Is the Long Wait Worth it? European Long-Term Investment Funds (ELTIFs) Finally Take Shape
The long-awaited European regulation on European long-term investment funds (ELTIF Regulation) was finally published in the Official Journal of the EU on May 19, 2015. The ELTIF Regulation will offer fund managers a new label for collective investment vehicles with a long-term investment horizon. Following an, at times, rather contentious legislative process, the ELTIF Regulation was adopted on April 29, 2015 and came into force on June 8, 2015. It will apply from December 9, 2015.
Several points in the ELTIF Regulation have been amended since the first draft (Draft Proposal) was published by the European Commission on June 26, 2013 and submitted to the European Parliament on April 17, 2014. Numerous other amendments (proposed by the European Parliament or the Council) that would have imposed unnecessary regulatory burdens, and therefore lessened the appeal of the new fund label, have fortunately been avoided.
Goals of the ELTIF Regulation
Forming part of the European Investment Plan unveiled on November 26, 2014, the ELTIF regime has two aims:
- First, to strengthen Europe’s “real” economy by providing a new (non-bank) access to “patient” capital to finance long-term projects (especially tangible assets and infrastructure projects). The ELTIF Regulation offers retail investors the opportunity to gain exposure to long-term capital appreciation and – in conjunction with a new “European passport” for marketing to retail investors – this should broaden both the investor audience for patient capital and increase (European-wide) competition among fund managers for asset allocations.
- Second, to address the specific needs of investors that commonly invest on a long-term basis (such as insurance companies and pension funds). Conceptually, the asset classes in which ELTIFs are permitted to invest must, therefore, provide investors with long-term, stable returns.
Authorized Investment Assets
The ELTIF Regulation requires an ELTIF to adhere to strict investment rules. First, it may invest only in so-called “eligible investment assets” (save for certain liquid assets that may not exceed 30% of the ELTIF’s capital – see Qualifying Portfolio Undertakings, below). Once that first investment restriction has been met, then (except for “real assets”) an ELTIF may invest only in instruments issued by so-called “qualifying portfolio undertakings.”
Eligible Investment Assets
“Eligible investment assets” comprise: (i) equity or quasi-equity instruments;1 (ii) debt instruments; (iii) loans granted by an ELTIF (note that loan receivables may not be acquired); (iv) investments in other ELTIFs, EuVECAs and EuSEFs;2 and (v) direct or indirect holdings of individual real assets that require an up-front capital expenditure of at least €10 million (or other currency equivalent).
The ELTIF Regulation now explicitly spells out that equity or quasi-equity instruments may also be acquired from a third party via the secondary market – this was not clear in the Draft Proposal. Debt instruments may still only be acquired directly from the issuer. This distinction does not appear to be plausible – a liquid secondary market for debt instruments makes financing for enterprises cheaper, which would, in turn, facilitate the financing of the EU’s real economy, a stated goal of the ELTIF Regulation.
Unlike the Draft Proposal, the ELTIF Regulation now contains a definition of the term “real assets.” This is any asset that has value due to its substance and properties and can provide returns – including infrastructure and other assets that give rise to economic or social benefit. It also includes commercial property or housing, but only if “they are integral to, or an ancillary element of, a long-term investment project that contributes to the Union objective of smart, sustainable and inclusive growth.” Given the significance of the term “real asset” (because it can broaden the range of investments an ELTIF can make), this definition is unhelpful. On the one hand, almost every asset (except for a pure financial asset) has a value due to its substance and properties. On the other hand, it is not easy to ascertain whether an asset gives rise to an economic or social benefit (take, for example, a nuclear power plant). The ELTIF Regulation’s recitals do shed some light on what the term “real asset” is supposed to mean – recital 17 describes these as assets which yield a predictable cash flow, so that they can be modeled and valued based on a discounted cash flow valuation method. This would exclude assets such as wine or jewelry. Clearly, additional guidance will be needed, both for manager certainty and investor protection.
Qualifying Portfolio Undertakings
A “qualifying portfolio undertaking” must, to qualify for investment by an ELTIF, be established in an EU Member State or a third country that meets specific requirements (e.g., compliance with the standards laid down in Article 26 of the OECD Model Tax Convention). The ELTIF Regulation now permits investments in listed companies if these have a market capitalization of no more than €500 million. In line with the Draft Proposal, a “qualifying portfolio undertaking” may not be a financial undertaking (i.e., credit institution, MiFID investment firm, insurance company or financial holding company), unless the financial institution itself exclusively finances “qualifying portfolio undertakings” or real assets.
