UK: FCA Finalises Its Rulebook For The New UK Authorised Open-ended Fund To Invest In Illiquid Assets: The Long Term Asset Fund (LTAF)

The FCA's Policy Statement published on 25 October 2021 provides feedback to its May 2021 consultation (the Consultation) and sets out the final rules and guidance for the new authorised open-ended fund regime to invest in illiquid assets, the Long Term Asset Fund (LTAF). The LTAF is to be a separate and distinct category of authorised fund contained in a new chapter in the COLL Sourcebook, a shift of emphasis from the original plan to classify the LTAF as a sub-set of the Qualified Investor Scheme (QIS) for the purposes of the FCA Handbook. The FCA has made some important adjustments to reflect industry feedback – for instance, the final design allows LTAFs to be promoted to certified HNWIs as well as sophisticated retail and professional investors, and paves the way for broader distribution, with amended rules expected to be consulted on in 2022. However, to cater for regulatory concerns around liquidity mismatch, the final rules introduce new specified minimum standards that require LTAFs to permit redemptions no more frequently than monthly, and to have at least a 90-day notice period on redemption.

There is widespread industry support for the LTAF. It poses an appealing alternative to the Non-UCITS Retail Scheme (NURS) or QIS for authorised fund vehicles such as PAIFs, CoACS and AUTs investing in real estate, infrastructure, private equity or private debt and that are targeting professional, sophisticated retail, certified HNWIs and DC pension scheme investors. The final rulebook will be welcomed and has addressed some key industry concerns (including the limited initial target market, rules on valuation and issues with some specific investment restrictions). However, there are still some other issues and features that will need careful consideration when considering launching an LTAF (including the removal of the ramp up period for the prudent spread of risk to apply, potentially less flexibility to manage liquidity and onerous reporting requirements).

We have set out below a summary of the key points in the final rules, including where there are changes to the original proposals consulted on. The LTAF regime will come into force on 15 November 2021 and the FCA encourages firms actively looking to establish LTAFs (or to convert from a QIS) to proactively engage with it in the authorisation process.

Key LTAF features

Despite some industry pushback (eg to cater for hybrid strategies and not be overly restrictive) the FCA is sticking to an expectation that at least 50% of the value of the scheme property is invested in long-term illiquid investments (ie unlisted securities, interests in immovables or indirect interests in such long-term assets via other collective investment schemes (CIS)). However, it has adapted its guidance to clarify this is not a hard-wired obligation or limitation in terms of setting investment strategy.

As set out in the Consultation, only full-scope UK AIFMs can act as authorised fund managers (AFMs) of LTAFs, and they must demonstrate to the FCA that they possess the necessary expertise and skills for their proposed investment strategies (whether or not they intend to delegate).

The FCA notes that in some cases (ie real estate assets) it is not workable for the depositary to hold scheme property and intends to consult on changes (in line with the AIFMD ownership model which has a carve out for non-custodial assets, but with appropriate protection for retail investors) in H1 2022. In the meantime, it will consider applications to modify or waive the LTAF custody requirements.

The term LTAF is to be used only by those AFMs operating this type of fund under the LTAF FCA rules.

Distribution rules

Although still treated as a NMPI, the FCA is amending its Handbook guidance (at COBS 4.12.13G) to allow certified HNWIs to access LTAFs in addition to (as per the original proposals) those other retail clients who are sophisticated investors and professional clients. Where the fund is an Authorised Contractual Scheme, additional investor eligibility requirements still apply.

The FCA intends to consult in H1 2022 on the wider distribution of LTAFs to non-sophisticated retail investors in the future.

In addition, the FCA has responded to feedback and amended the final rules to achieve its policy intention for distribution of the LTAF to DC default workplace pension schemes, as either professional investors or by a unit-linked insurance wrapper (by revising the rules and application of the permitted links rules and by exempting the LTAF from the 35% limit on illiquid investments within any unit-linked fund).

LTAF investment powers

LTAFs will be subject to an overarching requirement to have a prudent spread of risk (as is the case for UCITS and NURS, the QIS rules provide simply for a spread of risk). However, the FCA has dropped the rule giving a 24 month period to apply this rule – this may cause operational issues for AFMs who engage in a high concentration of risk during the early investment phases (eg when a  portfolio initially only consists of a single asset).

The investment powers for the LTAF are largely unchanged: for instance, the restriction that no more than 15% of the fund value can be invested in underlying funds of unregulated CIS that applies to QIS, is substituted with a principles-based requirement on the AFM to ensure that the scheme does not indirectly invest in itself. Other QIS restrictions apply, for instance the LTAF cannot invest more than 20% in QIS, other LTAFs or unregulated schemes unless the AFM has carried out due diligence and the CIS/other schemes comply with the relevant legal and regulatory requirements (on an ongoing basis). Following the Consultation the FCA has removed the requirement for second schemes to have a prudent spread of risk. This is helpful, as it means that the prudent spread of risk assessment is only at LTAF level, as described above. Underlying second schemes are likely to be unregulated CIS that would not typically have these requirements in private markets. The due diligence and other basic protection requirements will apply to second schemes.

The final rules are more relaxed on loan origination, although restrictions prohibiting loans to natural persons or to the AFM/depositary/their associates remain.

