This Focusing on Funds looks at the LTAF regime that was introduced in 2021 by the FCA to promote investment in long-term, illiquid assets by professional investors (including pension funds) and sophisticated investors.
Why is this relevant to fund managers?
The LTAF remains comparatively new, and with recent traction in the market it is of increasing interest to UK fund managers; and with the UK government continuing to actively promote investment in long-term assets, the degree of political support backing the LTAF will only add to that interest, not only from fund managers, but scheme promotors and investors too. However, while the first LTAF launches are to be welcomed, what remains to be seen is whether the authorisation process and the prescription of the FCA’s rules will enable the LTAF to truly compete with existing, established alternatives as well as potential new up-and-coming new structures, such as the Reserved Investor Fund.
Background
The provision for the LTAF is part of a wider drive from the government and the Bank of England to direct pension investment towards illiquid UK assets to support the country’s recovery after the Covid-19 pandemic. As stated in an open letter from the Prime Minister and the Chancellor to the pensions industry, the government’s strategy is to ignite “an Investment Big Bang, to unlock the hundreds of billions of pounds sitting in UK institutional investors and use it to drive the UK’s recovery”. To further support this strategy, within the Budget 2021 the Chancellor announced a plan to make additional changes to the charge cap - currently 0.75% on the default arrangement of certain employer pension schemes – to encourage trustees of DC pension schemes to consider investing in long-term assets. The structure and nature of the LTAF has therefore been designed to allow investment flows towards assets such as infrastructure, private equity and real estate from investors that have historically been reluctant to invest in long-term assets, despite such assets being in line with their investment horizons. The potential benefits for investors could include higher returns as well as improved risk management due to a wider portfolio diversification.
The FCA consulted on draft rules for the LTAF in May 2021 in its Consultation Paper 21/12 (CP 21/12), and it published the final rules in the its October Policy Statement PS21/14 (PS21/14). These final rules are broadly consistent with the draft rules the FCA consulted on, with the addition of some adjustments made to reflect industry feedback and which are discussed below.
What is the LTAF?
LTAF is the newest category of UK authorised open-ended fund. An authorised fund is one which is authorised and regulated by the FCA. The LTAF sits alongside the other three, well-established, categories of UK authorised fund: UK UCITS; Non-UCITS retail scheme (NURS); and Qualified Investor Scheme (QIS).
A discrete chapter of rules within the Collective Investment Schemes sourcebook, COLL 15, applies to LTAFs, their managers and (in respect of certain requirements), their depositaries.
What form can the LTAF take?
LTAFs can take one of the following legal forms:
- authorised contractual scheme (ACS) – either a co-ownership scheme or an authorised limited partnership scheme
- authorised unit trust (AUT)
- open ended investment company (OEIC)
The first LTAF to launch took the form of an umbrella ACS (with multiple sub-funds).
As the legal form of LTAFs is no different from existing legal forms, there is no separate tax regime applicable to LTAFs. This means that LTAFs structured as OEICs whose scheme property comprises predominantly directly-held real estate or shares in REITs (or similar) can elect into the property authorised investment fund (PAIF) regime, which remains subject to the pre-existing tax legislation. This also means that prevailing seeding reliefs may also be available.
LTAFs may also be structured as feeder or master funds.
Who can manage it?
The LTAF is a type of alternative investment fund (AIF) which, as a reminder, is defined under AIFMD as “any collective investment undertaking, including investment compartments thereof, which raises capital from a number of investors with a view to investing it in accordance with a defined investment policy for the benefit of those investors and which does not require authorisation pursuant to the UCITS Directive”.
In order to ensure a higher degree of consumer protection, only a firm that is authorised as a full-scope UK AIFM with permission to manage an authorised AIF and which has the “knowledge, skills, and experience of managing the appropriate asset classes” can manage a LTAF.