The ELTIF Regulation grants the manager of an ELTIF the ability to permanently invest up to 30% of the ELTIF’s capital (determined on a committed capital basis) in liquid assets (primarily securities, bank deposits, money market instruments and UCITS) that are not eligible investment assets. During the ramp-up phase, while the ELTIF’s portfolio of long-term assets is being assembled, the percentage of liquid assets may even be higher, giving a manager the ability to manage the ELTIF’s liquidity and cash flows more actively.3 Under certain circumstances (e.g., with additional capital calls), the ELTIF is also allowed to temporarily invest a higher proportion of its capital in such liquid assets.
An ELTIF is not allowed to invest in assets in which the manager has a direct or indirect interest, nor can the ELTIF effect short sales or gain direct or indirect exposure to commodities.4 The ELTIF Regulation, however, now permits securities lending, securities borrowing and repurchase transactions, provided that no more than 10% of the ELTIF’s assets are used for these purposes.
Diversification, Issuer Limits and Borrowing
Because the nature of long-term investments makes it rather difficult to manage the risks arising from concentration in a few assets, the ELTIF Regulation sets forth specific diversification rules. For example, no more than 10% of the ELTIF’s capital may be invested in: (i) assets issued by the same qualifying portfolio undertaking; (ii) an individual real asset; or (iii) the interests of any single ELTIF, EuVECA or EuSEF. The investment restrictions stated in (i) and (ii) may be increased to 20%, provided that the aggregate value of the ELTIF’s investments in qualifying portfolio undertakings and in individual real assets that account individually for more than 10% of the ELTIF’s capital does not exceed 40% of the value of its capital (again, determined on a committed capital basis).
Unlike the Draft Proposal, the ELTIF Regulation now provides that a violation of the diversification rules may be rectified within an appropriate period of time if the violation was beyond the control of the ELTIF’s manager – this provides some comfort against the risk of market movements. By implication, however, this means that if the violation was within the control of the ELTIF’s manager, no grace period is available. The ELTIF Regulation does not, however, specify what the legal consequences of such non-compliance can be.5
Pursuant to the ELTIF Regulation, ELTIFs may borrow up to 30% of their capital, provided that, among other things, the loan has a maturity no longer than the life of the ELTIF and the credit agreement is denominated in the same currency as the assets to be acquired with the cash raised. In order to address concerns related to shadow banking activities, the cash borrowed by the ELTIF may not be used for granting loans (this is a not entirely unexpected addition, since the Draft Proposal did not include this requirement).
Management and Approval of ELTIFs
Due to the limited nature of the types of assets in which an ELTIF may invest, an ELTIF does not qualify as an undertaking for collective investment in transferable securities (UCITS). Rather, an ELTIF is subject to the AIFM Directive.6 Consequently, ELTIFs may be managed only by companies established within the EU that are properly authorized as alternative investment fund managers in accordance with the AIFM Directive and that have obtained an additional authorization to manage ELTIFs. A separate authorization is required for the management of each ELTIF – this arguably means that a manager can manage both ELTIFs and non-ELTIFs.
The manager is responsible for ensuring that the ELTIF complies with the requirements of the ELTIF regime at all times. While the ELTIF Regulation states that the manager is liable for all damages and losses resulting from the failure to discharge its duties under the ELTIF Regulation, it is unclear who would be entitled to such damages. Although investors would appear to be the stakeholders who might suffer loss as a result of the ELTIF manager’s failure, it is unclear whether other persons may also have a cause of action.
Moreover, the ELTIF Regulation requires the ELTIF to apply for authorization from its home regulator,7 using the same authorization process as under the AIFM Directive. A complete application must be considered (and either approved or rejected) within two months, and will only be granted if certain conditions are satisfied, including an approval of the ELTIF’s fund rules or instruments of incorporation.
The final version of the ELTIF Regulation allows ELTIFs to not appoint an external AIFM. In this case, the ELTIF will itself assume the functions and responsibilities of an AIFM and will need to be authorized under the AIFM Directive. The application for such authorization must be filed simultaneously with the application for authorization as an ELTIF and be considered (and either approved or rejected) within three months, making this a much quicker process than for other regulatory approvals.
Marketing of Interests
In respect of the marketing of fund interests, the ELTIF Regulation goes beyond the AIFM Directive – subject to certain conditions being satisfied, authorized ELTIFs may be marketed to both institutional investors and retail investors in EU Member States (thereby offering a so-called “European passport”). Unlike the Draft Proposal, the final version of the ELTIF Regulation provides for a minimum investment amount for retail investors of €10,000, although this amount can be spread across more than one ELTIF. This requirement does not apply to those retail investors whose portfolio of financial instruments exceeds €500,000.
