The European Commission has made a welcome intervention by amending proposed new regulatory technical standards (RTS) that concern European long-term investment funds, but it may not be enough to promote long-term success of those products.
The Commission’s intervention concerned draft RTS issued by the European Securities and Markets Authority (ESMA) on 19 December 2023. The proposed RTS were designed to supplement ‘ELTIF 2.0’, an EU regulation finalised last year, and provide granularity in key areas. However, the RTS published by ESMA must be adopted by the European Commission to have effect.
ELTIF 2.0 tasks ESMA with formulating specific rules around exit liquidity and ensuring complimentary portfolio requirements. The way ESMA approached exit liquidity for ELTIF 2.0 was strange, however. This is notwithstanding the fact that the ELTIF 2.0 Regulation itself approaches things in a somewhat chaotic manner, allowing illiquid funds to sit next to hybrid funds with little meaningful regulatory separation.
The Commission has taken the view that ESMA failed to take a proportionate approach in its formulation of the draft RTS “with regard to the calibration of the requirements relating to redemptions and liquidity management tools”. On 6 March 2024, it sent a letter to ESMA notifying it of its acceptance of the RTS with certain amendments. These can be summarised as follows:
Removal of ex post notification of material changes to redemption policy
The draft RTS envisaged a deadline of three business days from the date of a material change to redemption policy to notify such changes to the national competent authority of the ELTIF. The Commission does not believe that ELTIF managers should be able make such changes without the prior authorisation of the national competent authority.
Minimum notice periods for redemptions
The draft RTS provided for a minimum notice period of 12 months for all ELTIFs, unless they meet minimum asset liquidity thresholds. The Commission saw this approach as arbitrary and failing to consider the portfolio specifics for each ELTIF in question. As such, it recommended the removal of the minimum notice period of 12 months for all ELTIFs.
Liquidity requirements related to standardised notice periods
This is perhaps the crux of the issue, which is the calibration of the liquidity notice period for the ELTIF based on the liquid basket of assets of the fund.
Again, the Commission considered that requiring the simultaneous application of these requirements fails to take into account the individual situation of each ELTIF and would hamper ELTIFs pursuing certain investment strategies, such as real estate, infrastructure and private equity. It gave the following illustration: “an ELTIF with a quarterly redemption frequency and a 2% gate would limit the redemptions up to 8% each year. However, the draft RTS proposed by ESMA would force such an ELTIF to maintain at least 40% of the ELTIF’s portfolio in liquid assets”.
The Commission also identified the issue of cash-drag caused by such requirements and broader questioning around their ability to fund long-term projects. It has suggested that ESMA revises these provisions and makes proportionate amendments that consider the specifics of individual ELTIFs.
Liquidity management tools (LMTs)
The draft RTS were incorrectly focused on anti-dilution levies, swing pricing and redemption fees as the required LMTs, which is a more limited approach to LMTs than was intended under ELTIF 2.0. Once again, this approach was inflexible and failed to account for the specifics of different ELTIFs but was also out of kilter with the approach for other alternative investment funds (AIFs).
Redemption gates
ESMA had calibrated the redemption notice based on the redemption gate and the proportion of liquid assets in the ELTIF. However, the Commission considered this approach to be overly conservative and at odds with the other liquidity provisions of ELTIF 2.0. As such, it requested that the RTS “be amended in a manner that does not introduce new ELTIF-specific requirements with respect to selecting and implementing liquidity management tools beyond those set out in Article 18(2) of the ELTIF Regulation or otherwise limit the capacity of ELTIF managers in selecting and implementing liquidity management tools”.
Common definitions, calculation methodologies and presentation formats of costs
The Commission identified a number of deficiencies in the approach to costs disclosures proposed by ESMA, essentially requiring better alignment of the rules with the PRIIPs Regulation, MiFID and the AIFMD.
Why is this important?
The curious EU legislative process has a provision whereby the Commission generally has a period of six weeks from the publication of a draft RTS to propose amendments. However, in the Regulation that created ESMA and the other European supervisory authorities, the Commission can make its own decision as to what to adopt, or indeed reject draft RTS where it considers that ESMA has not submitted a document that is consistent with the Commission’s proposed amendments.
The Commission went further here, giving ESMA a bit of a bloody nose, by pointing out that regulatory technical standards “shall be technical, shall not imply strategic decisions or policy choices and their content shall be delimited by the legislative acts on which they are based”. In essence, it told ESMA that it not just failed to discharge its duties effectively, but strayed off the reservation in terms of its use of powers.
Comment
ESMA’s draft RTS were poor; they seemed to choose chaos when it came to ELTIF exit liquidity. However, fixing these issues only goes so far. While regulatory trends elsewhere have been towards homogenisation and facilitating side-by-side comparisons of products, the creation of hybrid funds sitting next to illiquid funds with no meaningful regulatory separation may hamper the long-term success of the product.
There remains a benchmarking issue, where products could seem broadly similar, and indeed they would be branded as retail ELTIFs, but where one could be illiquid and invested in real assets while the other could be required to have at least 40% of its portfolio in UCITS eligible securities.
Finally, there remain more commercial and technical questions around how wealth management platforms can reflect such distinctions and features of ELTIFs along with their existing product offerings.
The Commission’s intervention is welcomed, but there are other challenges ahead for ELTIF 2.0.
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