The FCA's final rules relating to the "long-term asset fund" ("LTAF"), a new authorised fund regime in the UK for investing in long-term investment assets/productive finance (such as venture capital, private equity, private debt, real estate and infrastructure), came into force on 15 November 2021.
The LTAF is intriguing.
It is the first change to the UK's fund regime after Brexit and there are a number of convergences: retail investors and asset classes that have to date been considered suitable only for institutional/professional investors; an open-ended fund investing in illiquid assets; and regulated funds and liquidity management tools that have historically been available only to their unregulated counterparts.
This note updates our original note from June and highlights the changes between the proposed and final rules.
LTAF. Not to be confused with the ELTIF (the European Long-Term Investment Fund, which has had limited take-up) or the LTIF (the UK's Long-Term Investment Fund, which was derived from the EU's ELTIF regime).
A LTAF needs to be authorised by the FCA and has its own chapter of rules within the FCA handbook (COLL 15).
LTAFs are alternative investment funds and only firms authorised as full-scope UK alternative investment fund managers (AIFM) with the appropriate permission are permitted to manage LTAFs.
In line with the requirements for AIFMs operating UK authorised funds, the AIFM of a LTAF must ensure that at least one quarter of the members of its governing body are independent natural persons. If the governing body comprises fewer than eight members, the AIFM must instead ensure that at least two of its members are independent natural persons.
The FCA will seek to authorise LTAFs in between one to six months and it is encouraging those applying for authorisation to engage with it directly prior to submission of the application.
We expect that early applications will require a number of discussions with the FCA around various topics, particularly the liquidity management tools that the LTAF wishes to be available.
A LTAF needs to appoint a depositary. The FCA received feedback that the requirement for the depositary to register the title to assets in its own name, rather than the name of the fund or the manager, is not practical for all eligible assets that a LTAF might invest in. The FCA is aiming to consult on alternative registration options more broadly in the first half of 2022. The FCA noted that where a firm wishes to launch a LTAF under the current rules, it would consider applications to waive the requirement for the depositary to be the legal owner of a LTAF’s non-custodial assets in accordance with the relevant statutory tests. The FCA recommended firms approach it before submitting a waiver application.
What legal form can a LTAF take?
A LTAF can be an ICVC (an investment company with variable capital), an AUT (an authorised unit trust scheme) or an ACS (an authorised contractual scheme, which can take the form of a co-ownership scheme or a limited partnership scheme).
It should be noted, however, that an ACS LTAF requires a minimum investment of £1 million from a non-professional investor.
Who can invest?
The main objective of the LTAF regime is "[t]o encourage UK pension funds to direct more of their half a trillion pounds of capital towards [the UK's] economic recovery" and "to enable investors, particularly Defined Contribution (DC) pension schemes, to more confidently invest in illiquid assets (such as venture capital and infrastructure) than they can using existing fund structures". Indeed, the FCA noted that it would consider the new rules successful if LTAFs are launched and DC pension schemes choose to invest in them. DC pension schemes are expected to rise to over £1 trillion in assets by 2030.
In addition to professional investors, however, a LTAF may be marketed to "certified sophisticated investors" and (following a preliminary assessment of suitability conducted by the firm promoting the investment) "self-certified sophisticated investors" and "certified high net worth investors" and that these investors may invest in a LTAF.
A "certified sophisticated investor" is a person who meets the requirements set out in article 23 of the Promotion of Collective Investment Schemes Order, in article 50 of the Financial Promotions Order or in COBS 4.12.7 R.
A "self-certified sophisticated investor" is a person who meets the requirements set out in article 23A of the Promotion of Collective Investment Schemes Order, in article 50A of the Financial Promotions Order or in COBS 4.12.8 R.
A "certified high net worth investor" is a person who meets the requirements in COBS 4.12.6 R. This additional category was not in the original proposals.
Despite the inclusion of "certified high net worth investors" in the final rules, the "retailisation" offered by the LTAF is limited. It should be noted that the FCA plans to consult in the first half of 2022 on potentially changing the restrictions on promoting LTAFs to retail investors so watch this space.
The LTAF's manager must ensure that, taking account of the investment objectives, policy and strategy of the LTAF, the scheme property of the LTAF aims to provide a prudent spread of risk. This is the standard expected of a UCITS or a Non-UCITS Retail Scheme (NURS). A Qualifying Investment Scheme (QIS) simply has to have a spread of risk.
The final rules do not include the original proposal that LTAFs should have 24 months to achieve a prudent spread of risk. In any event, the FCA does consider that a LTAF should be allowed time to build up its portfolio, although the LTAF should not engage in excessive concentration of risk during this time. For example, the FCA would not expect a LTAF to invest all (or a high proportion of) its assets into a single investment during the start-up phase.
The investment strategy of a LTAF must be to invest mainly in long-term illiquid assets. The FCA would expect LTAFs to invest mainly (more than 50% of the value of the scheme property) in unlisted securities and other long-term assets such as interests in immovables or other collective investment schemes investing in such securities or long-term assets. However, a LTAF could have a strategy of investing mainly in a mix of unlisted assets and listed but illiquid assets.
Participants in the consultation had queried whether the 50 per cent guidance should apply at the point of investment or on an ongoing basis. The FCA responded that it did not intend the 50 per cent guidance to constitute a limit to be monitored on a day-to-day basis. The FCA noted that the guidance applies to the investment strategy rather than the holdings in the fund at any time. While this is somewhat helpful in clarifying that managers should seek to ensure that LTAF portfolios are more illiquid than liquid, managers that invest in a range of diversified assets may need to monitor this limit on an ongoing basis in light of evolving portfolio valuation.