Compared to the Draft Proposal, the regulatory costs associated with the “European passport” have been increased,8 because the manager of an ELTIF is required to: (i) put in place facilities available for making subscriptions, making payments to investors, and repurchasing or redeeming units/shares in each Member State where the manager intends to market the ELTIF; (ii) establish and apply a specific internal process for assessment of whether the ELTIF is suitable for marketing to retail investors; and (iii) establish appropriate procedures and arrangements to deal with retail investor complaints, allowing retail investors to file complaints in the official language of the ELTIF or one of the official languages of their Member State.
In a broadening of potential structures, ELTIFs may now be structured as partnerships even if they are marketed to retail investors. This is, however, subject to the condition that the ELTIF’s legal form may not entail any further liability for the retail investor or require any additional commitments on behalf of such an investor, apart from the original capital commitment.
Term of the Fund and Redemption Rights
While no fixed minimum term is prescribed, the term of the ELTIF must be long enough to cover the life cycle of each of its assets and to facilitate the achievement of the stated ELTIF investment goal. More detailed rules on this will be stipulated in regulatory technical standards to be adopted by the European Commission. In any event, the ELTIF Regulation provides that the term of the ELTIF must be clearly stated in the form of a specific date in the fund rules or in the instruments of incorporation of the ELTIF, and must be disclosed to investors. The final version of the ELTIF Regulation now grants the manager of the ELTIF the right to temporarily extend the ELTIF’s term.
Given the illiquid nature of the assets held by the ELTIF, the Draft Proposal provided that investors could not redeem their interests before the end of the ELTIF’s term. Since this limitation aims at mitigating potential conflicts of interest between investors wanting to exit and those preferring to stay invested, the final version of the ELTIF Regulation sticks to this principle. However, derogating from the general rule, ELTIFs may (but are not required to) offer the possibility for early redemptions if they comply with certain additional requirements, including: (i) establishing a liquidity management system; (ii) setting out a defined redemption policy; and (iii) limiting the amount of redemptions in a given period to a certain percentage of liquid assets. Fund sponsors should consider thoroughly whether they want to offer investors early redemption rights – if redemption requests are not satisfied within one year from the date on which they were made, the investors have right to request that the ELTIF be wound down.
Finally, the ELTIF Regulation requires that each ELTIF prepare a schedule – itemized by individual assets – for the orderly disposal of its assets. The Draft Proposal did not stipulate the time when this schedule must be prepared – the final version of the ELTIF Regulation now brings clarity in this respect, requiring the schedule to be disclosed to the competent authority of the ELTIF no later than one year before the end of the ELTIF’s term.
ELTIFs may make distributions of income only to the extent that such income is not required for future investments. This right extends to regular income and the capital appreciation realized after the disposal of an asset – this means that an ELTIF may only make distributions of net proceeds arising from the disposal of assets to the extent that the disposal results in a net profit. Because this would not have been in line with common market standard for closed-ended funds,9 the final version of the ELTIF Regulation now provides that, subject to certain conditions, an ELTIF may reduce its capital if an asset is disposed of during the ELTIF’s term. Such a reduction of registered capital frees up available cash, which may then be distributed to the ELTIF’s investors on a pro rata basis. This enables an ELTIF to distribute the proceeds from a disposal of an asset even if the disposal did not generate net income. In effect, not only income, but also capital, may be distributed to investors provided that sufficient cash is available, thus bringing the ELTIF Regulation in line with common market standard for closed-end funds.
General and German Tax Aspects
Contrary to the Draft Proposal, the final version of the ELTIF Regulation does not contain any provisions in relation to the legal form of the ELTIF. As a consequence, each EU Member State is free to determine the legal forms that an ELTIF may take. In general, the main European fund jurisdictions (i.e., Luxembourg, Ireland, Germany and the UK) offer a variety of fund vehicles, which can be categorized into corporate, partnership and contractual or mutual fund type vehicles.
Overview of Fund Taxation
Although the specific rules on the taxation of fund vehicles differ significantly from country to country (including within Europe), because tax laws generally have not yet been harmonized, many jurisdictions provide for specific fund taxation regimes that aim to create a level playing field for all domestic fund vehicles irrespective of their legal form.
The general idea from a tax perspective is to put the fund investor in at least as good a position as the investor would have been if investing in the underlying asset directly. This means avoiding an additional layer of taxes at the level of the fund vehicle and imposing taxation solely at the investor level.
The following are different ways for domestic tax rules to achieve this:
- The fund vehicle may be disregarded or treated as transparent for tax purposes;
- The fund vehicle may be tax-exempt; or
- The fund vehicle may be taxable but benefit from a favorable tax regime.
