• ESMA has submitted its proposals for RTS supplementing ELTIF 2.0 to the European Commission

• The RTS detail stringent conditions on liquidity and redemption provisions including in principle maximum quarterly redemption frequency and minimum 12 months prior notice

• Information is provided on the requirement to have in principle at least one anti-dilution liquidity management tool

• There is further clarification on matching mechanism and cost disclosures

Introduction and background

As detailed on our OnPoint, “ELTIF 2.0: retailization of private funds – the gateway to heaven or a storm in a teacup?”, the European Commission (EU Commission) published its proposals for reform of the ELTIF Regulation on 25 November 2021. Following trilogue discussions and finalisation of the EU legislative process, on 20 March 2023 the text of the regulation amending the ELTIF Regulation (ELTIF 2.0) (Regulation (EU) 2023/606 amending the ELTIF Regulation) was published in the official journal of the EU (OJ). ELTIF 2.0 entered into force on 9 April 2023 and has applied from 10 January 2024.

ELTIF 2.0 mandated ESMA¹ to develop a number of regulatory technical standards (RTS) to build on the provisions in the level one text (i.e., the text of the amending regulation).

In this OnPoint we look at ESMA’s proposed RTS, focusing on the main requirements for ELTIFs that are granting redemption rights to their investors.

The RTS

ELTIF 2.0 provides that ESMA develop RTS to determine the following:

• the criteria for establishing the use of financial derivative instruments for hedging purpose;
• the circumstances in which the life of an ELTIF is considered compatible with the life-cycles of each of the individual assets, as well as different features of the redemption policy of the ELTIF;
• the circumstances for the use of the matching mechanism, i.e., the possibility of full or partial matching (before the end of the life of the ELTIF) of transfer requests of units or shares of the ELTIF by exiting ELTIF investors willing to transfer their units and potential investors willing to acquire these units;
• the criteria to be used for certain elements of the itemised schedule for the orderly disposal of the ELTIF assets; and
• the disclosure obligations on costs and the format to be used for this purpose.

Following a public consultation² which took place between 23 May and 24 August 2023, ESMA submitted its final report on the RTS³ to the EU Commission on 19 December 2023. The final report includes a draft delegated regulation, and the EU Commission has three months (which may be extended by another month) to adopt the draft RTS. The EU Commission may also reject the RTS, propose amendments to the RTS and return them to ESMA for further consideration. If the RTS are adopted, the European Parliament and the EU Council will have an additional three months to review the RTS. If the EU Commission rejects the draft RTS, it would delay the adoption of the final RTS, possibly to October or November 2024.

ELTIF 2.0 became effective on 10 January 2024, meaning that there will be a period when the RTS – that provide important additional detail to supplement ELTIF 2.0 – will not be available nor applicable nor even be in agreed final form. The practical impact of this is that ELTIF’s launched now under ELTIF 2.0 will be operating in the absence of finalized technical standards. It is therefore important that the delegated regulation on the RTS applies as soon as possible. The delegated regulation on the RTS is contemplated to become effective as of the day of its publication in the OJ. If the EU Commission rejects or proposes amendments to the draft RTS, there will be an even longer period of uncertainty for issuers and investors alike.

Criteria to determine the minimum holding period for investors in an open-ended ELTIF⁴

ELTIF 2.0 provides at Article 18 that the manager of the ELTIF determines the minimum holding period (also known as the lock-up period) for an investor. When making this decision, the ELTIF manager will have to take into consideration the criteria listed in the draft RTS. These include, amongst others, (i) the investment strategy and the underlying asset classes, (ii) the investor basis (retail or professional investors), (iii) the liquidity profile of the ELTIF, (iv) the valuation of the assets and the time needed to produce a reliable, sound and up-to-date valuation of investments, (v) the extent to which the ELTIF lends or borrows cash and (vi) the portfolio composition and the level of diversification of the ELTIF.

The manager of the ELTIF must be able to demonstrate to the competent authority of the ELTIF based on these criteria the appropriateness of the duration of the minimum holding period and its compatibility with the valuation procedures and the redemption policy of the ELTIF.

