Today (15 November 2021) the Financial Conduct Authority ("FCA") is introducing new rules and guidance aimed at facilitating investment in long-term, illiquid assets through a new category of authorised open-ended fund structure known as the 'Long Term Asset Fund' ("LTAF"). Until now, some investors have been unable, or unwilling, to invest in long term illiquid assets even though these assets could meet their investment goals.
In this insight, Sushil Kuner, principal associate within our Financial Services Regulatory team, summarises the background to the introduction of the LTAF and the key aspects of the new LTAF framework.
The FCA has found that some investors with long-term investment horizons are not investing in long-term assets when these may present a useful alternative investment opportunity, provided of course that they are able to bear the risks of such investments. The Regulator refers specifically to default arrangements of defined contribution ("DC") pension schemes which commonly choose not to invest significantly in these assets, despite the long-term nature of their investment horizons. In fact, the FCA reported that according to a recent survey commissioned by the Department for Work and Pensions ("DWP"), two-thirds of DC schemes do not invest in illiquid assets, while the remaining third invest between 1.5% and 7%, mainly in property.
Illiquid assets include venture capital, private equity, private debt, real estate and infrastructure and the FCA recognises that while these potentially present higher risk than diversified portfolios of listed equities or bonds, they also have the potential for higher long-term returns in return for less or no immediate liquidity.
On the basis that most DC pension investments are in default arrangements, DC scheme members rely on investment returns to grow their contributions and the fact that DC pension schemes are forecast to continue to grow rapidly, expecting to rise to over £1 trillion by 2030, it is no surprise that the FCA has set out to design the LTAF to encourage and facilitate more investment in long term illiquid assets through open-ended funds. However, they have made clear that these open-ended funds would need to match the underlying liquidity of the assets in which they invest with the redemption terms that they offer to investors in order to minimise any liquidity mismatches which can create systemic risk.
Through the LTAF, the FCA aims to address two key barriers that have historically hindered investment in long-term illiquid assets:
- there being no UK authorised open-ended fund structure that enables investment in long-term illiquid assets while offering appropriate structural safeguards; and
- the permitted links rules for unit-linked insurance which specify 12 categories of assets (five of which related to long term illiquid assets) in which firms may invest to provide linked benefits in unit-linked life policies where the investment risk is borne by policyholder who is a natural person (mainly retail investors). These rules apply to DC pension schemes, since it is the members who typically bear the investment risk, and include restrictions in terms of the proportion of total assets which could be invested in such permitted links.
The LTAF framework
All LTAFs must be authorised by the FCA and, as they will be alternative investment funds which may invest in complex and risky assets, the FCA has made clear that they can only be managed by authorised full-scope UK Alternative Investment Fund Managers ("AIFMs").
AIFMs managing LTAFs will therefore be subject to FCA rules in its FUND, COLL, PRIN, COBS and SYSC Sourcebooks (amongst others). They must also meet certain criteria which have been introduced via a new Chapter 15 in the FCA's Collective Investment Scheme Sourcebook ("COLL"). However, rather than being prescriptive in nature, the LTAF framework is intended to be very much principles-based, facilitating investment through a UK authorised fund in assets that are less liquid and potentially higher risk, while securing an appropriate degree of protection for investors for whom LTAFs are suitable.
Requirements specific to LTAFs
- Strong governance - firms will need to have governance and oversight arrangements which are commensurate to the risks that the LTAFs are exposed to. The authorised fund manager ("AFM") will need to assess how it has managed the LTAF in the best interests of the fund, its investors and the integrity of the market. The assessment will need to consider how the assets of the fund have been valued by the AFM or (where relevant) the basis for the appointment of an external valuer, how due diligence has been conducted in line with good practice and how the manager has managed liquidity and conflicts of interest in the best interests of the fund, the investors and the integrity of the market. The annual report of an LTAF will need to include details of these assessments, similar to the current report on the assessment of value in an authorised fund.
The governing bodies of the AFM of an LTAF will need to have the collective knowledge, skills and experience to be able to understand the AFM's activities, in particular the main risks involved in those activities and the assets in which the specific LTAF is invested. The AFM will also need to allocate responsibility for complying with these requirements to an approved person under the Senior Managers and Certification Regime ("SMCR") and where the chair of the governing body of the AFM is an approved person, this responsibility must be allocated to them.
- Clear disclosure - there are certain disclosures which are expressly required to be made in the prospectus by AFMs of LTAFs (see below) in a manner which is fair, clear and in plain language. In particular, AFMs will need to disclose how any performance fees work to enable investors to make an informed judgment about the merits of investing in a fund. While the FCA is not setting any caps on or banning performance fees (it will allow the market to decide the appropriate structure and amount of any performance fees based on full disclosure), managers will need to undertake an annual assessment of value. AFMs will also need to be mindful of the FCA's expectations on the design, delivery and disclosure of environmental, social and governance ("ESG") and sustainable funds as set out in its Dear Chair Letter to AFMs published in July 2021.
