Travers Smith's Alternative Insights: Policymakers, retail investors and private funds

A regular briefing for the alternative asset management industry.

As we wrote earlier this year, there is growing demand for alternative investments from individual investors – and many private fund sponsors are keen to oblige. A range of private equity, credit and infrastructure strategies are expected to come to market between now and the end of Q1 2023. The largest, typically global, alternative asset managers are leading the charge. European lawmakers are keen to help.

But targeting the retail market does mean real change for the fund manager because – even though the underlying investments are the same – the products, distribution channels and compliance requirements are very different.

Unlike their institutional-focused equivalents, most private funds aimed at the retail market are evergreen, fully drawn and semi-liquid, typically offering monthly subscriptions and quarterly redemptions.

The distribution model is also new for many firms: initially, managers often grant exclusivity to one or two wealth management firms or private banks, but then subsequently distribute them more widely, usually through other discretionary wealth managers.

And retail clients multiply the compliance burdens, chances of regulatory enforcement, and reputational risks.

All in all, it's a strategic decision that should not be taken lightly.

Navigating the European regulatory hurdles to wider distribution remains challenging, especially as the EU generally treats sophisticated investors as "retail". There are Luxembourg structures that work, and a number have been successfully launched, but the industry has been pressing lawmakers for a better, more bespoke, structure.

In October, they obliged: the European Council and Parliament announced political agreement on reforms to the EU's ELTIF – the European Long Term Investment Fund. The agreed changes have been warmly welcomed by the market, including industry associations AIMA and Invest Europe, who have worked hard to get policymakers to this point.

Unlike many of the existing retail funds in the market, the ELTIF, even after these reforms, cannot be an evergreen structure and must have a fixed term. That will limit its attractiveness for some and means that the current structures will not disappear any time soon. But other features of the ELTIF are appealing – in particular, its full retail passport and (after the forthcoming changes) no minimum subscription. The reforms will also facilitate ELTIF funds of funds (so long as underlying funds are EU), master-feeder structures (if the master fund is also an ELTIF), real estate and fintech focused funds, and prudent borrowing. Some limited early redemptions will be possible, and the revised text should clarify some specific rules on conflicts of interest that have been inhibiting adoption.

The ELTIF reform process is not quite over: technical details are still to be agreed and some issues still need to be ironed out. The implementation timetable is unclear, but provisions are expected to allow the new rules to be adopted early by both existing and new funds.

Meanwhile, policymakers in the UK remain keen to facilitate wider uptake of the UK's new structure, the Long-Term Asset Fund (LTAF). So far, there has been limited appetite for the vehicle, that was initially envisaged as a way to encourage more defined contribution (DC) pension schemes to invest in private equity and infrastructure.

The UK-centric LTAF may take longer to get traction in the market … Alternatives managers are currently focussed on the bigger opportunity for pan-European products

Here, again, there has been promising progress. As part of its wider consultation on the LTAF's regulatory framework, the UK regulator, the FCA, has proposed changes to the "permitted links" rules for unit-linked pension products to facilitate the inclusion of LTAFs in a qualifying scheme's "self‑select options", subject to certain protections to prevent over-exposure to LTAF‑linked funds. There are also reform proposals that will allow wider access for investors in non-qualifying schemes if the individual has appropriate advice.

But one major obstacle to the wider adoption of LTAFs will be harder to overcome: the fee structure. Many DC schemes are not fond of performance fees or carried interest, which are ubiquitous in private markets.

Part – although only part – of this obstacle is regulatory. In that respect, policymakers are keen to help by allowing DC scheme trustees to exclude certain "well-designed" performance fees from the 0.75% cap that otherwise applies to the total charges in a default DC fund (the so-called "charge cap").

Draft statutory guidance published last month – including a non-exhaustive and broad definition of the types of fees that can be excluded – would give significant discretion to trustees to exercise their fiduciary duties thoughtfully, and with the benefit of advice, to secure good risk-adjusted net returns for members. This is to be welcomed given the diversity of approaches to performance-based fees (and similar arrangements) in the private markets, and the benefit in allowing schemes to participate in established market-tested arrangements. There are some issues with the proposed guidance which will be fed back to the government by the industry – including a failure to confirm explicitly that carried interest may be excluded where it satisfies certain criteria, though this must be intended.

In any case, solving this regulatory issue is only part of the answer. There is a significant reluctance among trustees to accept the higher fees that prevail in private markets, partly a result of the labour-intensive, active investment model. As successive studies have emphasised, trustees ought to consider the net-of-fees returns, and indeed other benefits, that are available in the private markets.

At the same time, there is also a willingness to open the LTAF to retail investors more widely. Current regulation restricts retail distribution. However, the FCA's consultation on LTAFs that closed last month proposed to allow distribution to individuals who (amongst other requirements) have been subject to appropriateness assessments and who invest a maximum of 10% of their investible assets into LTAFs and related products as part of a wider investment portfolio. Many in the industry have welcomed these proposals, although the BVCA response stresses the need for appropriate investor protection to ensure that individuals understand the product, especially its lack of short term liquidity.

The UK-centric LTAF may take longer to get traction in the market, in part because many alternatives firms do not currently have the right UK regulatory licence to operate an authorised fund. Alternatives managers are currently focussed on the bigger opportunity for pan-European products targeted at EU-based wealth managers – which also generally work for UK wealth managers with high-net-worth clients and possibly also Middle Eastern and Southeast Asian investors. The LTAF is a worthy project, though, which may become a useful sister to other international structures as "democratisation" of alternatives takes hold.

Firms that want to tap high net worth investors – a growing and potentially significant distribution channel – should not underestimate the internal changes that will be required and the risks that must be carefully managed, especially if any UK FCA authorised firm is involved in the distribution chain. But, with help from policymakers, the path to retailisation is growing clearer. Firms that can dedicate the required time and resources are using it effectively to diversify their investor base.

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