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UK FCA policy statement on long term assets funds (LTAFs)

  • United Kingdom
  • Financial services and markets regulation
  • Investment funds and asset management
  • Pensions
  • The future of funds - Long Term Asset Fund
  • Financial services

29-10-2021

 

Introduction

FCA policy statement PS21/14 “A new authorised fund regime for investing in long term assets”, sets out their response to the feedback to consultation paper CP21/12 “A new authorised fund regime for investing in long term assets”.  The consultation on CP21/12 closed on 25 June 2021.  Eversheds Sutherland LLP was amongst those bodies and organisations which responded to the consultation.

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.  Instead, the FCA has stated that funds will only be able to deal monthly and with a minimum notice period of 90 days.

We welcome the FCA’s careful consideration of the feedback and the changes which have been introduced to the LTAF regime to accommodate industry comment.  Of particular note is the promise to consult on allowing LTAFs to be distributed more widely and also the commitment to consult on the requirement for depositaries to hold certain assets in custody in early 2022.  The policy statement also provides clarity around some of the issues which had been unclear in CP21/12.

The final rules set out in PS21/14 come into force on 15 November 2021 and it will be interesting to see how many managers look to establish funds in this form.  The FCA is encouraging firms wishing to establish an LTAF to speak with them before making a formal application.  Firms will use the existing Forms 12, 242 and 261C (which we expect to be updated), depending on whether they wish to establish an LTAF as an OEIC, unit trust or authorised contractual scheme.  It is also worth noting that firms can apply to convert existing funds into LTAFs (subject to compliance with the relevant rules).

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The long-term asset fund 

Basis of regime: governance and disclosure

The rules and guidance provided for under PS21/14 are unchanged from those set out in the initial consultation.  Managers of LTAFs will be subject to strong governance and oversight requirements in light of the nature of investments which may be held within an LTAF.  Accordingly, such managers must be full-scope UK AIFMs in possession of the necessary knowledge, skills and experience to understand the activities of the relevant LTAF, the risks associated with such activities, and must employ personnel with the requisite knowledge, skills and experience.

PS21/14 requires the UK AIFM of an LTAF 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 (akin to that required for a value assessment).

There are four further considerations which the manager of an LTAF must assess and report against annually.  These are:

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

The disclosure rules proposed in CP21/12 are unchanged.  PS21/14 mandates certain disclosures in an LTAF’s prospectus to assist investor understanding of the nature of the product.  The FCA does not intend to add specific sustainability disclosures to the LTAF rules.  Rather the FCA anticipates the forthcoming UK sustainability disclosure regime will apply to LTAFs.

Firms will need to consider the experience on their governing body in relation to illiquid assets and determine whether or not this needs to be supplemented, as it is not possible to get this experience through delegates or third parties.

Purpose

PS21/14  clarifies that the FCA did not intend for the guidance that at least 50% of investments should be in illiquid assets be seen as a hard limit.  They have explained that this guidance applies to the investment strategy and not the holdings in the fund at any time. 

The FCA makes clear that investment by LTAFs is not strictly limited to assets commonly regarded as ‘productive finance’ and PS21/14 does not attempt to define ‘productive finance’ or ‘illiquid assets’.

Investment powers

PS21/14 removes the proposed 24 month grace period during which limits on investment do not apply.  The FCA considers the overall requirement to achieve a prudent spread of risk to be a sufficiently broad framework within which to manage an LTAF.

The contemplated rules on investment in loans have been made less prescriptive on the basis that existing rules on conflicts and best interests more suitably address the FCA’s concerns in this area.  Certain of the limitations on lending remain if the loan is to a natural person or to a person with whom it isn’t possible to appropriately manage a conflict (e.g. the portfolio manager or the depositary).

PS21/14 removes the proposed requirement for a prudent spread of risk within a second scheme held by an LTAF on the basis that it is more appropriate for such assessment to be at the level of the LTAF itself.  This dispenses with the requirement for look-through in respect of any other scheme held within the LTAF.  Due diligence requirements in relation to investment in second schemes have been retained, albeit in a clarified form which implicitly acknowledges that for some schemes it may not be possible to assess every aspect of the due diligence considerations contemplated in the FCA rules.

Borrowing

The rules as consulted on in relation to borrowing remain unchanged, and so the maximum permissible level of borrowing by an LTAF is 30% of portfolio value.  As previously noted, given that a QIS can borrow up to 100% of portfolio value, this 30% limit for the LTAF is perhaps out of step with the other aspects of an LTAF’s investment powers which are broader than those of a QIS.

Valuation

The rules on valuation have been amended in light of the industry feedback on the rules proposed in CP21/12.  In place of an unqualified determination that the manager has the knowledge, skills and experience required to value the assets of an LTAF independently, the depositary must determine that the manager has the resources and procedures necessary for carrying out valuations.

The requirement that an independent valuer be appointed (save for if the manager can demonstrate that they are sufficiently competent to value the assets) was retained, however, it is subject to further consideration by the FCA in conjunction with the Treasury. 

Redemptions and subscriptions

PS21/14 adjusts the proposed rules on redemptions and subscriptions also. To counteract the liquidity mismatch which can arise when an open-ended fund holds illiquid assets, LTAFs will be required to redeem units no more frequently than monthly and all such requests will be subject to a minimum 90 day notice period. The FCA has though stressed that this notice period is very much a minimum requirement and so the appropriateness of the notice period for any particular LTAF should be assessed by reference to the nature of the holdings in the portfolio – i.e. where the assets are highly illiquid, a notice period greater than 90 days may be more appropriate.

