Open-ended ELTIFs & the RTS – Where do we stand?

Marc Meyers & Dr. Sebastiaan Niels Hooghiemstra

Ever since the European Securities and Markets Authority (“ESMA”) published its Final Report on the Draft regulatory technical standards (the “RTS”) on 19 December 2023 (“Final Report”), in particular, the redemption policy, minimum holding period and mandatory liquidity management tools (“LMTs”) of European long-term investment funds (“ELTIFs”) have been points of intense discussion. On 8 March 2024, ESMA received a letter from the European Commission (“EC”) in which it informed ESMA that it intends to adopt the RTS with amendments and invited ESMA to submit a new draft that would cater for the “individual characteristics of different ELTIFs”. ESMA responded to this in an “Opinion” on 22 April 2024 with a substantially revised draft (the “Opinion”). This contribution sheds some light on the revised RTS and how the redrafted provisions on redemption policies and LMTs would impact (open-ended) ELTIFs, if adopted in current form.

1.???? Background: ESMA’s Original RTS Proposal on Redemption Policies and LMTs

Regulation (EU) 2023/606 (“ELTIF 2.0”) contains a provision in which ESMA is requested to develop regulatory technical standards that specify certain elements of the ELTIF redemption regime in more detail, such as the minimum holding period, the minimum information to be provided to the competent authority of the ELTIF, the requirements to be fulfilled by the ELTIF in relation to its redemption policy and LMTs, and criteria to assess the percentage of the “liquidity pocket”.

1.1.?? Minimum Holding Period

Following up on its the mandate assigned by ELTIF 2.0, ESMA published its Final Report on 19 December 2023 that had been submitted to the EC for endorsement and final approval. In general, the Final Report was well-received, as it is principle-based and allows both fund managers and competent authorities a sufficient degree of flexibility. Most concerns raised during the consultation period that followed ESMA’s consultation paper published in May 2023, such as the “comply-or-explain” minimum holding period of three years, had been addressed by ESMA in its Final Report.

1.2.?? Minimum Notice Periods, Anti-dilution levies & Liquidity Pockets

However, there was one item which was particularly criticized, namely the mandatory LMTs that were proposed in the Final Report to be employed for open-ended ELTIFs. Although the AIFMD and also the agreed text of AIFMD 2.0 leave fund managers a certain degree of discretion in picking a set of LMTs that fit the specific fund in question, the Final Report proposed a strictly regulated minimum set of LMTs to be employed. In addition to NAV suspensions, these were proposed to include a mandatory notice period that was, by default 12 months, one anti-dilution liquidity management tool, which could be anti-dilution levies, swing pricing or redemption fees; and redemption gates.

The Final Report proposed a minimum notice period of 12 months for investors. For open-ended ELTIFs that wished to implement a shorter notice period, the Final Report proposed those ELTIFs to comply with rigid standards in terms of both liquidity pockets and redemption gates.

With respect to redemption notices of less than 12 months, the Final Report proposed maximum redemption gates that were, generally, considered to be high enough to meet market standards, in particular, as they were proposed to be “ceilings”, which were set fairly high. However, the minimum liquidity pockets that were proposed for ELTIFs with a notice period of less than 6 months were suggested to be 40%, which is more than double the current Luxembourg market and regulatory practice for products with either monthly or quarterly redemption windows. This received a lot of criticism in the market, as, in order to approach such standards, managers would need to impose a minimum notice period of, at least, 9 months to a year. The proposed liquidity pockets where 40% of the assets would be held in UCITS eligible assets were considered to negatively impact the return profile of (semi-)open-ended ELTIFs and, hence, were considered to make ELTIFs unattractive.

1.3.?? Redemption Gates

To avoid dilution of investors, risks in relation to financial stability and first mover advantage related issues, ELTIF managers were proposed to implement, at least, one of the mentioned anti-dilution LMTs. If any of the anti-dilution LMTs was considered not to be adequate for a specific ELTIF, ELTIF managers were also allowed to select and implement other LMTs. For retail ELTIFs, managers were proposed to provide a justification to the competent authority why other LMTs are more appropriate and in the interest of investors.

To reduce the probability of a NAV suspension, ELTIF managers were proposed to implement redemption gates to mitigate the risks related to financial stability and stressed market conditions, where numerous or voluminous redemption requests may not be able to be processed by the ELTIF manager or the fund administrator; and where the sale of assets to meet those requests is either impossible or implies a sale at a highly discounted price.

2.???? The EC’s Response Letter & ESMA’s Opinion with New RTS Draft

Further to the letter of the EC, ESMA has suggested a number of amendments in its Opinion with respect to, amongst others, (i) the minimum notice period, (ii) LMTs and (iii) redemption gates. The feedback of the EC in its letter, as well as the suggested amendments are subsequently discussed.

2.1.?? Minimum notice periods, Redemption Frequencies/Gates & Liquidity Pockets

In its letter, the EC considered that linking the length of the notice periods with fixed percentages of minimum liquid assets and maximum percentages that can be redeemed, failed to sufficiently take into account the individual situation of each ELTIF. Accordingly, the EC indicated that the draft RTS should be amended to remove the requirement of a minimum 12-month notice period and suggested a more proportionate approach in relation to the redemption policy and LMTs.