When applying these concepts, is it quite common that jurisdictions differentiate between corporate vehicles (which are treated as tax-opaque) on the one hand, and partnership, contractual or mutual fund vehicles (which are treated as tax-transparent) on the other hand. To a certain extent, this is also how Germany treats the taxation of domestic fund vehicles.
German Taxation of ELTIFs
In the context of the German fund taxation environment, two different tax regimes exist:
- The taxation regime of investments in funds (Investmentfonds); and
- The taxation regime for investment entities (Investitionsgesellschaften), with further distinctions between
- investment partnerships (Personen-Investitionsgesellschaften); and
- investment corporations (Kapital-Investitionsgesellschaften).
Investment funds are taxed in a special quasi-transparent fashion. For German investment funds, this is achieved by exempting the fund vehicle from tax and making only the investors taxable upon receipt of real or deemed distributions by the fund. However, a German ELTIF will likely not qualify as an investment fund because an investment fund treatment requires, among other conditions, that investors be entitled to redeem interests at least once per year. While not excluded by the ELTIF Regulation, in practice this would be difficult, given the underlying nature of ELTIF assets (i.e., long-term investments).
Investment corporations can be structured in Germany as investment stock corporations (Investmentaktiengesellschaften) or contractual or mutual funds (Sondervermögen). They, again, would seem not to be suitable fund vehicles for German ELTIFs because, likely lacking the qualification as investment funds, these fund vehicles would be fully subject to corporate income and trade tax in Germany – resulting in an aggregate tax leakage of approximately 30%.
Therefore, investment partnerships in the form of an investment limited partnership (Investment-Kommanditgesellschaft) are the most appropriate set-up for a German ELTIF from a tax perspective. Investment limited partnerships are not subject to corporate income tax and are only subject to trade tax if they are “trading” or deemed to be trading. If investment limited partnerships, by contrast, are merely “asset administrating” (i.e., holding assets with a view to generate ongoing income, rather than trading in the assets in order to realize capital gains), they are not subject to trade tax. Depending on the specific investment strategy, it would generally be possible to structure a German ELTIF in a tax-efficient way – and without any tax leakage at the ELTIF level – if structured as an investment partnership.
The creation of ELTIFs is closely linked with other European initiatives in the field of investment fund and manager regulation, such as the establishment of the European Venture Capital Fund (EuVECA) and European Social Entrepreneurship Fund (EuSEF) regimes. Unlike these products, ELTIFs are not intended to facilitate the funding of specific “niches” of the EU economy (venture capital funded start-ups in the former case, and companies whose activities will have a social impact in the latter case), but to contribute to improving the financing environment for all undertakings in the real economy.
From the fund manager perspective, the main benefit of the ELTIF Regulation seems to be the European passport for marketing to retail and non-retail investors. As this passport comes with several regulatory strings attached, it remains to be seen whether ELTIFs really will turn out to be viable option. The flexibility that an additional regime offers is, of course, to be welcomed.
1) “Quasi-equity” refers to any type of financing instrument where the return on the instrument is linked to the profit or loss of the qualifying portfolio undertaking and where the repayment of the instrument in the event of default is not fully secured.
2) For further information regarding EuVECAs and EuSEFs, please refer to European Fund Regulation – Just Like London Buses?
3) The final version of the ELTIF Regulation dispensed with the condition that the ramp-up phase may last no longer than five years after the authorization of the ELTIF.
4) The final version of the ELTIF Regulation has not provided clarification as to whether an ELTIF is also prohibited from holding equity instruments issued by an undertaking that both satisfies the “qualifying portfolio undertaking” definition and is active in commodities mining and/or trading. The wording of the relevant provision (“indirect exposure”) suggests that such an investment cannot be made. However, this interpretation would not be in line with the spirit of the ban, which is to prevent an ELTIF from engaging in commodity speculation. An argument could certainly be made that the mere financing of commodity undertakings should not qualify as commodity speculation.
5) Note, however, that in these cases, the competent authority of the ELTIF manager can prohibit the use of the designation “ELTIF” or “European long-term investment fund” (see Art. 33 para. 3 of the ELTIF Regulation).
6) Regarding the question whether the minimum size exemption of the AIFM Directive applies, see European Long-Term Investment Funds (ELTIFs).
7) If the ELTIF has no legal personality (e.g., if the ELTIF is constituted in contractual or trust form), the application is to be made by the manager of the ELTIF.
8) For more information on the provisions already included in the Draft Proposal, see European Long-Term Investment Funds (ELTIFs), supra note 6.
9) The fund documentation for a typical closed-ended fund usually provides that all available cash (i.e., cash that is not required for covering expenses or making investments) may be distributed.