FCA consults on its long term asset funds (LTAFs) proposals

• United Kingdom

• Financial services and markets regulation
• Investment funds and asset management
• Pensions - Public sector
• Financial services - Asset managers and funds
• Financial services - Retail finance
• Local government

07-06-2021

FCA consultation paper CP21/12 “A new authorised fund regime for investing in long term assets” seeks views on the FCA’s proposals for a long term asset fund (“LTAF”).  The LTAF is intended to facilitate investment in long term assets, also known as productive finance, by professional investors and sophisticated retail investors through an authorised open ended fund vehicle.  As LTAFs will hold illiquid assets they will not be required to offer daily dealing. 

If firms were hoping that the LTAF would be a UK answer to the Irish qualifying investor alternative investment fund (“QIAIF”) and the Luxembourg reserved alternative investment fund (“RAIF”), offering the same kind of flexible investment in long term assets with limited restrictions and regulation, they will be disappointed. 

The form of LTAF contemplated by the consultation is highly regulated and in some respects arguably more regulated than a UCITS or a non-UCITS retail scheme (“NURS”).  While described by the FCA as being based on the qualified investor scheme (“QIS”), in many ways the LTAF is a hybrid of a QIS and a NURS.

In some respects the LTAF will have broader investment powers than a QIS, however the costs of this flexibility are limits on distribution (like those of a QIS), additional investor reporting, additional disclosures, limits on borrowing and enhanced value assessment.  Managers may find these too heavy a price to pay.

The publication of the LTAF consultation paper coincides with the publication of FCA feedback statement FS21/8 “Feedback to consultation paper on liquidity mismatch in authorised open-ended property funds”, the feedback on FCA consultation paper CP20/15 “Liquidity mismatch in authorised open-ended property funds” (the “liquidity mismatch consultation”), with which the LTAF consultation paper overlaps.  See our client briefing “FCA feedback statement on liquidity mismatch and open-ended property funds”.

The consultation closes on 25 June 2021.

The LTAF consultation

Overview

The consultation sets out proposals for the LTAF, a new category of authorised open-ended fund intended to enable efficient investment in long-term, illiquid assets.  The provision of appropriately designed and managed investment vehicles for investing in illiquid assets is key to supporting the UK government’s plans, discussed in the Patient Capital Review, for greater investment in infrastructure and the transition to a low carbon economy.

The limitations of existing UK fund structures for investing in illiquid assets were thrown into sharp relief by the collapse of the Woodford patient capital funds.  The FCA’s cautious approach to the LTAF may in part be informed by the FCA’s understandable sensitivity to public criticism of its role as Woodford’s regulator.

The LTAF rules will be set out in a new chapter 15 of the FCA’s COLL sourcebook, based on COLL 8 (the current section dealing with QIS).  Helpfully for firms and their advisers the draft proposed COLL 15 in Appendix 1 to the Consultation sets out the rules applicable to the LTAF in full.  This is an improvement on COLL 8 which imports parts of other provisions by cross reference.  

LTAFs will be able to invest in all those classes of assets in which QIS are permitted to invest, but in addition will be able to invest in loans, including direct lending.  

LTAFs will be alternative investment funds (“AIFs”) and make investments in assets which may be relatively complex and risky.  The FCA proposes that only firms authorised as full-scope UK alternative investment fund managers (“AIFMs”) will be able to manage LTAFs.

The LTAF is intended to be the first of a series of open ended funds without daily dealing, broadly along the lines of that set out in the liquidity mismatch consultation.  While the FCA has proposed a 90-180 day notice period for withdrawals from the property funds proposed in the liquidity mismatch consultation, LTAFs will be fully flexible as to how they choose to manage their liquidity and may choose longer notice periods or alternate mechanisms to regulate redemptions.

Initially investment in LTAFs will be subject to the same distribution rules as QIS and restricted to professional investors and sophisticated retail investors.  However, the consultation also asks how LTAFs could be safely opened up to ordinary retail investors in the future.  If an LTAF is made available to retail clients within the scope of the packaged retail and insurance-based investment products (“PRIIPs”) regime, then a PRIIPs key information document (“KID”) will need to be provided.

Strong governance

The managers of LTAFs will be subject to strong governance and oversight due to the nature of the investments which will be held in the LTAF:

• they must be full-scope UK AIFMs, and also possess the knowledge, skills and experience necessary to understand the activities of their LTAF and the risks involved in those activities and of its assets, and employ personnel with the necessary knowledge, skills and experience
• the FCA plans to require an LTAF’s AIFM to assess how it has managed the fund in the best interests of the fund, its investors and the integrity of the market in an annual report similar to the current report on the assessment of value

There are four elements which an LTAF must assess and publicly report:

• valuation of investments
• due diligence
• conflicts of interest
• liquidity management

The LTAF’s manager will be required to allocate responsibility for complying with these requirements to an approved person.

LTAFs will be subject to the same requirement to have independent directors as UCITS and NURS.