Further to this, the EC suggested various options in two annexes that ELTIF managers could opt for. Under their proposed Annex I (with three sub-options), they suggested a maximum percentage for a redemption gate based upon the length of the notice period and redemption frequency that both vary between 1 (or 2) month(s) and 12 months in which certain maximum percentages of redemption gates are to be applied that are mentioned in line with the chosen notice periods and redemption frequencies. The second option proposed a minimum percentage of liquidity pocket that was solely linked to the redemption frequency that varied between (less than) 1 month and 12 months. Based upon the redemption frequency, a minimum percentage of liquidity pocket and a maximum percentage in terms of redemption gate would be required.

ESMA took note that stakeholders, as well as the EC, were not in favour of an approach under which a mandatory notice period would be set for all ELTIFs, given, in particular, the variety of ELTIF strategies and assets in which an ELTIF may invest in.

However, given the illiquid nature of the eligible assets of ELTIFs, the fact that ELTIFs can be marketed to retail investors, and, in line with the international work on LMTs conducted, in particular, at the FSB and IOSCO, ESMA remains of the view that a certain level of prescriptiveness is needed in relation to the requirements on the notice period of an ELTIF. This would also ensure that the ELTIF brand is not put in danger by a liquidity strain, such as the one that affected certain types of real estate vehicles in some Member States in 2023.

Considering this, ESMA’s redraft reads as follows:

This proposal is in line with the second option that was proposed by the EC. However, the first option (with three sub-options) is not retained by ESMA in its Opinion, as it does not make it mandatory for the ELTIF manager to hold minimum percentages of liquid assets. Furthermore that option also allows that in certain circumstances (e.g. no notice period and weekly redemption frequency) the maximum amount that can be redeemed is less than 2%, which does not seem compatible with the fact that retail investors may invest in ELTIFs. Furthermore, the table proposed by ESMA’s Opinion replaces “redemption frequency” with “notice period”, because, if the reference to redemption frequency was to be kept, ELTIF managers would not have time to stagger the sales of assets, if all redemption requests were formulated one day before the redemption day. ESMA is of the view that it is more appropriate to make the link between notice periods and the minimum percentage of liquid assets.

Lastly, ESMA proposes in its Opinion that the need to justify the appropriateness of the notice period to the competent authority should be triggered if the notice period is less than six months, instead of three months.

2.2.?? Liquidity management tools & Redemption Gates

In relation to LMTs, the EC considered in its letter that the RTS could be viewed as disincentivizing or limiting the possibility for ELTIF managers to implement different LMTs, other than anti-dilution LMTs, that could be equally or even more compatible with the long-term investment strategy of the ELTIF. The EC, therefore, suggested to delete the obligatory requirement for the manager of an ELTIF to select and implement at least one anti-dilution LMT, among anti-dilution levies, swing pricing and redemption fees.

ESMA took note of this. Furthermore, ESMA recognized that the variety of assets in which an ELTIF may invest in, as well as the variety of ELTIF strategies, which may also be linked to different types of investor bases, may trigger the need, in some cases, for other sets of LMTs.?

In its Final Report, ESMA already reflected this by including a derogation allowing the ELTIF manager to deviate from the requirement to implement at least one anti-dilution tool, provided that adequate justifications are given to the competent authority of the ELTIF.?

For that purpose, ESMA included in the Recitals of its redrafted RTS a reference to the generic activation/deactivation of the new list of LMTs in AIFMD 2. Furthermore, the draft has been amended in a way that anti-dilution LMTs are not yet anymore seen as the “default” for which a derogation request for the use of any other LMT would need to be made to a competent authority. Instead, the new draft mentions that ELTIF managers “may” select and implement, at least, on anti-dilution LMT. In addition, the new draft also mentions that also other LMTs “may” be selected, if appropriately justified to the competent authority.

3.???? Outlook: LMTs & Open-ended ELTIFs – Does it work in practice?

From the above, it is clear that ESMA has made an effort to implement both the EC, as well as the comments made by the industry in the redrafted RTS of its Opinion.

In terms of open-ended ELTIFs, ESMA now suggests to calibrate the redemption policy of ELTIFs, in the first place, on the length of the notice period that are then accompanied by a maximum threshold for redemption gates and a minimum threshold for liquidity pockets to be used. The maximum thresholds for the redemption gates do not pose any constraints in practice. Interestingly, the redemption frequency is also not limited by any maximum thresholds. Instead, a “comply-or-explain mechanism” is proposed to be introduced in which ELTIF managers would need to justify the use of redemption frequencies that are less than quarterly to their respective competent authorities. A lot of flexibility is, thus, there in this respect.

Instead, practitioners mostly will pay attention to the length of the minimum notice period, as well as the related minimum liquidity pocket required by the RTS. Liquidity pockets intervene in the risk/return profile of an ELTIF. Hence, it is important that the size is set neither too low nor to high. In this respect, notice periods of three months will be necessary to meet industry demands in terms of the size the liquidity pocket. In some instances, industry practitioners may see this as too long, but, in general, the table is considered to be reasonably workable by practitioners.

We also note that the redrafted RTS align more closely with the flexibility to activate/deactivate LMTs under AIFMD 2. The “mandatory cocktail” or “one-size-fits-all” proposal that suggested that, apart from notice periods, there should be anti-dilution LMTs and redemption gates in place, has been relieved significantly. The amended text suggests that ELTIF managers “may” implement anti-dilution LMTs and redemption gates. However, they may, with proper justification, use other LMTs as well.

While the redrafted RTS meet a number of industry demands, it will be interesting to see what the final text will ultimately look like.