ELTIF 2.0 – Expanding Opportunities for European Private Market Investors. What Should the SEC Do?

The year started with a landmark moment affecting European jurisdictions. On January 10th, 2024, the launch of the revised regulatory framework for European long-term investment funds (ELTIF 2.0) was unveiled.

What exactly occurred?

The modification of the existing EU regulation regarding European long-term investment funds (ELTIFs) was approved by the European Parliament and the Council of the European Union on 15 March 2023. Regulation (EU) 2023/606 (”ELTIF 2.0”). With ELTIF 2.0, the EU legislature hopes to make the ELTIF a more accessible and attractive investment vehicle by improving the flexibility of the regulatory regime. The regulations went into effect on January 10^th of 2024.

ELTIFs, or European Long-Term Investment Funds, are a type of European Alternative Investment Fund (AIF) managed by a European Alternative Investment Fund Manager (AIFM) with a specific long-term ELTIF label. Regulation (EU) 2015/760 laid down operating conditions and investment policies necessary for the authorization of such funds in the EU. The primary aim of this initiative was to encourage investments that would contribute to sustainable growth within the region. However, since their inception in 2015, the uptake of these new long-term funds has fallen short of expectations. Only 57 ELTIF funds were launched, raising a total of EUR 2.4 billion, and were domiciled in just four countries. Clearly, adjustments were necessary to address this shortfall.

Stepping back, a fundamental principle of the Private-Passive Investor (iPrivate Markets) strategy is for accredited investors to prioritize investment in private equity or debt FUNDS over individual private properties or businesses. Diversification plays a pivotal role in ensuring long-term success, and most well-established private investment firms utilize fund structures for their investments. In the United States, the regulatory framework revolves around defining Accredited Investors to govern who can participate in private market endeavors. Once investors attain accredited status, the SEC framework doesn't impose strict limitations on the specific investment vehicles they choose. It's crucial to recognize that private investments vary significantly in risk levels.

Notable exceptions to the traditional SEC Registration Requirements (1933 Act) are Public Real Estate Investment Trusts (REITs), offering accessibility to all investors (but requiring different level of SEC disclosures).  Another piece to the USA regulatory framework is interval funds. Interval funds appear to have similar objectives to the European LTIFs, and also suffer from lack of “uptake” by issuers and/or investors.  Interval fund offerings seem to be expanding, and this topic will be covered in a future blog post.

Changes in Europe are important to watch as a potential precursor to modernization of the USA framework down the road. Democratization of private markets is a key objective, especially access to proven investment fund products from top tier sponsors. Europe appears to be moving away from an “only the rich can invest” framework to a model of “everyone can invest in these safe fund alternatives” model.

ELTIF 2.0 – ELTIF Structural Changes

·       ELTIF 2.0 allows ELTIFs to make use of master-feeder structures by investing in master ELTIFs.  Accordingly, an ELTIF may now invest in a diversified portfolio of other ELTIFs.

·       Fund-of-funds structures are considered a common and effective means to invest in illiquid assets (such as real estate) and to reinvest excess cash. ELTIF 2.0 gives ELTIFs the possibility of investing in other funds by adopting the structure of a fund-to-fund vehicle.

·       Taking the common fund-of-funds strategies into account, an ELTIF will also be permitted to invest in undertakings for collective investment in transferable securities (UCITS) as well as EU alternative investment funds (AIFs) managed by EU AIF managers.

ELTIF 2.0 – Expansion of Eligible Assets for Fund Managers

·       Regarding the investment management side, various changes have been introduced to allow more flexibility in asset allocation and structuring options. For example, the minimum investment in eligible assets (within a fund) has been lowered from 70% to 55%, while the maximum investment in a single asset has been raised from 10% to 20%.

·       Regulation (EU) 2015/760 required that eligible investment assets that are individual real assets have a value of at least EUR 10 million. However, in practice, real asset portfolios are often composed of a number of individual real assets which each have a value of significantly less than EUR 10 million. To address these issues and to make ELTIFs more accessible, ELTIF 2.0 abolishes the requirement for a minimum value of individual real assets. It is expected that the removal of this threshold will contribute to the diversification of investment portfolios and will stimulate investments in real assets by ELTIFs.

