Funds Annual Briefing 2022 - Headline grabbers

In October 2021, the FCA finalised rules for a new UK fund structure – the Long-Term Assets Fund or "LTAF". The LTAF is a UK authorised fund that is designed to be focussed on long-term, illiquid assets and is particularly targeted at increasing Defined Contribution (DC) pension scheme investment into alternative assets. The FCA rules were effective from 15 November 2021.

The LTAF is an authorised fund so can be structured as an open-ended investment company (ICVC), unit trust or contractual scheme.

As an authorised fund, the LTAF is required to be open-ended, albeit the rules do provide that redemptions cannot be made more frequently than monthly with a 90 day notice period. The FCA has stated that depending on the underlying asset class, less frequent redemptions may be appropriate. That said, the FCA were clear that if a fund intends to make investments that are only suited to a closed-ended vehicle, it would not expect the manager to seek authorisation as an open-ended fund. Clearly there is an inherent tension in using an open-ended fund to invest in illiquid investment portfolios so managers will need to plan liquidity management strategies to account for this when launching an LTAF.

In terms of product level regulation, the fund is asset class neutral where DC schemes are the target investors (and it also permits fund of funds and master-feeder structures subject to certain requirements being satisfied) provided that the portfolio must be at least 50% invested in illiquid investments following a ramp up period. It is permitted to borrow up to 30% of NAV and required to apply a "prudent spread of risk" in respect of investment diversification.

As an authorised fund, the LTAF will be required to appoint a UK-full scope AIFM which is also an Authorised Fund Manager. In the alternatives sector, not many managers will currently have this permission within their group so there will be challenges in this respect, not least given the FCA's current focus on the host AFM model.

As noted above, DC schemes are the clearly identified target investor base (at least for now) for LTAFs. LTAFs will also be available to retail clients who are sophisticated investors and certified high net worth individuals (the latter category having been added since the original consultation as the FCA agreed with consultation respondents that such individuals can access unauthorised funds). The guidance relating to non-mainstream pooled investments (NMPIs) has been amended to provide for this. The FCA plans to consult in the first half of 2022 in relation to broader retail access.

In October 2021, the Bank of England published a report by the Product Finance Working Group (PFWG), entitled "A Roadmap for Increasing Productive Finance Investment".

The report considers the key barriers to investment in long-term, less liquid assets, summarising the practical solutions that they have developed, specifically focussing on UK workplace defined contribution (DC) pension schemes.

The four key recommendations are:

• shifting focus to long-term value for DC scheme members – DC trustees should actively consider how increasing investment in less liquid assets could generate value for their members, monitoring returns using effective metrics;
  
  
• building scale in the DC market, with the DWP continuing with a DC schemes consolidation agenda. Additionally, trustees should consider the schemes' ability to deliver value and access a diversified range of asset classes in their consideration of whether to consolidate;
  
  
• developing industry guidance on good practices for liquidity management – the guidance should focus on appropriate ranges for dealing frequency and notice periods for different asset types. Following this guidance, asset managers should develop products, including long-term asset funds (LTAFs), that suit DC schemes' needs and give trustees confidence to invest in less liquid assets; and
  
  
• widening investment in less liquid assets – the FCA should consult on removing the 35% cap on investment in illiquid assets for all permitted links, where the underlying investor is not self-selecting their investments. Additionally, the FCA should review the Financial Promotion rules in relation to LTAFs and consider the appropriateness of applying this framework to LTAFs as part of its review of the potential safe distribution to retail investors.

The Department for Work and Pensions (DWP) is consulting on proposals to exclude 'well-designed' performance-based fees (specifically ones that are paid when an asset manager etc. exceeds pre-determined performance targets) for certain categories of investment, such as venture capital and other forms of private equity, from the DC automatic enrolment scheme default fund charge cap.

Broadly, the current charge cap prevents such DC schemes from applying charges of more than 0.75% annually on a member's default fund pot (noting that some charges are excluded and can be charged in addition to costs falling within the charge cap). The charge cap is widely seen as limiting the ability of such schemes to invest in long-term, illiquid assets (though there are also other obstacles to significant investment in this area, such as a need for liquidity). The DWP consulted on the charge cap in September 2020 and in March 2021 before publishing the proposals. The aim of the proposals is to ensure trustees of occupational DC pension schemes are able to take advantage of long-term, illiquid investment opportunities without diluting the current protections in place to protect members from 'predatory' charges.

In June 2021, the government introduced regulations on a mechanism to allow schemes to smooth performance fees within the charge cap, which came into force in October 2021. The smoothing mechanism is, however, broadly considered to be of limited benefit. The government is therefore now looking into whether performance fees for certain kinds of investment can be excluded altogether, whilst ensuring that other investment product fee structures cannot be amended to fall within the exclusion. In doing so, it also wants to encourage market participants to reform existing performance fee structures, taking into account the needs of DC schemes. The scope of the performance fee exemption would be limited to venture capital, private equity, infrastructure and private credit. The fixed fee element of such investments would not be excluded.

If it proceeds with this, so as to ensure greater transparency on performance fees excluded from the charge cap, the government is minded to require disclosure of such in a DC scheme's annual chair's statement and to remove the smoothing option, unless transitional measures are needed.

Specific design considerations are also put forward to apply as types of performance-based fees that could be excluded from the list of charges subject to the charge cap, including:

• principles for typical hurdle rates for performance fees across different asset classes;
  
  
• accrual methodologies for performance fees;
  
  
• linking performance fees directly to realised profits;
  
  
• circumstances when caps on performance-fee-incurring assets within the portfolio might be appropriate;
  
  
• incentivising the development of alternative fee methodologies such as '1 and 30';
  
  
• requirements for a high-water mark; and
  
  
• banning the practice of clawback.