Subject to the above, LTAFs have wide investment flexibility. The FCA intends that a LTAF may invest in a range of long-term illiquid assets, with few restrictions on eligible investments. The FCA, however, declined to provide a comprehensive definition of "illiquid assets".
Like a QIS, a LTAF may invest in certain specified investments under the Regulated Activities Order, as well as certain types of immovable assets and commodities. Unlike a QIS, however, a LTAF is permitted to invest in loans (with some restrictions) including investment in direct lending as part of a lending syndicate.
A LTAF is be able to invest in certain other collective investment schemes (CIS) without the restrictions faced by a QIS where managers have to establish that a CIS will not invest more than 15 per cent of its assets into other CIS.
The maximum level of borrowing is 30 per cent of a LTAF's net assets, which is in contrast to 10 per cent for a NURS and 100 per cent for a QIS.
There are no specific limits on the aggregate borrowing of underlying investments.
The AIFM of a LTAF will have to appoint an "external valuer" (in accordance with AIFMD rules) unless it can demonstrate that it has the competence and experience to value assets of the type in which the LTAF invests. It will be for the depositary, during the authorisation application process, and on an ongoing basis, to assess the manager's competence to value the scheme's assets and to determine that the manager has the "resources and procedures" for carrying out a valuation of those assets.
As with a NURS, the LTAF's assets have to be valued at least monthly.
The UK's AIFMD rules provide "[i]rrespective of any contractual arrangements that provide otherwise, an external valuer is liable to the AIFM of an AIF in respect of which the external valuer is appointed for any losses suffered by the AIFM as a result of the external valuer's negligence or intentional failure to perform its tasks".
This provision has hindered the appointment of external valuers by AIFs and, given the nature of the LTAF's assets and the potential liability involved, we do not expect many external valuers to throw their hats into the ring. The FCA notes: "We would like the market for external valuers to work better, so that all managers of LTAFs can access their services on reasonable terms. The liability standard comes from the AIFMD and was transposed through the Treasury’s secondary legislation as part of implementing the Directive. We are unable to change the requirement at this stage, but are considering the function of external valuer together with the Treasury."
The final rules provide that redemptions cannot take place more frequently than monthly and that the redemption notice period must be at least 90 days. In practice, the FCA would expect that many LTAFs would have notice periods significantly longer than 90 days. It should be noted that the FCA stated: "For a fund to be fair to all investors, we would expect redemptions to be met from the sale of a representative sample of the investment portfolio".
Rather than being overly prescriptive or prohibitive, the FCA seems to be allowing managers to work with their advisers to choose the liquidity tools that are appropriate to their investment strategy.
The FCA refers to notice periods on redemptions and subscriptions, the ability to defer redemptions, and the ability to limit the amount of the fund that could be redeemed at any dealing point but notes that a LTAF should not expect to use, nor rely on, suspension as a means of managing fund liquidity in the normal course of events. The FCA notes that "Suspension of dealing is not a liquidity management tool. It exists to protect investors in exceptional circumstances."
The draft rules also refer to minimum holding periods, in kind redemptions, dilution levies or adjustments to sales and redemptions of units and the use of side-pockets.
It should also be noted that the FCA states that "managers may need to make additional agreements with [DC] investors to deal with liquidity events".
The full range of liquidity management tools appears to be available in order to structure the LTAF's terms properly. Clients who manage hybrid funds, hedge funds or other open-ended unregulated funds have had to deal with the issues arising from investing in illiquid assets for years and we would be well placed to advise here.
At the end of the day, however, the AIFM will need to convince the FCA that its desired liquidity management tools are appropriate during the authorisation process.
Crucially, LTAFs need to be open-ended and we would note the FCA's strange comment: "If a fund intends to make investments that are only suited to a closed-ended vehicle, we would not expect the manager to seek authorisation as an open-ended fund". This comment seems to contradict one of the main points of the LTAF regime but we think that it is just unfortunately worded.
In relation to capital commitments, the FCA noted: "We have considered whether an LTAF may operate a commitment approach to subscriptions. We do not rule this out, but any LTAF that wanted to operate in this way would need to comply with the existing legislative framework for authorised funds, as well as with the fund rules. If a firm is considering applying for authorisation on this basis, we would welcome early engagement with us on their proposed model."
As there may be complex charging structures, the LTAF has fee disclosure requirements equivalent to those for a UCITS or a NURS, including the requirement to provide examples of how any performance fee will operate.
There are three reporting requirements for the LTAF. As with other authorised funds, investor reports will be required on a six-month and yearly basis. In addition, the LTAF is required to produce a quarterly report providing investors with details on investments, transactions and any other significant developments. Quarterly update reports should be produced within 20 business days of the quarter end.
The LTAF might not be a private equity fund for the masses but the new LTAF regime helpfully expands the current range of UK domiciled and regulated funds to cater for institutional investors such as DC pension schemes that are looking to invest in long-term assets over a long-term investment horizon, in an appropriately regulated structure. As for its broader appeal, whether the LTAF structure will appeal to retail or non-UK investors remains to be seen.
If managers and DC pension scheme investors can work together to create a liquidity solution that is acceptable to the FCA, then the LTAF may well make a substantial amount of investment capital available to managers and give DC pension schemes much needed access to longer-term investments.
This article was produced with contributions from Maria Kodilinye and Christina MacLean.
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