The European Council last week reached an agreement on the 2015 Eltif framework, giving the fund management industry a channel through which to welcome non-institutional investors into asset classes such as private equity, private debt, infrastructure and real estate.
Several obstacles were removed from the 2015 iteration and important clarity was given in other areas of the framework, according to a press release from the European Council last week, which could result in an additional €100bn of funding into alternative assets over the next five years, according to research by industry representative the Alternative Investment Management Association.
And for Luxembourg, the new agreement represents a huge opportunity.
“We expect an explosion in Eltifs (European long-term investment funds). The product will grow exponentially in Luxembourg,” said Silke Bernard, partner at law firm Linklaters, who has worked on Eltifs since their inception in 2015.
However, Bernard and others cautioned that Luxembourg would need to scale up its financial services to cater for the demand.
“There’s an anti-money laundering challenge--hundreds of thousands of investors in an alternative fund compared with only 10-12 institutional investors previously. Fund managers will need to beef up their technology,” said Laurent Capolaghi, a partner at the consultancy EY in Luxembourg.
The Eltif and Luxembourg
The Eltif is a fund dedicated to long-term, alternative investments that can be distributed on a cross-border basis to both professional and retail investors. Luxembourg already has €843bn in net alternative assets under management, according to the Association of the Luxembourg Fund Industry, making it a significant global centre for alternative investments. With experience in cross-border distribution, and retail investment products such as Ucits, Luxembourg expects to be the first choice jurisdiction for those setting up the amended ‘Eltif 2.0’ in Europe.
“We’ve been platform for cross-border since the 1980s [with] Ucits and AIFM since 2013 and Eltif will bridge the two,” said Capolaghi.
Luxembourg has also actively jockeyed for position with Eltif. Since 2015, when Eltif was first introduced, Luxembourg has lobbied through working groups set up within Alfi and close work with the financial regulator CSSF to provide stronger guidelines on the framework and structuring of Eltifs.
“A lot of effort has gone into preparing Luxembourg as a country for the Eltif,” said Bernard.
And it has paid off. Nearly half of all Eltifs structured in Europe so far have been structured in Luxembourg. Yet this is only the beginning, pointed out Bernard.
“My entire team is working in Eltif and we need to scale it up. [The regulator] CSSF created an internal Eltif working group. We will upgrade the frequently asked questions. We need to get up to speed with the new rules to fully capture [Eltif’s] potential.”
Ease of rules for professional investors
Bernard estimates there are currently 82 Eltifs in Europe--but this is set to increase dramatically. One of the reasons for this is clarity: “What used to hold Eltif back was too many uncertainties, which was why many shied away,” said Bernard.
However, another important factor is the removal of important obstacles to Eltif’s functioning. The first is a new ease of rules for Eltif funds distributed solely to professional investors.
“There’s quite a range of carve-outs, lower diversification requirements and higher borrowing (up to 100% of the value of the fund) for professional Etifs which brings it more into line with Luxembourg’s AIF (alternative investment fund),” said Bernard. “The advantage being that with the Eltif you have a recognised label and certain protections.”
Benoit Sauvage, director at consultancy Deloitte Luxembourg, said that the new rules will benefit infrastructure funds.
“The old rules were too constraining for infrastructure funds. There were constraints in terms of size or limited investment opportunities that have now been more or less removed and brought into line with the professional market,” said Sauvage.
“One of these was the thresholds. Now the borrowing thresholds allow the financing of big infrastructure. Another is the possibility to co-invest. The more participants that can join an infrastructure project mean bigger projects.”
Broader scope of eligible investments
As well as being important for infrastructure funds, co-investments allow for greater participation of private equity and venture capital funds in Eltifs, as these funds often co-invest their own capital with their investor capital.
Bernard explained: “Co-investment also allows retail investors to participate in existing successful strategies, something that wasn’t possible before under old Eltif rules.”
The Eltif now allows for a broader scope of eligible investments such as investment in certain financial institutions, in fintech startups and a new possibility to invest in certain securitisation vehicles,” said Bernard.
The changes not only widen investor access to a broader range of assets, but they are in better harmony with policy goals of financing European infrastructure and European small to medium-sized enteprises, said all of the sources.