·       A “real asset” is defined in ELTIF 2.0 simply as “an asset that has an intrinsic value due to its substance and properties” which is a much broader definition than under the current regulation and no longer makes a specific distinction between infrastructure and other assets. For example, commercial property will be permitted since it can contribute to the objective of smart, sustainable, and inclusive growth. As a result, a larger pool of assets will likely qualify as eligible real assets.

ELTIF 2.0 – Changes in Capital Raising Provisions

·       Raise capital from professional clients but also from retail investors in the 27 Member States of the European Union by removing the threshold constraints of the first version of the regulation. Under the original ELTIF framework, retail investors were required to make a minimum investment of €10,000 and distributors had to ensure that investors with portfolios worth less than €500,000 did not invest more than 10% of their overall assets in ELTIFs.

·       The first version of the regulation, distributors and managers were required to set up local facilities agents in each member state where ELTIFs were marketed and perform “suitability assessments” for retail investors. These restrictions have also been removed.

·       There is still a suitability assessment, which is important to note. The suitability test that needs to be performed when distributing ELTIFs to retail investors will now be aligned with the markets in financial instruments directive (referred to as MiFiD II). Investors will not be left totally unprotected or allocating too high a percentage of net worth to alternatives.

·       Concentration limit: the 25% threshold is raised to 30% for an underlying fund. This limit does not apply for professional investors or for master/feeder fund structures.

Directionally, Europe is clearly moving to liberalize private market investing for all. But they will be relying more on fund vehicles to provide such access and to require the distributors of such funds to document suitability assessments for the protection of Retail Clients (vs. “Professional Clients”).

How does the current SEC framework differ versus ELTIF? Note the table below is generated by MS Co-Pilot.

Within the EU, the concept of accredited investors is covered by MiFID II (Markets in Financial Instruments Directive II), which was issued by the European Securities and Markets Authority (ESMA). See above.

In the EU, accredited investors are often referred to as “Professional Clients.”

To qualify as a Professional Client, candidates undergo both qualitative and quantitative assessments:

·       Qualitative Assessment: Evaluates a candidate’s knowledge, experience, and proficiency to determine if they can make informed investment decisions.

·       Quantitative Assessment: Candidates must meet at least two of the following conditions over the preceding four quarters:

1.       Engage in an average of ten substantial transactions on the relevant market.

2.       Have a portfolio of financial instruments (including cash deposits) exceeding €500,000.

3.       Work or have worked in the financial sector for at least one year in a professional position that requires knowledge of the transactions or services envisaged.

These criteria aim to ensure that investors have the necessary expertise and financial capacity to participate in certain investment opportunities.

It is clear that “Professional Clients” will have unfettered access to alternative assets and funds. In the context of ELTIF 2.0 or any updated regulations, there may be changes or clarifications regarding the suitability assessment requirements for Private Clients. Investment advisors or FinTech platforms will be required to perform such assessments to some extent.

What might the SEC learn from the progression of ELTIF in Europe? The concept of defining criteria and parameters for long-term private investment funds that would require SEC authorization is appealing. Fund investing greatly reduces the risk associated with private offerings relative to selecting a nascent enterprise on Crowdfunder.com, for example. So, this is the first principle – structure and blessing of specific private equity or debt funds – a seal of approval.

The SEC. will likely not abandon the accredited investor framework. However, I would like to see a carve-out to allow all investors to freely invest in private equity and debt funds that meet predetermined criteria established similar to that in Europe. Limits on how much to invest in this manner are not advisable – Europe initially tried this and backed off. If limits are deemed necessary, a simple rule of no more than $100,000 per fund may be invested in this manner. As many of the better funds have minimums of $100,000 or greater, the SEC could require a criteria for authorized funds to have a lower minimum investment requirement, such as $25,000 or $50,000 to broaden participation.

I would also propose the development of an "alternative pathway to accreditation" in conjunction with the fund initiative. Under this approach, once investors demonstrate a certain level of activity in private market funds, they will be accredited for a period of three years. This could be administered by fund distributors or by third-party verification firms, which have become more prevalent in recent years for administering existing accredited investor financial tests. Accreditation should be attainable based on investors' experience and education, rather than solely on their net worth or income. This pathway would provide a more inclusive route for investors to participate in private market opportunities.