Borrowing

The LTAF borrowing limit is 30% of NAV (more restrictive than the 100% limit for a QIS) as originally proposed, and with no look through to borrowing in underlying investments. This is designed to enable LTAF to operate efficiently without being exposed to excessive risk.

The FCA did not endorse suggestions made in response to the Consultation, such as to allow flexibility for short-term borrowing facilities up to 100% of NAV to allow for subscription lines and working capital facilities.

Liquidity issues

The original proposals allowed an AFM of an LTAF discretion to set dealing frequency to align with the liquidity of its investment strategy and to disclose details of the liquidity management tools it expected to deploy in its prospectus. This has been curtailed in part in the final rules, which impose requirements for an LTAF to redeem its units no more often than monthly and a notice period of redemption of at least 90 days. The FCA comments that this is to ensure that the policy intent for LTAFs not to be daily dealing is clear within the rules; whilst noting that there may be scenarios where longer notice periods and less frequent redemption windows are more appropriate.

The FCA would welcome industry guidance on appropriate lengths of notice periods for different types of assets; and comments that the LTAF is not workable for closed-ended strategies, as was muted in Consultation feedback. However it does not rule out FCA authorisation for an LTAF operating with a commitment approach, where funds are drawn down only when the manager makes an investment. The FCA  notes that it is still considering next steps finalising its policy in general (as discussed in its August 2020 Consultation paper CP20/15: Liquidity mismatch in authorised open-ended property funds) on introducing mandatory notice periods for property funds, including considering input from the Productive Finance Working Group.

The FCA rules on mandatory suspension of dealings where there is material uncertainty about the valuation of at least 20% of scheme property, (that applied, amongst others, from September 2020 under the FCA Policy Statement PS19/24 on illiquid assets and open-ended funds), will not apply to LTAFs. However, the AFM of the LTAF can, with the prior agreement of the depositary, and must without delay, if the depositary so requires, temporarily suspend dealings of units, where due to exceptional circumstances it is in the interest of all the unitholders. The FCA comments that it does not expect an AFM to rely on suspension as a means to manage liquidity.

Governance, disclosure and investment due diligence

There are no changes to those governance proposals originally consulted on: that SMCR prescribed responsibilities (namely, assessment of overall value, requirement for independent directors on AFM boards and acting in investors' best interests) will apply to AFMs of LTAFs. In addition, an AFM must appoint an approved person to assess and report on the LTAF's investment valuations, due diligence, conflicts of interest and liquidity management.

An LTAF prospectus is to include examples of how any performance fee will operate and its maximum amount (this is equivalent to the UCITS and NURS requirement, but not applicable to QIS). The FCA is not imposing a cap or prohibiting performance fees but suggests the market will decide structure and amount, based on full disclosure.

The FCA anticipates that the Sustainability Disclosure Requirements recently proposed in the Government's Roadmap to Sustainable Investing (see our recent briefing for more on this) will apply to the LTAF, and draws attentions to its Guiding Principles on ESG and sustainable investment funds. No additional ESG-related disclosures are expected to apply.

Again, in line with the original proposals, AFMs are to carry out due diligence (to ensure compliance with the objectives, investment strategy and any risk limits of the scheme) "in line with good market practice" and to disclose in their prospectus how they do this. In practice we would expect most AFMs to conform to this standard.

Reporting

The reporting rules are unchanged from those set out in the Consultation: in addition to the half yearly and annual reporting requirements for AFMs, an LTAF's AFM must deliver quarterly updates to investors. These updates are to cover portfolio investments, including details of any transactions during the period (together with an explanation of how the transaction is consistent with the LTAF's investment objectives, policy and strategy) and any significant developments in the investments for which investors require reasonable notice.

The Consultation responses raised concerns over timing and the unnecessary burden of mandated quarterly reporting, but the FCA response is that the format and timings it originally proposed are appropriate and therefore unchanged (quarterly reports within 20 business days of the quarter end; half-yearly within 2 months; annual reporting within 4 months).

Valuations

 The final rules have been amended so that the original proposal (that unless the AFM has the necessary competence and experience to do so, assessed on authorisation and on an ongoing basis by the depositary, it must appoint an external valuer to fulfil the valuation function) has been replaced with a requirement based on AIFMD, that the AFM need not appoint an external valuer if the depositary has determined that the AFM has the resources and procedures for carrying out asset valuation. Also for an LTAF that invests in other CIS or AIFs subject to external independent valuations, that the AFM can rely on those – thus avoiding duplication of costs.

As originally proposed, to provide transparency for investors, the FCA confirms that LTAFs must publish monthly valuations, regardless of their dealing policy.

The FCA notes the AIFMD valuation point which has been raised across the industry, including in the current AIMFD review by the European Commission (that external valuers are subject to unlimited liability if they are found to be negligent in their valuation, and this is widely interpreted as 'simple' negligence, which could be the result of an error made in good faith). The FCA will consider this issue with HM Treasury.

The introduction of the LTAF comes at an exciting time in the UK funds industry; alongside developments in the Qualifying Asset Holding Company (QAHC) regime, UK REIT reform and expected further government output on other initiatives flowing from HM Treasury's review of the UK funds regime (for instance, a UK unauthorised professional investor fund). There is also broader industry work (such as the recommendations of the Productive Finance Group) looking at how best to create an environment where investment in longer-term, less liquid assets can flourish.

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