Investment due diligence

The rules consulted on in CP21/12 are unchanged.  The FCA takes the view these are compatible with, rather than duplicative of, existing AIFMD requirements.  These rules require that the manager uses good market practice when carrying out due diligence and that the process and extent of this due diligence is suitably disclosed in the prospectus.

Knowledge, skills and experience

The rules consulted on in relation to knowledge, skills and experience are also unchanged.  Given the potentially complex nature of the asset classes involved, an LTAF manager must be a full-scope AIFM. Managers seeking to offer LTAFs must be in a position to demonstrate to the FCA that they have sufficient skills and experience to manage a fund with illiquid and long term assets.  It is worth stressing that this requirement cannot be satisfied by delegation or outsourcing arrangements. 

Reporting 

The rules on reporting remain those set out in CP21/12.  In addition to the half-yearly and annual reporting requirements, the manager of an LTAF must provide quarterly reporting on:

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

Depositary ownership of assets

There is particularly good news on a number of fronts for depositaries.  First, the FCA has recognised that it is not appropriate to ask depositaries to determine whether or not the AFM has the knowledge skills and experience to value the assets of an LTAF independently.  Instead, they will be asked to ensure regularly, and at least annually, that the AFM has the resources and procedures to carry out the valuation.  Secondly, the FCA has confirmed that depositaries will not have a role in overseeing the value assessment.  Finally, the FCA has recognised that it may not be appropriate for the depositary to be the legal owner of non-custodial assets held in an LTAF.  They have committed to consulting on changing the rules in this regard in 2022.  In the meantime the FCA will consider a waiver of the rule but only if they are satisfied that any alternative custody mechanism provides sufficient protection for investors.  This issue has been a focus of concern and lobbying by the depositary industry for some time, so the chance to put their arguments to the FCA in a formal consultation process is welcomed.

Permitted links rules

“Permitted links” refers to the rules put in place by the FCA that are designed to ensure that if a natural person ultimately bears the investment risk of a unit linked life policy, the underlying assets are appropriate for retail investors.   Under the current rules, there is a cap on illiquid investments within any unit-linked fund of 20 or 35% (with the higher cap applying where the insurer provides additional risks warnings and take steps to ensure the fund is suitable for those investing in it). 

Additional flexibility for investments by DC pension schemes

The FCA is amending the permitted links rules insofar as they apply to a unit-linked contract that forms part of the default arrangement of a DC pension scheme.  A “default arrangement” is the investment arrangement used by the pension scheme for savers who have not chosen their own investment arrangements.  The vast majority of DC pensions savings in the UK are in default arrangements.  The amendment will remove the 35% limit for LTAF-linked funds that form part of the default arrangement of the pension scheme by creating “conditional permitted LTAFs” within the permitted links rules and making them available only in relation to default arrangements.  

The purpose of the amendment is to allow more flexibility in the construction of DC default arrangements, which are often made up of a combination of different linked funds under a unit-linked contract.  By removing the limit on illiquid assets for LTAF-linked funds, it is envisaged that firms will be able to better market the LTAF to managers of pension schemes and the managers of pension schemes will have the option of using the LTAF as the vehicle for exposure to illiquid assets within the default arrangement.

These changes to the permitted links rules will be welcomed by the managers of pension schemes as it will give them more flexibility in how their default arrangements are constructed.  The changes are also aligned with the Government’s drive to see DC pensions savings used to support long term assets such as infrastructure.  The LTAF is one way this can be achieved. 

Wider application of LTAF to linked contracts of insurance

In contrast to the position adopted for default arrangements for DC pension schemes, the FCA has decided not to proceed with amending the “permitted links” rules more widely to remove the 20 or 35% cap for insurance based investment products.  As a result, the degree to which a unit linked investment can be exposed to LTAF investments will be constrained by the 20 or 35% cap if the investment risk of the contract is with a natural person. 

The FCA recognised there was broad advocacy for the wider use of the LTAF as a permitted link and that arguments were made that managed investment portfolios outside of the DC default arrangement space can be analogous to default arrangements.  However, the FCA decided that, although it remains open to potentially extending the distribution of the LTAF if investors have professional support, it will defer consideration of this and a wider overhaul of the permitted links rules to an undetermined later date.

Distribution

Despite most respondents saying that classifying LTAFs as non-mainstream pooled investments (“NMPI”) for distribution purposes will overly restrict the market for LTAFs, the FCA is standing firm on initially treating LTAFs as NMPIs and making them subject to the same guidance as qualified investor schemes (“QIS”).  This will limit eligible investors to professional investors, including DC pension schemes, and certified sophisticated retail investors.  The FCA has amended COBS 4.12 so that certified high net worth investors are also eligible to invest in LTAFs.  However, the FCA accepts that there is a case to be made for broader access and is planning a consultation on potentially changing the restrictions on promoting LTAFs to retail investors for the first half of 2022.

The more detailed distribution questions in CP21/12 elicited a wide range of answers and it is not clear from the FCA summary and response quite how they intend to take things forward in this regard. 

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.

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