Lighter retail investor requirements
Strong retail investment appetite for alternative funds is something Eltif seeks to capture, but the framework’s first iteration made retail requirements too onerous, said the sources.
Now, rules regarding retail investor participation also appear to have been simplified and brought into harmony with the Markets in Financial Instruments Directive II rules. However, Bernard explains, the final text will set this out.
“We need to see the final text--in the past there was a specific set of rules for retail investors can’t invest more than €10,000 into one Eltif.”
Capolaghi pointed out that in the original Eltif, diversification rules were too strict and inadequate to tackle demand from the retail side. “Retail investors need diversification and for alternative diversification you need a fund of funds.”
Fund-of-funds structure introduced
One significant change to the new Eltif is the possibility for a fund-of-funds structure. “[The fund-of-funds structure] is important for me and my clients,” said Bernard, “because it opens a whole range of new strategies, feeding into target funds that are already successful.” The fund-of-funds is also more streamlined. “Before, you had to do one Eltif for each fund but now you can do one for a fund of fund.”
However, as with the other changes, the devil will be in the detail, and it will depend on the percentage that can be invested in the target fund. “If the percentage is too low, it will limit the fund of fund strategy,” said Martin Mager, another partner at Linklaters.
International investor appetite
For international investors eyeing European alternative asset classes, the new Eltif is very attractive, said Alessandro Silvestro of Lemanik Asset Management.
“Globally and in the US there is a careful push to help retail investors get access to private equity and long-term investment because these asset classes perform better long term than equities and bonds,” he said.
In Asia, coming to Europe is a question of maturity. “Most funds tap into Singapore, southeast Asia, and then Europe. Therefore I imagine it will be the big guys in private equity and in infrastructure who will be the first, followed by the middle market funds.”
When choosing a jurisdiction, Silvestro believes that Luxembourg has the edge. “Luxembourg is stronger [than other European jurisdictions] on private equity, venture capital and traditional Ucits. Luxembourg has the edge on alternative investments in structures like the Reserved Alternative Investment Fund. “
Sauvage agreed.:“If you look at competencies across EU, Luxembourg has a natural advantage, it is the first place an asset manager will think of for alternative investment funds. It is also home to the framework for alternative funds. Luxembourg has all the financial services for supporting Eltifs and for distributing cross border.”
However, there are some challenges to retail investors entering alternative investment funds, warned Capolaghi. “Distributing alternative products to larger crowd is different to Ucits, which is listed investments held by retail fund. Alternative investment vehicles are used to onboarding and managing around one dozen sophisticated professional investors. With retail investors, the ticket size will be smaller, and the number of investors will be far larger.”
The management of this growing volume of investors will be something that alternative fund managers operating Eltifs will need to get to grips with, particularly with applying know-your-customer and anti-money-laundering processes to a larger and more granular investor base.
Recently, the financial services industry has used distributed ledger technology to relieve the growing operational burden in alternative funds.
This works by automating participants in the ledger, simplifying internal processes and making the verification of transactions and assets easier.
“Funds that invest in private companies have a liquidity risk as the capital is locked up longer. This makes asset liability management important for the fund manager,” said Capolaghi. “There is also the challenge of obtaining a fair value of the underlying assets.”
DLT goes some way to addressing this problem too, by tokenising units of funds to facilitate the trading of secondary products thereby creating value in a secondary market.
Luxembourg has, in general, been welcoming to DLT. The ‘blockchain laws’ of 1 March 2019 and 22 January 2021 recognise DLT and its use in financial services.
Ucits made Luxembourg the gateway to Europe for retail investors in the 1980s and 1990s. With its crossborder features, Eltif has the same potential in the alternative investment space.
“The potential is obvious the market is massive,” said Sauvage. “We have to remember though that for the AIF it took a while to get established in Luxembourg so we would do better to compare it to the AIF market but with the advantages of targeting a larger, crossborder investor base.”
Bernard agrees. “It won’t reach Ucits numbers because the funds concerned are long-term, illiquid investments,” she said. “However it will be seen as another big success for Luxembourg.”