AIFMs should check that they have the requisite permissions to manage an authorised AIF. Full-scope AIFMs which only have permission to manage an unauthorised AIF or small authorised AIFMs will, if they want to manage a LTAF, need to submit a Variation of Permission (“VoP”) application to the FCA. Typically, the CIS Authorisations Team will not consider an application for fund authorisation from a manager until it has the necessary permissions.
Managers wishing to launch a LTAF who do not have the correct permission of “managing an authorised AIF” could potentially avail themselves of the services of a host-AIFM – however, the challenge in using a hosted model is persuading the FCA that the host has the requisite knowledge, skill and experience of the relevant asset classes; for the rules make it clear that the host-AIFM may not rely on the expertise of a delegate.
In line with the rules for the other types of authorised funds, the FCA also requires the AIFM of a LTAF to:
- appoint a minimum of two independent directors to its board (with independent directors to account for at least 25% of the total board membership); and
- carry out a Value Assessment at least yearly and report publicly on its conclusions.
As the LTAF is a form of AIF, the rules provide that a depositary must be appointed for the safekeeping of the fund’s property; this extends to all property in registered form. This remains a controversial aspect of the FCA’s rules as it gold-plates AIFMD requirements in respect of non-custodial assets and the rules, as made, could create risk and liability issues for depositaries. FCA acknowledged in its response that the prevailing rules around ownership of assets for NURSs and QIS, which it has maintained for LTAFs may not work for all the eligible LTAF asset classes. FCA committed to a consultation on an alternative model in 2022 but no rule changes have yet been published. In the meantime, FCA are open to considering waiver applications from firms and their chosen depositary who wish to launch an LTAF under the current rules. It is to be noted, however, that FCA recommend that firms approach FCA before submitting any such applications.
The LTAF manager must also appoint an external valuer unless exempt under the rules. The FCA has responded to feedback in respect of its proposals on valuation and no longer stipulates that the depositary needs to make an assessment “without qualification” as to whether the manager has the competence to act as an internal valuer.
Instead, the requirements of UK AIFMD are reflected.
What can it invest in?
The FCA expects LTAFs to invest “at least” 50% of its asset value in long-term, illiquid assets. These could include:
- Private equity
- Private credit
- Venture capital
- Infrastructure
- Real estate
- Forestry
- Collective Investment Vehicles that invest in private asset classes, including limited partnerships
- Precious metals
- Unlisted securities
Despite the government’s call to direct investors’ capital towards UK assets to promote national financial recovery, LTAFs are not limited to investment in UK-only assets.
There is an over-arching requirement for the manager to maintain, at all times, a prudent spread of risk. Whilst what is “prudent” is not defined, this does align to the FCA’s designs to have high levels of flexibility. Indeed, FCA took on-board comments through the consultation to amend certain of its investment proposals, including those pertaining to loans, removing some of the prescription on the types of permitted loans.
There remain, however, some disappointing constraints particularly around the due diligence that managers will need to undertake in relation to investment in certain schemes. Any manager wishing to invest more than 20% in unregulated schemes, QISs and other LTAFs must effectively – on a reasonable efforts basis - replicate the due diligence requirements imposed on NURSs. This could limit the appetite for managers wanting to operate fund of fund strategies.
Who can invest in it?
The LTAF framework was designed primarily to target professional investors, particularly DC pension schemes, as well as sophisticated retail investors (as defined in COBS 4.12.7 R) in line with non-mainstream pooled investment (NMPI) rules. Following consultation, the FCA has marginally widened the distribution rules to allow LTAFs to be marketed to certified high net worth individuals.
The FCA consulted in August 2022 on a potential relaxation of the LTAF promotion rules to potentially allow for distribution to retail investors “in a controlled way”. The key proposals in the FCA’s consultation (CP22/14) included:
- Reclassifying the LTAF as a restricted mass market investment (“RMMI”) based on the rules set out by the FCA in PS22/10 on strengthening financial promotion rules for high-risk investments. As it stands, LTAF promotion is restricted to professional investors, certified and self-certified sophisticated investors, and certified high-net-worth individuals. Restricted retail investors would be able to invest as long as they undertake appropriateness assessments to show they understand the risks and redemption terms before they are allowed to invest up to 10% of their portfolio in the LTAF. Further, the regulator proposes that restricted retail investors should be shown a specific risk warning, including specific references to investment horizon, liquidity and redemptions.