The proposals sit alongside the government's other recent initiatives towards addressing the barriers to investment in long-term illiquid investments in the UK, including the publication of the final report of the Productive Finance Working Group in September (discussed above) and the introduction of the Long Term Asset Fund (LTAF) in October (discussed above).

Following an announcement in its March 2020 Budget, the government has been undertaking a review of the UK funds regime, covering taxation and relevant areas of regulation. The overarching objective of the review is to identify options which will make the UK a more attractive location to set up, manage and administer funds and which will support a wider range of more efficient investments better suited to investors' needs. The review consists of three workstreams:

• a "call for input" which was published in January and closed in April (the CFI);
  
  
• proposals for a new tax privileged regime for asset holding companies in alternative fund structures (discussed further below); and
  
  
• a review of the VAT treatment of fund management fees (discussed further here).

The CFI was very broad in scope and, although a number of specific issues were raised, HM Treasury made clear that it also wanted to hear about any other measures that enhance the UK funds regime.

One area covered by the CFI was the possible introduction of new fund structures. The LTAF was discussed, with the focus being on the tax treatment. Since then, the regulatory rules and guidance for the LTAF have come into effect (see above for more detail) but, so far, the government has provided little detail on the extent to which the tax rules for the LTAF will differ to those for other types of authorised funds. An exception to this has been the recent introduction of regulations primarily relating to the application of the "genuine diversity of ownership" condition to the LTAF, which we discussed in a recent briefing.

The CFI also discussed different options for a flexible, tax-efficient, unauthorised fund structure, capable of investment in alternative asset classes, which would be targeted at professional investors, aimed at filling another gap in the current UK offering. The proposals being considered on which the CFI sought views, are (1) those of the UK Funds Regime Working Group and the Alternative Investment Management Association that the fund could be structured as either a corporate or as a partnership; and (2) the Association of Real Estate Fund's suggestion that it could be structured as a contractual scheme.

From a tax perspective, specific issues raised in the CFI include:

• considering whether authorised funds should be exempted from tax altogether (noting that this could make claiming treaty relief under double tax treaties difficult);
  
  
• improving the position of multi-asset/balanced authorised funds;
  
  
• after observing that the number of registrations of UK-domiciled limited partnership funds has declined over recent years, exploring whether bespoke partnership taxation rules could provide the opportunity for improved tax administration and certainty of tax outcomes;
  
  
• exploring how features of the UK's double tax treaty network could be enhanced for funds; and
  
  
• changing the REIT rules (see here).

As part of its review of the UK funds regime (see above), the government considered the attractiveness of the UK as a location for asset holding companies (AHCs) in alternative fund structures and, in response to feedback, is set to introduce a new tax regime for QAHCs.

The wide-ranging tax benefits include a broad exemption from tax on gains from shares (other than in UK property rich companies) and non-UK land, a deductions regime that should keep taxable income very low (by giving deductions for profit-related interest), and a complete exemption for foreign property business income. In addition, there are tax benefits for investors, with certain of the normal tax rules disapplied to make it easier for returns from the QAHC to be passed to investors in capital form.

The new regime is an exciting development and should allow the UK to compete with vehicles on offer in rival European fund centres, in particular Luxembourg and Ireland. Its availability will be particularly welcome for many managers who have been concerned about the need to build substance in Luxembourg, especially in light of the shell entity directive (ATAD 3). Indeed, a poll of attendees at the BVCA's recent Tax, Legal and Regulatory Conference in November showed that over half (55%) thought it likely that they would make use of the QAHC as soon as the regime comes into force.

For more information, please see our full briefing on the new regime.

In November 2021, the European Commission finally issued a proposed directive (AIFMD II) to amend the Alternative Investment Fund Managers Directive (AIFMD). Overall, the package of reforms is relatively limited in scope, but it includes significant proposals in respect of delegation, loan origination, liquidity risk management, data reporting and depositaries.

Key proposals relate to:

• Permitted activities for AIFMs;
  
  
• Delegation;
  
  
• Substance;
  
  
• Loan origination;
  
  
• Liquidity management;
  
  
• Depositaries;
  
  
• Disclosure to investors;
  
  
• Annex IV regulatory reporting; and
  
  
• Third country marketing arrangements (NPPRs).

Some of the proposed changes to AIFMD would also apply to the UCITS Directive.

Full details of the proposals are in our briefing.

In November 2021, the European Commission issued a proposed regulation (ELTIF II) to amend the existing European Long-Term Investment Funds Regulation (ELTIF Regulation). The driver for this proposal has been the relatively low number of European Long-Term Investment Funds (ELTIFs) established in the EU and therefore ELTIF II seeks to encourage greater uptake in the future.

The proposals in ELTIF II largely focus on extending the types of assets in which an ELTIF can invest and the activities that it can carry out. There is a further broadening of certain rules for "professional investor only" ELTIFs but we would not expect these to be widely used as the ELTIF is a product used very much for its retail marketing passport. There are also provisions regarding co-investment aimed at alternative asset management arrangements such as private equity and venture capital which largely codify certain practices that have already been adopted by regulators.

Full details of the proposals are in our briefing.

Please note that this briefing is for information purposes only. It is not legal advice and should not be relied upon. It is not a substitute for taking specific legal advice in any particular situation. No liability is accepted by Travers Smith, its employees, partners or any other person for the content of this briefing or for the consequences of any action taken or not taken in reliance upon it.