Clear disclosure and ESG

In a departure from the approach taken for other funds, the FCA are mandating certain disclosures in an LTAF’s prospectus so that investors can understand the nature of the fund.  The FCA are also seeking views on whether LTAFs with an ESG strategy should be subject to specific requirements, which would presumably be in addition to the principles for funds with an ESG objective which the FCA are currently working on.

A requirement for “plain language” is included, as for a retail product.

Purpose of the fund

The principal objective of an LTAF must be to invest “mainly” in long-term and illiquid asset classes, either directly or indirectly through investment in collective investment schemes which invest in such assets.  Over 50% of the portfolio must be invested in long-term and illiquid assets.   There is an acceptance that portfolios will need to include a buffer of more liquid assets in order to facilitate the necessary liquidity to meet redemptions.

Custody of assets

At the moment there are no proposals to change the requirement that all assets that can be held in custody must be held by a depositary.  The FCA is concerned about the risks of changing the current model for authorised funds.  However, in the CP the FCA recognises the concerns that depositaries have raised in relation to being required to hold non-custodial assets and the FCA welcomes further engagement.

Investment powers

The LTAF investment powers are based on QIS investment powers.  LTAFs will be able to invest in all classes of assets in which QIS are permitted to invest and are thus relatively flexible, subject to a requirement for the fund to achieve a prudent spread of risk within 24 months after launch.  The “prudent spread a risk” is a higher standard than that applicable to a QIS, which requires only a “spread of risk”.

In addition:

• LTAFs will be able to invest in loans, including direct lending
• the rules applicable to LTAFs in relation to their investment in other collective investment schemes (“CIS”) will be a relaxed version of the rules applicable to a QIS’ investments in other CIS
• LTAFs may invest in CIS which do not have a restriction on their ability to invest in turn in other CIS, but will be subject to principles-based rules to ensure LTAFs do not indirectly invest in themselves
• an LTAF can only invest up to 20% of its net asset value (“NAV”) in unregulated schemes unless the manager has carried out due diligence on each of the second schemes and has taken reasonable care to determine that each second scheme complies with all relevant legal and regulatory requirements

The LTAF has broader investment powers than the QIS but as a consequence the LTAF is subject to greater checks and balances to ensure investor protection.  

Borrowing

The FCA has set the maximum level of borrowing at 30% of the portfolio value.  This is surprising given the nature of the asset class and the ability of QIS to borrow up to 100% of portfolio value.

QIS conversion to LTAF

The draft amendments to the COLL rules envisage that a QIS will be able convert to an LTAF if the manager makes the necessary changes to the constitution and fund processes to ensure compliance with COLL 15.  A charity authorised investment fund (“CAIF”) could be established as an LTAF.

Valuation

The consultation recognises the challenges of valuing a portfolio of assets which is likely to be illiquid and may not have regular market prices.  Valuations will be required at least monthly and they will need to be published in the same way as a NURS is required to published its NAV.  The FCA is proposing to require an LTAF to have an external valuer unless it is able to demonstrate that it has the competence and experience to value the assets in which it invests.  If the manager does take responsibility for valuation it must be done in accordance with good practice.

The FCA has asked whether valuation might need a further layer of assurance.  It is unclear at this stage what this might comprise of but if adopted will no doubt build in extra cost, in addition to the cost of meeting the external valuer requirement.

The role of the depositary will be enhanced.  The depositary must assess the manager’s competence to value the assets at the point of authorisation and on an ongoing basis.  We believe this to be an unwelcome extension of the depositary role and a responsibility which many depositaries may feel ill equipped to assume.

Redemptions and subscriptions

LTAFs will not be required to deal daily.  They will be allowed to make full use of the liquidity tools available to fund managers, including notice periods and deferrals. 

The consultation makes no reference to tools such as side pockets and the FCA specifically notes that suspension should not be used to manage liquidity in the ordinary course of business.  The FCA acknowledges that long notice periods, in excess of 180 days, may be required. 

The liquidity mismatch consultation focused on real estate investment, however respondents to that consultation noted that the usual current operational platform requirements for open ended UK funds to deal daily were an impediment to investing in all illiquid assets, not just real estate. 

Given the nature of potential investors in an LTAF and the requirements under Article 47 of the AIFMD to consider the investor profile when managing liquidity, the FCA raises the idea of managers entering into separate liquidity arrangements with certain investors to help manage the liquidity profile of the fund, and asks whether industry standards could be helpful in this space.

Investment due diligence

In line with other AIFs, managers of LTAFs will have to carry out due diligence on their investments and they must ensure prospectuses set out the extent and process of due diligence.

Knowledge, skills and experience

Given the potentially complex nature of the asset classes in which LTAFs can invest, the FCA will require an LTAF manager to be a full-scope UK AIFM.  A person seeking authorisation as an LTAF manager will need to demonstrate to the FCA that they have sufficient skills and experience to manage a fund with illiquid and long term assets.  Importantly, the manager will not be able to use delegation or outsourcing to satisfy the requirement to have sufficient skills and knowledge to understand the risks associated with an LTAF.