Information to be provided to the competent authority and to be contained in the redemption policy of an ELTIF

In addition to the usual information to be provided on any redemption policy, such as the conditions and procedures for redeeming units and the availability of liquidity management tools (LMTs), Article 4 of the draft RTS requires the manager of the ELTIF to provide the competent authority of the ELTIF with (i) information on how the assets and liabilities of the ELTIF are adequately managed in case of redemption of units, (ii) a description of the procedures to prevent redemptions causing dilution effects for investors and (iii) a description of the valuation procedures of the ELTIF demonstrating that at each valuation date the ELTIF has substantial, reliable, sound, and up-to-date data on each of its assets.

Article 5 of the draft RTS lists the minimum requirements that need to be contained in the ELTIF’s redemption policy. The list is largely overlapping with the information required to be provided to the competent authority under Article 4. However, in addition to the usual elements of any redemption policy – such as the minimum holding period, the conditions to request the redemption of units, and the periodicity of redemptions and the payment delays – the redemption policy is to describe the LMTs that are available for the ELTIF, their calibration and the conditions of their activation.

Determination of the redemption prices

The redemption price must reflect the fair value of the underlying assets of the ELTIF⁵. An estimate of the net asset value (NAV) does not seem to be acceptable for serving as a redemption price. In practice, this will significantly reduce the frequency of redemptions for an ELTIF which is partially invested in assets where the determination of the fair value can turn out to be cumbersome, as is the case for illiquid assets. As an ELTIF is also an alternative investment fund, with respect to redemption price and valuation dates, the requirements of Article 19 of the AIFMD would apply.⁶

The manager of an ELTIF should also ensure consistency between the frequency of calculation of the NAV of the ELTIF, the availability of a reliable, sound, and updated valuation of ELTIF’s assets, and the frequency of redemptions during the life of the ELTIF.

Maximum frequency of redemptions⁷

The maximum frequency of redemption shall in principle be quarterly. If a higher frequency of redemption is contemplated, the manager of the ELTIF must justify this to the competent authority of the ELTIF considering the features of the ELTIF, including the composition of the portfolio, the life of the ELTIF and its liquidity profile. In this context, the manager must also ensure a reliable, sound and updated valuation of the assets of the ELTIF.

Minimum notice period for redemptions⁸

In the May 2023 public consultation, ESMA stated its view that redemptions of the ELTIF units or shares should only be possible after a certain notice period given by each investor to the manager of the ELTIF.

As a starting position, redemptions are only possible if a notice period of at least 12 months is given.⁹ However, there are exceptions and an ELTIF may allow investors to redeem their shares with a notice period of less than 12 months. In such cases, the notice period shall be calibrated based on the minimum percentage of liquid assets contained in the portfolio and be subject to mandatory redemption gates (i.e., the maximum percentage of assets that redemption can represent) as follows:

If the notice period is less than three months, the manager of the ELTIF must justify to the competent authority of the ELTIF why the short notice period is consistent with the elements of the redemption policy and to which extent the notice period is in the best interest of the investors. If the ELTIF is solely marketed to professional investors, an exemption of this justification can be granted by the competent authority of the ELTIF.¹⁰

The requirements on minimum liquid assets and mandatory redemption gates under the draft RTS for having a notice period of less than 12 months does not consider the availability of quantity-level LMTs¹¹ and whether the ELTIF is pursuing an investment strategy generating a stable income flow, as is often the case for investments in real estate and infrastructure. These requirements are stricter than what is currently required in certain EU member states. As an example, for open-ended alternative investment funds under part II of the Luxembourg law of 17 December 2010 on undertakings for collective investment, as amended, the CSSF accepts liquidity pockets between 15 percent and 20 percent of the NAV in combination with certain quantity-level LMTs.

Obligation to select at least one anti-dilution LMT¹²

To ensure fair treatment and avoid dilution of remaining investors in the ELTIF that may be driven by first mover advantage-related issues, the manager of an ELTIF should select and implement at least one anti-dilution LMT, which could be anti-dilution levies, swing pricing or redemption fees.¹³ There is a derogation from this requirement and the manager of the ELTIF may select and implement other LMTs provided that the ELTIF manager explains to the competent authority of the ELTIF why the use of anti-dilution based LMTs are not adequate for this specific ELTIF and why another set of LMTs, such as quantity-based LMTs, would be more appropriate, taking due account of the interests of investors.

