Democratisation of alternative investment funds
Alternative investments (such as private equity, private credit, real estate and infrastructure) have historically been reserved for institutional investors but, in recent years, we have seen market and regulatory focus on the development of products and regimes that allow non-professional investors access to alternative investments – a trend known as the democratisation of alternative investment funds.
Careful planning needs to go into the structuring of a democratised fund, and to ensure that any applicable local requirements are appropriately catered for.
Cross-border distribution of alternative funds to certain types of retail investors requires fund sponsors to navigate a complex patchwork of rules that apply on a jurisdiction-by-jurisdiction basis. Careful planning needs to go into the structuring of a democratised fund, and to ensure that any applicable local requirements (such as regulatory notifications or the appointment of representatives) are appropriately catered for.
There is currently no single fund structure that ticks all the boxes for the cross-border marketing of every alternative fund strategy to retail investors across the EU, but the main fund structure for a democratised fund has converged around the Luxembourg Part II UCI in recent years, with or without the pass portable European Long-Term Investment Fund 2.0 (ELTIF 2.0) overlay.
The ELTIF was originally introduced in 2015 as an EU label granted to alternative investment funds targeting EU long-term investments, with the ability to pool capital from both retail and professional investors. An advantage of the ELTIF was its access to an EU marketing passport, which enables distribution to EU retail investors on a cross-border basis. However, due to the restrictive nature of the ELTIF regime, it suffered a lacklustre uptake in its original form. Following a review process, a new and improved ELTIF 2.0 regime came into force in January 2024, although the detailed requirements, to be set out in Regulatory Technical Standards, remain under construction (in particular, redemption terms) and are unlikely to be formally adopted before October 2024. Consequently, although the ELTIF 2.0 is available for use (and is being used), sponsors establishing a fund under the ELTIF 2.0 regime must be prepared to make appropriate adaptions to the fund terms in the near future, once the Regulatory Technical Standards have been finalised.
Both the Luxembourg Part II UCI and the ELTIF 2.0 go a significant way to clearing hurdles to the cross-border distribution of alternative investment funds to EU retail investors. Nevertheless, there will often be a need for one or more additional jurisdiction-specific vehicles within a democratised fund’s structure, depending on the relevant investment strategy and target investor markets. The types of target investors within each jurisdiction may also be a relevant factor for a fund’s structure and distribution format, e.g. this may impact whether a product can be distributed directly or indirectly via a “wrapper” (such as an insurance product).
Aside from the structural considerations, making alternative investments available to retail investors also impacts a fund’s terms. Alternative investment funds often hold illiquid assets and are therefore typically closed-ended structures with limited (if any) liquidity options. Whereas, retail investors have short time horizons and will therefore expect more flexibility when it comes to liquidity. As a result, appropriate liquidity management tools should be incorporated into a democratised fund’s terms, tailored to the fund’s investment strategy, pipeline and cash flow dynamics. It is also important to ensure an appropriate range of liquidity management tools are available, as certain tools would not be appropriate for day-to-day liquidity management and some would only be called on in extreme conditions. To this end, there are a range of tools available which can help manage liquidity, including redemption fees, NAV adjustments, redemption gates, in-kind redemptions, side pockets and suspensions.
European Retail Investment Package
The Package’s objective is to enhance EU retail investors’ trust and confidence and increase their participation in financing the economy.
In line with the alternative investments democratisation trend, the European Commission adopted the proposal for a European Retail Investment Package (an omnibus amending directive and regulation) in May 2023 (the Package). The Package’s objective is to enhance EU retail investors’ trust and confidence and increase their participation in financing the economy. To achieve this, the Package focusses on investor disclosures and marketing communications, inducements and value for money by seeking to: (a) adapt disclosures to the digital environment and ensure disclosures and marketing communications are relevant and not misleading; (b) improve the alignment of interests between financial intermediaries and retail investors to ensure advice is non-biased, good quality and adapted to the investors; and (c) enhance cost efficiency for retail investors.
The European Council and Parliament’s positions on the Package are still under discussion, and once finalised, the Package will go through the usual adoption process, meaning that there will be some time before any changes come into force. Considering the potential wide range of the Package’s impact, and that Member States are still split on the appropriate approach to several key aspects, this is absolutely a space to watch!