- Purpose - the investment strategy of an LTAF must be to invest mainly in assets which are long-term and illiquid in nature or in other collective investment schemes ("CIS") which invest in such assets. At least 50% of the value of the scheme property must be invested in unlisted securities and other long term assets or other CIS investing in such assets.
- Investment powers - these are based on the existing rules for Qualified Investment Schemes ("QIS"). To secure an appropriate degree of consumer protection for investors in LTAFs, LTAFs will be required to have a prudent spread of risk, similar to the standards expected of Undertakings for the Collective Investment in Transferable Securities ("UCITS") and Non-UCITS Retail Schemes ("NURS"). Contrastingly, QISs simply have to have a spread of risk. Managers of LTAFs will need to have regard to whether the fund's exposures are sufficiently diversified, including, where relevant, exposures to underlying investments.
LTAFs would also be permitted to invest in loans (provided they meet certain baseline conditions, including, for example, that they are not made to individuals or to a party where it may be difficult or impossible to manage a conflict) in addition to the assets permitted for a QIS. LTAFs may also invest in a wider range of second schemes that a QIS can invest in. While the FCA's initial proposals required for a prudent spread of risk within a second scheme, the FCA has listened to feedback and removed this requirement, concluding that application of a prudent spread of risk at the level of the LTAF itself delivers an appropriate level of investor protection. Managers would, however, be expected to make reasonable efforts to undertake due diligence on second schemes and ensure basic protections exist.
- Borrowing - the maximum level of borrowing that an LTAF may undertake is 30% of net assets which is higher than the maximum level of borrowing permitted for a NURS (10%) but less than the maximum permitted for a QIS (100%). The Manager will have to consider an appropriate level of borrowing for the investment strategy but because LTAFs will invest mainly in illiquid assets, and because they are open-ended, the FCA has limited the level of borrowing that an LTAF can undertake at 30% of net assets which it considers should allow LTAFs to operate efficiently without being exposed to excessive risk. The rules only limit borrowing by the LTAF and not in any underlying investments.
- Valuation - as the assets within an LTAF are likely to be illiquid and many will not have regular market prices, a fair and accurate valuation of an LTAF is crucial. As such, the depositary will be required to determine that the AFM has the resources and procedures for carrying out a valuation of the assets. While AFMs may use the support of valuation advisers to value individual assets, the AFM will be responsible for carrying out the valuation and for ensuring that it is done impartially. Where the LTAF invests in other CIS that are themselves subject to an independent valuation by an external valuer, the AFM of the LTAF may rely on that valuation. In terms of frequency, LTAFs must be valued on at least a monthly basis. While there are no suspension requirements for LTAFs where there is material valuation uncertainty, AFMs should consider whether it is in the interests of unitholders to suspend dealings.
- Redemptions and subscriptions - an LTAF will be required to redeem units no more often than on a monthly basis. Given the nature of investments LTAFs are likely to hold, the FCA contends that this sets an appropriate maximum redemption frequency for an LTAF. There will also be a minimum notice period for redemptions of at least 90 days although the FCA recognises that many LTAFs would have notice periods significantly longer than this. For a fund to be fair to all investors, redemptions will also need to be met from the sale of a representative sample of the investment portfolio. If the LTAF plans to invest in highly illiquid assets when a notice period of 90 days is insufficient to sell such a representative sample, firms should expect the FCA not to authorise it with a 90 day notice period.
- Investment due diligence - when investing in private assets, AFMs must conduct due diligence that is commensurate with the risks they pose and to disclose in the prospectus how they do this. Full-scope AIFMs have long been subject to rules requiring due diligence around investments in their AIFs and so the FCA has not set out any detailed guidance on this.
- Knowledge, skills and experience - managers that wish to offer LTAFs will have to have or acquire the knowledge, skills and experience of managing the appropriate asset classes. While there are existing requirements for AIFMs to be sufficiently experienced for the investment strategies pursued by the alternative investment funds they manage, as LTAFs may be very different from other types of authorised funds, the FCA has imposed this higher standard.
- Reporting - managers of LTAFs will need to produce a report along the lines of the value assessment report, explaining how they have met the additional requirements for LTAFs set out above. The LTAF report should be prepared on a quarterly basis (within 20 business days of the quarter end) and include details on the investments in the portfolio, transactions during the period and any significant developments in the investments which the investors should be aware of. This is an additional requirement to the half yearly and annual reports that are required for authorised funds.
Amendments to the permitted links rules
On the basis of industry feedback that, in practice, the existing 20/35% cap on illiquid investments within any unit-linked fund means that firms find it difficult to market these funds to DC schemes, the permitted links rules have been amended to remove the 35% limit for LTAF-linked funds that form part of the default arrangements of a pension scheme, while keeping requirements on insurers to provide risk warnings and ensure that the fund is suitable for the ultimate investors. The changes will provide more flexibility in the construction of DC scheme portfolios while maintaining an adequate level of protection for DC default scheme investors.
If you have any questions or are interested in learning more about LTAFs, please get in touch with Sushil Kuner.