ELTIFs: Fostering Retail Investors’ Access to Alternative Investments and the Need for Increased Transparency and Harmonization across Reporting Standards
This blog was co-authored by Anas Ben Chekroun, Intern, Capital Markets Policy EMEA.
European Long-Term Investment Funds (ELTIFs) are EU Alternative Investment Funds (AIFs) managed by alternative investment fund managers (AIFMs). These funds aim to create a source of long-term financing for infrastructure projects (e.g., sustainable energy, transport, social infrastructure), unlisted companies, and listed small and midsize enterprises (SMEs). Such entities generally have difficulties raising funds from bank lending or by accessing the stock exchange. ELTIFs complement traditional sources of capital while enabling the financing of the real economy, which, in turn, contribute to the EU’s sustainable and inclusive growth.
The ELTIF regulation grants European retail investors access to ELTIFs but subject to strict disclosure requirements and additional rules. For instance, ELTIFs are required to provide retail investors with a key information document (KID) — in addition to the prospectus — in accordance with the regulation on Packaged Retail Investment and Insurance Products (PRIIPs). [Editor’s note: KIID is the information document for UCITS. KID is the information document for PRIIPS.] Moreover, despite the illiquid nature of long-term investments, which implies that investors lock up their capital for a long period of time, investors may be offered early redemption rights under certain conditions. To further incentivize retail investors’ participation in these funds, units or shares of ELTIFs are admitted to trading on regulated markets or multilateral trading facilities. These secondary markets make ELTIFs more marketable to retail investors providing them with the opportunity to sell their units or shares before the end of the life of the fund. Note that the ELTIF regulation does not promote speculative investments.
In our 2018 CFA report “Capital Formation: The Evolving Role of Public and Capital Markets,” we discussed the need for similar regulatory developments aimed to improve transparency and disclosure requirements as a consequence of the increased importance of private markets. Indeed, the report acknowledges the higher asymmetric information, illiquidity, and risk exposure associated with these markets relative to public markets. It also emphasized, however, the important and increasing role of private markets in the financial ecosystem and the need to efficiently channel capital toward them. Therefore, CFA Institute welcomes EU efforts to responsibly support public access to private market investments through better disclosure and transparency standards that ensure strict investor protection.
CFA Institute is concerned, however, about granting retail investors the opportunity to redeem their shares or units before a fund’s end of life. On one hand, the illiquid nature of ELTIF assets makes them difficult to close out and, despite the conditions imposed on managers in relation to their redemption policy, there is a potential risk of promising liquidity to retail investors for illiquid assets. On the other, the life of an ELTIF may be undermined in the short term given the right of investors to wind down the fund if their redemption requests have not been satisfied within one year. In fact, an AIF’s liquidity position is usually negative in the early years because of large upfront investment costs and management fees, but this generally is followed by positive cash flows later in the fund’s life as the investments mature (a phenomenon known as the J-Curve effect).
Article 25 of the ELTIF regulation states that the prospectus of an ELTIF should provide information to investors in relation to the different costs that are directly or indirectly borne by them. Under Article 25(3), the European Securities and Markets Authority (ESMA) is required to develop draft regulatory technical standards (RTS) regarding cost disclosure requirements that apply to ELTIF managers. Consequently, in March 2019, ESMA issued a second consultation paper seeking advice on this matter. The first consultation paper on ELTIF cost disclosures was published in July 2015, and CFA Institute responded to it. Specifically, ESMA is required to specify the common definitions, calculation methodologies, and presentation formats of the various costs borne by investors (costs related to setting up the ELTIF, acquisition of assets, management and performance fees, distribution, and other costs), including an overall ratio of the costs to the capital of the ELTIF.
ESMA proposes that cost disclosure information under both the ELTIF regulation and the Undertakings for the Collective Investment in Transferable Securities (UCITS) KIID should be similar. This will enable ELTIF managers to benefit from an existing cost disclosure framework, that of the UCITS KIID, while also reducing the impact of the final RTS on EU member states in terms of additional costs.
CFA Institute has responded to this second consultation. Overall, the organization supports and further encourages convergence and standardization of the EU’s rules and directives on investment funds reporting requirements. Indeed, harmonization across reporting standards eases their implementation and understanding by firms, which in turn promotes the cross-distribution and marketing of financial products. More important, it enables increased market transparency and stronger investor protection. CFA Institute also emphasizes the need for significant burden of disclosure to retail investors seeking to invest in ELTIFs, mainly because of the illiquidity of the underlying assets and the long-term investment horizon.
CFA Institute also brought perspectives on more technical issues raised in the consultation. The organization disagrees with ESMA’s consideration of performance fees as annual or fixed costs, which in turn may distort the expression of these costs as a percentage of the capital. By definition, these fees vary with the performance of the fund. In addition, performance fees usually are generated over a period of more than a single year and therefore may not apply annually. Therefore, CFA Institute suggests that performance fees should be expressed separately. Moreover, the organization advocates for a better distinction between one-off costs, fixed costs, and variable costs, which appear to be mixed in Article 25(1) of the ELTIF regulation.
CFA Institute also disagrees with ESMA in considering acquisition costs as fixed costs. The organization argues that the nature of ELTIFs requires significant transaction costs and, consequently, acquisition costs should be treated as such. In the first consultation by ESMA on ELTIF cost disclosures, CFA Institute also had expressed divergent views on some technical issues discussed in the paper. For instance, the organization noted that amortizing entry costs borne by the investor throughout the entire life of the fund may result in a disproportionate allocation of expenses toward the end of the life of the ELTIF. Therefore, CFA Institute proposed the use of the average duration of the fund instead. Furthermore, the organization disagreed that these costs, along with other fixed costs, including the costs of setting up the ELTIF and distribution costs, need to be incorporated into a single overall ratio. Their inclusion may limit comparability between ELTIFs with varying fixed entry costs. Furthermore, CFA Institute believes that these fixed costs should be separate from ongoing costs to improve comparability.
To conclude, ELTIFs are important sources of capital that could help fill the financing gap needed to boost European long-term investments in projects with huge economic growth potential as well as environmental and social impact. The complex and illiquid nature of these funds, however, requires substantial disclosure requirements that CFA Institute fully supports for investor protection purposes, as reflected in the organization’s own Global Investment Performance Standards (GIPS®). CFA Institute welcomes ESMA’s endeavor to limit additional costs associated with such requirements for ELTIF managers while also fostering harmonization across reporting standards by adopting a suitable approach in compliance with Article 25(3) of the ELTIF regulation.
Image Credit: Busakorn Pongparnit