Disclosure of charges

In view of the potentially complex charging structures of LTAF assets, the FCA will require full disclosure of all costs and charges an LTAF directly or indirectly incurs.  For example, full details of any performance fees will need to be disclosed in the same manner as for a UCITS or NURS. 

Reporting

An LTAF will be subject to additional reporting requirements.  As well as the half-yearly and annual reporting, which will include the assessment of value, an LTAF will be required to provide quarterly reporting on the following topics:

• investments in the portfolio
• transactions during the period
• any significant developments in the investments during the period of which investors should be aware

These reports must be produced within 20 days of the quarter end.

Other issues

The FCA flagged other issues of importance in its consultation:

• an LTAF could invest in an intermediate holding company, provided the company meets the definition of an eligible asset for an LTAF and its usage is permitted by the prospectus
• initially the FCA will not extend its one month service level agreement (“SLA”) which applies to the authorisation of QIS to authorisation of LTAFs.  The FCA commits to authorise funds without delay and has suggested that firms who wish to launch an LTAF should engage with them prior to submission.  The FCA will review this approach after a year

Permitted Links

One of the key issues that industry participants flagged prior to the consultation was the need to ensure that the permitted links rules contained in the COBS 21 are amended so that an LTAF will be an eligible investment for as many investors as possible and, in particular, defined contribution (“DC”) pension schemes.

While some DC pension schemes (principally those which are trust-based) can access QIS directly as professional clients, it is not common for them to do so.  From an operational and administrative perspective, many trust-based DC pension schemes still access their investments by using a life wrapper, which is subject to the permitted links rules.  Other DC pension schemes (eg contract-based schemes) may not be able to access a QIS directly due to their regulatory classification, and may only be able to do so through a life wrapper.

It is permissible for a unitised policy to be linked to a UCITS or NURS without the life company concerned having to undertake any investigation itself of the underlying portfolio.  Under the current rules, if they link to a QIS they need to check the underlying portfolio for acceptability under the permitted links rules, a requirement which is largely impractical.

The look-through obligation will make an investment into an LTAF extremely difficult.  Specifically, it will be very difficult to be certain that every asset of the target fund will comply on a look-through basis, particularly over the life of that investment.  If the LTAF is a third party managed fund, life companies will face challenges accessing sufficient data to get comfortable on a look-through basis.

Acknowledging the recent flexibilities added to the permitted links rules, the look-through obligations and constraints on instrument types in the permitted links rules will remain a barrier to access if left unamended.  The FCA seeks to facilitate this by:

• removing the 35% limit on illiquid investments if an LTAF forms part of the default arrangement of a DC pension scheme.  This is achieved by excluding the LTAF from the definition of a QIS in COBS 21.3, which will make an LTAF a conditional permitted link for default arrangements only
• including guidance that an insurer must consider the concentration risk of including an LTAF as part of the default option when considering investment in an LTAF

It appears that the FCA intends that the look-through obligation will not apply where the LTAF is included in default arrangements, which will be extremely helpful.

It is worth considering whether permitting investment into an LTAF only by the default arrangements of a DC pension scheme is sufficient.  There is an argument to say that this is suitable because, while the default strategy is held by an underlying retail customer, it is constructed by professionals and thus subject to professional scrutiny.  This prevents the risk of retail investors self-selecting illiquid strategies and, therefore, being subject to market events which prevent or restrict liquidity.  Conversely, this carves out a large proportion of DC assets which would otherwise be available for investment into LTAF, for example through funds of funds or balanced funds which can be self-selected or self-invested.

Another question to consider in this context is whether it is necessary for an LTAF to be open-ended.  Arguably the DC market is looking to match its strategies to the underlying assets.  This strikes us as a reason why the LTAF would benefit from the flexibility to be structured as either open- or closed-ended, which would provide true flexibility to mirror underlying assets.

Distribution

The FCA broadly views LTAFs as not suitable for sale to retail investors given the complexity of the likely asset classes and the long term nature of the investment. 

The FCA is currently reviewing the financial promotion regime following its discussion paper DP21/1 “Strengthening our financial promotion rules for high-risk investments and firms approving financial promotions”, and does not want to prejudge the outcome of this work.  Therefore it suggests that initially the LTAF will only be distributed to the same cohort of investors as a QIS - as set out in COBS 4.12 - professional clients, certified sophisticated investors and self-certified sophisticated investors.  The FCA is considering whether it may be possible to extend the category of potential investors to include certain types of retail investors.

How can Eversheds Sutherland help?

Our team have been advising on regulatory interpretation and product development for the fund management industry since the 1980s and we have been at the forefront of new products under European and UK regulation in the period since then. Our in depth understanding of the sector and experience with the practical implementation of new product categories mean that we are very well placed to guide you in complying with the changing product and regulatory environment.

If you would like further guidance on the possible impact of the LTAF proposals, or would like guidance in responding to the consultation, please get in touch.