- Increasing the amount of exposure that Funds of Alternative Investment Funds can have to the LTAF (up to a maximum of 50% of scheme property in LTAFs and 35% in any one LTAF) and switching off enhanced due diligence provisions under COLL for FAIFs which invest in LTAFs.
- Aligning some LTAF rules with the investor protection rules that apply to other retail authorised funds including: Removing the 35% restriction on illiquid assets in unit-linked products, where the investor is a qualifying default pension scheme. This would give LTAFs equivalent status to other illiquid assets, which would meet the conditions for securing an appropriate degree of consumer protection.
While it remains to be seen what the final rules will look like, any relaxation on the promotion of LTAFs could benefit not only a broader range of investors seeking portfolio diversification but also fund managers; as enabling access to a wider investor-base would bring with it more scale, thereby providing a greater chance of product viability.
What else should I know about the LTAF?
Redemptions
The redemption policy of a LTAF must be aligned to its investment strategy and the liquidity profile of the scheme. This means that the distribution strategy and intended target market should also be taken into account in defining the redemption policy. It is clear that LTAFs are not intended to be daily dealing. At an absolute minimum, the rules require investors to give 90 days’ notice of redemption requests and dealing to effect such requests is not allowed more frequently than monthly.
The rationale behind these redemption terms is to achieve consistency between the notice required from investors to redeem and how long it will take the LTAF realistically to sell its assets, in order to avoid a liquidity mismatch within the fund and potential wider systemic risks. Given FCA concerns around liquidity in authorised funds, the FCA will closely scrutinise not only the proposed redemption provisions in the draft documentation but also the liquidity profile and monitoring documents submitted as part of the application for authorisation.
In setting the redemption terms, managers wishing to structure their LTAF as an OEIC should be alive to the requirements of section 263(3) Financial Services and Market Act 2000; namely the requirement to satisfy the “investment condition” in order to qualify as an “open-ended investment company”. The investment condition
broadly encompasses a requirement that a reasonable investor would expect to be able to realise their investment in the scheme within a reasonable time. As the FCA sets out in PERG 9.7, what underlies the test is what a reasonable investor (taking into account the characteristics of the target investor) would think they were getting into if they were contemplating investment in a particular body corporate.
Commitments
Closed-ended funds often operate a commitment approach to subscriptions. Although the rules are silent on the point, such an approach can be applied for LTAFs and it is possible to structure subscriptions in this way,. Early pre- application discussions with FCA are recommended if a manager wishes to adopt such an approach.
Borrowing
The ability for LTAFs to borrow is limited. Borrowing is capped at 30% of the net asset value (NAV) of the scheme; as such this may constrain investment in infrastructure and other similar asset classes. The capping of the extent of borrowing is more restrictive than the QIS, which may borrow up to 100%, and potentially puts the LTAF at a disadvantage to other private funds.
Reporting
Distinct from requirements in relation to other authorised funds, LTAF managers will be required to produce quarterly reports providing basic information on portfolio developments. This is intended to compensate for the fact that investors will not be able to readily find market information on the illiquid assets in which the scheme is invested. The report needs to be produced within 20 business days of the end of the relevant quarterly reporting period. This is in addition to annual and half-yearly reporting requirements.
How does the LTAF compare to offshore alternatives?
