which can be sold to all types of investors. Part II funds that have appointed an EU AIFM can market their shares, units or partnership interests via a passport to investors across the EU.
This White Paper takes a closer look at ELTIFs and Part II funds as a gateway for retail investors searching for yield via a regulated vehicle tailor-made for long-term, illiquid and real assets.
A significant market trend across two continents…
Speaking at a recent webinar hosted by ONE group solutions, Jérôme Wigny (partner at Elvinger Hoss Prussen) and Brian McMahon (global head of Alternative Business Development at BNY Mellon) joined Revel Wood (founding partner at ONE) to examine the recent trends in this space and discuss how the changes in the ELTIF and Part II regulations can help bridge the gap between alternative investment products and retail investors.
Mr Wigny noted two coexisting developments in the market: retail investors’ growing appetite for alternative assets in their investment portfolios, and European and American asset managers in the private market sector wishing to tap into these large pools of retail assets. Mr McMahon emphasized the changes in pension regulations (401-k in the US and trend toward defined contribution plans in the EU) as well as the acceleration of the “retailization” of private markets. Whereas the availability of a pan-European marketing passport for ELTIFs is attractive for European managers, their American counterparts have concluded that the ELTIF regime is too restrictive, and have opted for the more flexible format of a Part II fund to replicate private market fund strategies they have been running successfully in the US (a Part II fund can only be actively marketed to professional investors but can passively accept any type of investor). According to Mr Wigny, several of these of Part II funds with real estate, private equity and private debt strategies have recently been approved by the CSSF, with more in the pipeline – specifically in the infrastructure sector. Time will tell if the recently proposed regulatory changes will convince US managers to revisit the ELTIFs. The panel was sceptical in this regard. Whilst US managers tend to be further along the learning curve and have a longer track record, Mr McMahon added that many of the large European managers have been launching their own investment funds in this space – which they can promote through their existing EU distribution networks.
… with some operational challenges
Mr McMahon summarised the key operational challenge of liquidity management when pairing a private market strategy with on open-ended, NAV-based fund structure. Scaling assets under management certainly helps (Mr McMahon sees funds currently being launched in the EUR 300-500 million range), but achieving an effective mix of illiquid assets around which the strategy is designed and performance is achieved, and liquid assets to accommodate subscriptions and redemptions in an open ended fund is key (even if potentially challenging in stressed markets). Most of funds in this space feature certain liquidity limitations, typically 5% of NAV per quarter. Striking an NAV on this type of portfolio is operationally demanding but of vital importance given the reputational risks associated with the inability to meeting redemption requests.
The cast of managers and the structuring options
Whilst the large private market asset managers have had a head start given their previous experience in the space, Mr McMahon noted that traditional liquid managers are either considering or have been entering the market – sometimes by acquiring entire investment management teams. Mr Wigny observed the challenges of managing an illiquid strategy whilst accommodating retail investors in an open ended structure in a heavily regulated fund. This has led to partnerships between European fund houses and (typically) US private capital managers.
ELTIFs can be structured as Part II funds or as Reserved Alternative Investment Funds (RAIFs). Whereas RAIFs are only available to professional investors and well-informed non-professional investors investing more than EUR 125’000, they have the advantage of not being CSSF-regulated allowing for a shorter time to market. A Part II ELTIF on the other hand can be freely marketed under the passport without the minimum investments of a RAIF. Finally, a Part II non-ELTIF allows for the most flexibility by not being constrained by the investment restrictions of an ELTIF. However, if the ELTIF regime continues to evolve and become more attractive to managers, it could potentially offer the best of both worlds. Mr Wigny noted that the choice of structure is usually led by the distributers of the fund.
A socially relevant question of returns
Mr McMahon cited a study by Georgetown University showing that retail investors deprived of the ability to invest in private capital markets could on average be disadvantaged by 15% in terms of their long-term investment performance. The current cost-of-living crisis makes this development towards giving retail investors access to private market a highly relevant socio-economic consideration. Mr Wigny cautioned that this doesn’t mean that all (or even most) private market funds will be structured as retail vehicles in the future, but the trend towards retail investors demanding better returns and diversification (either individually or through their pension schemes) is here to stay.
It is up to our industry and its regulators to meet that demand and service investors and society with innovating investment products in this space.
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