Alternative asset management

Mirroring developments around the world, regulators around Europe are creating new fund vehicles to offer flexibility to fund management companies and investors, and to compete for market share. Authorities are also aiming to bolster private investment in illiquid assets to assist economic recovery. Regulators are keen, though, to mitigate potential conduct risks and prevent harm.

Jurisdictions are competing for market share as fund and asset management domiciles. Along with domestic priorities reflecting the challenging economic environment, this is driving regulatory developments.

In the EU, the European Long-Term Investment Fund (ELTIF) Regulation, in force since 2015, is under review. ELTIFs are closed-ended and can invest in long-term investments, such as social and transport infrastructure projects, and real estate. According to the ESMA register, as at October 2022, 81 ELTIFs were authorised. These are domiciled in only four Member States (Luxembourg, Italy, France and Spain) and hold a relatively small amount of assets under management.

As summarised in our previous article, the ELTIF regulation is therefore being reviewed to make the fund rules more flexible, reduce barriers to entry for retail investors and increase the uptake of ELTIFs. The European Commission has proposed broadening the scope of ELTIFs' eligible portfolio investments, to allow more flexible investment rules and fund of fund strategies, to increase cash borrowing limits (allowing increased leverage), and to remove minimum investment requirements for certain investors.

Members of the European Parliament have called for wider-ranging changes, including: the creation of a sub-category of ELTIFs to be marketed as environmentally sustainable (meeting stricter requirements and being aligned with the EU Taxonomy Regulation); the possibility of open-ended ELTIFs; further changes to eligible assets; and the application of aspects of the MiFID II product governance requirements for ELTIFs marketed to retail investors. The European Council has also set out its three priorities, relating to channelling more finance to small and medium-sized businesses and long-term projects, enhancing the role of retail investors in the product, and maintaining high investor protection standards.

On 19 October 2022, the European Council announced it had reached provisional agreement with the Parliament on the review. The announcement suggested alignment had been reached on a number of the above topics. Following revisions, the final text will be submitted for adoption by the Council and Parliament. Final amendments might be agreed by early 2023, and the final rules will apply six months after the amended regulation enters into force. In the meantime, individual countries are considering how best to optimise the existing regime, including consideration of national tax treatments.

Given that ELTIF managers are AIFMs, they will also need to react to changes resulting from the ongoing review of the AIFMD. These might include new rules relating to loan-originating funds (requiring AIFMs to implement effective policies, procedures and processes for the granting of loans by AIFs they manage). Regarding distribution under AIFMD, the activation of the third-country passport and successful equivalence assessments remain a remote possibility. Non-EU fund managers will therefore need to continue to rely on Member States' National Private Placement Regimes to distribute funds to professional investors, on a jurisdiction-by-jurisdiction basis. Reverse solicitation practices are likely to remain under scrutiny by the European Commission and ESMA. A retail passport for non-EU funds is not on the table.

Some jurisdictions are also introducing new and amended national regimes. For example, in Switzerland, the planned Limited Qualified Investor Fund (L-QIF) regime will allow for the inclusion of various alternative assets for the first time. And in Italy, the rules for Italian “reserved” AIFs have been updated — the minimum initial investment was lowered, and annual and maximum investment limits were increased.

In the UK, the government “onshored” the EU ELTIF Regulation when the UK left the EU. However, no UK funds have been authorised under what is now called the “LTIF” regulation. Instead, the UK has focused on developing its Long-Term Asset Fund (LTAF) regime which launched in November 2021 (see more in our recent article here). In summary, LTAFs must be authorised, be at least 50 percent invested in illiquid assets, be valued at least once a month and have a minimum 90-day notice period for investor redemptions. Currently, LTAFs are available only to professional, sophisticated and high-net-worth investors, but the FCA has consulted on making these funds available to a broader subset of retail investors.

At the time of writing, no LTAFs have yet been authorised by the FCA, but some fund management companies are considering how an LTAF would align with their product strategy, capabilities, and resources. As with any new regime, fund managers will need time to adapt before LTAFs can be manufactured, authorised and marketed successfully.

More broadly, the UK government is progressing its review on the UK funds regime. At the start of 2022, it summarised responses to its “call for input” and committed to a shortlist of priorities along with the FCA. These included making the taxation of funds simpler and more efficient, expanding the range of investment products available in the UK (including a new unauthorised contractual scheme vehicle), and exploring opportunities to support the wider funds environment. In addition, the UK authorities will consult on options to simplify the VAT treatment of fund management fees and continue to facilities the roll-out of the LTAF.

Sentiment towards crypto-assets is constantly changing, but regulators have consistently warned retail investors of the risks. Enhancements to the regulatory framework may increase asset managers' and investors' confidence in such assets.

The Financial Stability Board has found that found that while hedge funds are allocating increasing amounts to crypto-assets, mainstream asset managers' interest remains limited. However, an IOSCO report noted an “exponential increase” in retail interest in crypto-assets.

Regulators are now considering the ability for retail funds to invest in crypto-assets (or derivatives based on crypto-assets). Most European regulators remain cautious about allowing crypto-assets as eligible assets in retail funds, but some are allowing greater flexibility for funds promoted only to professional investors. It will be interesting to see whether the imminent finalisation of the Market in Crypto-Assets (MICA) regulation, due to come into force in 2024, will have any impact on this sentiment.

ESMA has noted that the application of AIFMD to fund managers investing in crypto-assets needs to be assessed on a case-by-case basis. It reminded fund managers of the high risks involved in crypto-asset investments but stated that AIFs may in principle invest in any assets if the fund manager ensures compliance with AIFMD. More broadly, ESMA is considering potential financial stability risks. Along with the European Supervisory Authorities, it estimates that 90 EU funds have direct exposure to physical crypto-assets, and another 20 EU funds have indirect exposure. ESMA therefore regards overall fund exposure as marginal, given there are 60,000 EU-domiciled investment funds in total.

The Luxembourg regulator has noted that pension funds and UCITS for retail investors are not allowed to invest directly or indirectly in virtual assets, but that for funds for professional investors, investments in virtual assets “could be compatible” if this would not prevent compliance with existing rules. The Central Bank of Ireland has permitted certain funds for professional investors to invest in listed cash-settled bitcoin futures. It also considered whether a UCITS can invest directly or indirectly in crypto-assets and concluded that it would be “highly unlikely” to approve such UCITS. So far, the UK FCA has been silent on the treatment of crypto-assets in UK authorised funds.

The evolving product and regulatory landscape means this is an appropriate time for alternative asset managers to review whether they are utilising the full range of emerging products and fund structures, and their associated compliance arrangements. Firms should continue to track developments on both sides of the Channel, particularly as the LTAF and ELTIF regimes are reviewed and updated.