In the table below we give an overview of how the key features of the LTAF compares to some of the most popular off-shore alternatives: Lux Specialised Investment Funds (SIFs) and Irish Qualifying Investor Alternative Investment Funds (QIAIFs).
| LTAF | Lux SIF | Irish QIAIF | |
|---|---|---|---|
| Jurisdiction | United Kingdom | United Kingdom | Ireland |
| Regulatory Authority | FCA | Commission de Surveillance du Secteur Financier (CSSF) | Central Bank of Ireland (CBI) |
| Type of fund | Open-ended | It may be open-ended or closed- ended | It may be open-ended or closed- ended |
| Redemption terms | Minimum 90-day redemption notice, no more frequent than once a month | Flexibility in relation to redemption terms | CBI requires that the time between submission of a redemption request and payment of settlement proceeds usually must not exceed 90 calendar days |
| Structure |
|
|
|
| Management | Full-scope UK AIFM only, which may delegate in accordance with AIFMD (as implemented in the UK) | When structured in contractual form (FCP), the SIF must always be managed by a Luxembourg management company within the meaning of Luxembourg law of 17 December 2010 related to undertakings for collective investment. Corporate vehicles may be managed by an external AIFM (which may either be a registered or authorised AIFM, as applicable) or may be self-managed entities. A limited partnership must have at least one limited partner and one general partner. The limited partnership may, but need not be, managed by the general partner. Each of the general partner or the limited partner can serve as the SIF’s AIFM; alternatively, the SIF can appoint a third-party AIFM. The AIFM may delegate some of its functions in accordance with AIFMD. | Corporate vehicles may be managed by an external AIFM or may be a self-managed entity. Unit trusts and CCFs must appoint an Irish-domiciled AIFM. The ILP is managed by a general partner. The general partner can be the AIFM under AIFMD or can appoint an AIFM. |
| Investment Restrictions | At least 50% in long-term, illiquid assets. The principle of prudent spread of risk applies. This requirement matches the standard expected of a UCITS or NURS but is more onerous than that of a QIS, which is only required to have a spread of risk. May only borrow up to 30% of the scheme’s NAV. | No restriction on eligible assets. The main requirement for the SIF is in principle not to invest more than 30% of its assets in securities of the same type issued by the same issuer. | QIAIFs are subject to very few investment restrictions and no borrowing or leverage limits apply. For example, corporate vehicles must comply with the aim of “spreading investment risk” and must include this requirement in their constitutional document. |
| Eligible Investors |
If the LTAF takes the form of an ACS, additional eligibility criteria apply. | Investors who qualify as “well- informed investors”, which are institutional investors, (ii) professional investors, or (iii) investors who have confirmed in writing that they adhere to the “well- informed” investor status, and who either invest a minimum of EUR 125,000 in the SIF or have been assessed by a credit institution, investment firm or management company which certifies the investors’ expertise, experience and knowledge in adequately appraising an investment in the SIF. | Qualifying investors must invest at least €100,000 and:
CCFs only permit institutional investors. |
Timing
In line with other forms of authorised AIFs, the FCA has up to 6 months from the date on which it receives a complete application to make a determination on the application. The FCA has not yet published any indicative shorter timeframes for their review; but if this is an AIFM’s first LTAF, and/or the application is complex with novel features, the application will take the full 6 months to allow the FCA to get comfortable with the documentation. While the length of time for authorisation could be perceived as a disadvantage, some categories of investor might welcome the fact that the scheme will be subject to the full rigour of regulatory scrutiny rather than a lighter-touch regime.
How can we help?
Our UK authorised funds team has a Tier-One ranking in the UK’s Legal 500 Guide and has significant experience and expertise in setting-up all forms of UK authorised funds across all asset classes. Drawing on internal specialist sector expertise, particularly in real estate, private equity and infrastructure and our experience in structuring commitment subscription approaches for other authorised funds, we can help support any fund manager, or investor, interested in the LTAF through:
- Planning and structuring
- Drafting and submitting VoP applications
- Drafting scheme documents
- Advising on, and drafting waiver applications
- Dialogue with FCA
- Obtaining FCA approval
- Ongoing advice and support
