Travers Smith's Alternative Insights: The quest for a long-term fund vehicle

A regular briefing for the alternative asset management industry.

Last week's announcement that Vanguard is stepping up its partnership with HarbourVest to offer private equity products to more wealthy individuals is no surprise. Private funds managers are increasingly looking to access retail capital, especially the high net worth investors who may feel they are missing out on the returns offered by illiquid strategies. Of course, as we laid out in a paper last year, there are already structures available for that in Europe – but these do not always fit the bill. Policymakers, seeing long-term investment as a public good, are keen to re-double their efforts to establish an alternative structure that is appealing to – and appropriate for – retail investors, while making economic sense for the fund managers that want to tap this important source of capital.

The European Commission had high hopes for its new long-term private fund structure when it launched in 2015. The Commission (while admitting that it was hard to predict uptake) drew on experience in open-ended retail funds to argue that "a well-defined and understood brand can evolve into a globally dominant model". Tapping retail capital for long term investments could have significant social benefits, the Commission said, including for housing, health infrastructure and growth companies. But the European Long-Term Investment Fund, or ELTIF, has not yet fulfilled these lofty ambitions: when it announced a review last September, the Commission said there were only 27 ELTIFs with less than €2 billion of assets under management. The Commission now hopes that easing some of the more restrictive features of the rules will transform the fortunes of this well-intentioned regime. (The ELTIF review is part of a wider EU assessment of how its financial markets serve retail investors, on which it is presently consulting.)

Ironically, the review comes just as the ELTIF is starting to gain significant traction in the market. Many alternative asset managers are looking hard at the structure: in April, Blackrock closed its Private Equity Opportunities ELTIF with €509 million in commitments, and Neuberger Berman launched a private equity ELTIF last week. We are currently working on several ELTIF mandates and expect to see more products using the structure in the coming months.

There are certainly some restrictions in the ELTIF regime which could benefit from liberalisation – in particular, allowing an ELTIF to invest in a wider range of other funds, which would facilitate a fund of funds ELTIF; relaxing the rules on early redemptions, which are only allowed in limited circumstances at the moment; and reducing the minimum ticket size for an investor, which is now €10,000 across one or more ELTIFs.

However, whilst the consultation is welcome and the resulting reforms – expected to be announced later this year – could give the structure a boost, many managers are not waiting for its conclusions: helpful clarifications by regulators have already eased some manager concerns, particularly for those intending to invest a good proportion of ELTIF capital outside the EU. The ELTIF's pan-EU passport to market to (relatively) wealthy individuals – those with an investment portfolio of over €100,000 – offers a significant immediate opportunity, even if it does inevitably come with some steeper compliance requirements and investor protections.

Meanwhile, the UK, preferring not to tinker with the ELTIF that it inherited from the EU, is working on a new structure of its own – the Long-Term Asset Fund, or LTAF. Largely the brainchild of the Investment Association, the LTAF is currently positioned as an open-ended structure.

The UK regulator, the FCA, published a consultation paper earlier this month seeking industry views on the proposal – although time is short because the government's stated ambition is to see the first LTAF launched this year. Industry input will be critical: as the EU's ELTIF experience shows, unless the structure clearly meets investor and manager needs, it will be spurned in favour of other alternatives – and the UK has keen competitors in Luxembourg and Ireland.

...Industry input will be critical: as the EU's ELTIF experience shows, unless the structure clearly meets investor and manager needs, it will be spurned in favour of other alternatives – and the UK has keen competitors in Luxembourg and Ireland.....

There are certainly issues with the current proposals that need to be ironed out. For example, although there is flexibility to restrict redemption rights – which will usually be necessary to accommodate the liquidity profile of the underlying assets – an open-ended structure will present challenges. It is hoped that the Working Group on Productive Finance may offer some operational solutions to this inherent difficulty, although it is not insurmountable, but the private equity industry may press for a closed-ended option. There is also the question of licencing: an LTAF must be managed by a full scope UK Alternative Investment Fund Manager, which many global groups will no longer have. And, unlike the ELTIF, the LTAF would be an authorised fund. That may offer investors some additional comfort, but will add additional burdens for managers, who will also need to have a licence to operate authorised funds – and not only the traditional limited partnership funds with which they are likely to be more familiar. Monthly valuations and more stringent depositary requirements, for example, will add to costs.

It is quite clear that the focus for the LTAF, initially at least, is the deep pool of capital that sits in defined contribution ("DC") pension schemes, expected to exceed £1 trillion by 2030. As the FCA points out, a recent survey found that two-thirds of DC pension schemes do not invest in illiquid assets at all, despite their long-term investment horizons. Those that do, only invest between 1.5% and 7% in these assets, principally in property. There is clearly significant potential here for private funds, and it seems likely that a range of alternative strategies will be popular with investors looking for strong absolute returns and a diversified portfolio. In 2019, an All-Party Parliamentary Group found that diversifying DC pension scheme portfolios to include alternative investments could boost returns by 1.4% each year, while research by Mallowstreet and Partners Group suggests that UK schemes have an appetite for private markets.

But the problem for DC pension funds at the moment is not only the lack of a suitable structure. The current charge cap on the default funds makes more actively managed illiquid assets, by their nature more costly, a challenging asset class for DC money. This is not a new problem, but there may now be more willingness to tackle it: the Department of Work and Pensions is currently consulting on charge cap changes, especially as they apply to carried interest. It seems unlikely that the LTAF will see much take up unless changes are made that allow DC funds to focus on expected net returns, rather than costs. This DWP consultation is, therefore, key to unlocking more long-term capital in the UK.

The LTAF is far from a panacea. When it arrives, it will occupy a space between traditional (unauthorised) limited partnership funds, which will continue to dominate this market, and listed funds, which will remain the most suitable vehicle where there is a diversified, retail and institutional investor base that allows for daily share dealing. The LTAF certainly has a role to play, particularly so far as the UK's huge and growing DC pension pool is concerned but, like its EU equivalent, it is unlikely to supplant the existing structures. Continuing to improve those – and the regulatory rules that can make them unnecessarily expensive to run – remains important. And while the legislators catch up with the market, alternative asset managers are busy innovating to make the most of what is already available.

We are hosting a webinar on Europe's long-term fund structures, including LTAFs and ELTIFs, in September. If you are a client of the firm and you would like to attend, please register your interest.