If the ELTIF is solely marketed to professional investors, an exemption of implementing an anti-dilution LMT can be granted by the competent authority of the ELTIF.

Requirements on matching mechanism¹⁴

When an ELTIF uses the matching mechanism as foreseen under article 19 (2a) of ELTIF 2.0, the draft RTS require the manager of the ELTIF to disclose the following detailed information in the constitutive documents of the ELTIF,¹⁵ (i) the format, the process and the timing of the matching, (ii) the frequency or periodicity of the matching window and the duration of that window, (iii) the dealing dates, (iv) the requirements for the submission of purchase and for the exit requests deadlines, (v) the deadlines for the submission of purchase and exit requests, (vi) the settlement and pay-out periods, (vii) the safeguards to avoid any potential arbitrage against investors’ interest due to the asymmetry of information inherent to the matching of transfer requests and (vii) the details regarding the notice period.

Furthermore, the rules to determine the execution price related to the matching of transfer requests must be determined beforehand and disclosed. It is likely that the rules will need to be prescriptive and detailed. Where the NAV is not considered as reliable or appropriate to determine the execution price, another basis may be used to make the determination, provided that the fair treatment of all investors is maintained including the exiting and the remaining investors. Where the execution price related to the matching of transfer requests is based on the NAV, the matching shall be aligned with the valuation dates. Costs for the transfer of units including exit and purchase fees must be disclosed in the constitutive documents of the ELTIF.

Finally, the constitutive documents of the ELTIF must set out pro rata conditions for matching different transfer and offer requests. In particular, the constitutive documents of the ELTIF must address the question of how imbalances between transfer requests from exiting investors and the purchase offers from other investors are handled.

It should be noted that the above is without prejudice to the provisions of Article 19(2) of ELTIF 2.0 that expressly provides for the free transferability of units in an ELTIF.

Additional publications from FSB and IOSCO

On 20 December 2023, just one day after ESMA’s publication of its final report on the draft RTS, the Financial Stability Board (FSB) published its revised policy recommendations to address vulnerabilities from liquidity mismatch in open-ended funds¹⁶ and the International Organization of Securities Commissions (IOSCO) issued its final guidance on anti-dilution liquidity management tools for the effective implementation of the recommendations for liquidity risk management.¹⁷

On 22 December 2023, the supervisory authority of the financial sector in Luxembourg, the CSSF, ¹⁸ published a communiqué informing Luxembourg industry participants of the FSB and IOSCO reports.¹⁹

The recommendations from FSB and the guidance from IOSCO are addressed to any open-ended funds and will likely affect ELTIFs that are granting redemption rights to their investors. It is likely that competent supervisory authorities globally will consider these recommendations and guidance when assessing applications for approving an open-ended ELTIF.

Conclusion

The draft RTS are imposing strict conditions on ELTIFs wishing to grant redemption rights and on organising the matching of transfer requests. If the EU Commission adopts the draft RTS in their current form, operating an open-ended ELTIF is likely to be demanding and relatively onerous. From a practical perspective, the provisions in the draft RTS on notice periods and redemption limits make it very difficult for managers to set up relevant semi-liquid vehicles.

ESMA’s conservative approach towards open-ended ELTIFs reflects the general concerns from regulators and supervisory authorities across the globe on liquidity and systemic risks. While this is understandable, the success of ELTIF 2.0 may be diminished if open-ended or semi-liquid ELTIFs end up being rare and subject to high operating costs to comply with stringent regulatory requirements.

¹ European Securities Market Authority, the financial markets regulator and supervisor of the EU.

² ESMA’s May 2023 public consultation is available here.

³ ESMA’s December 2023 Final Report is available here.

⁴ Article 3 of the draft RTS.

⁵ Recital 7 of the draft RTS.

⁶ Article 5(4) of the draft RTS.

⁷ Article 5(4a) of the draft RTS.

⁸ Article 5(5a) and Article 5 (6) of the draft RTS.

⁹ Article 5(5a) of the draft RTS.

¹⁰ Article 5(1) of the draft RTS.

¹¹ Quantity-based LMTs operate by reducing the liquidity obligations of the open-ended fund through postponing or suspending redemption rights and delaying or deferring payments to investors. They are generally considered as an exceptional form of intervention and in practice activated after first mover advantage related issues already occurred.

¹² Article 5(7) of the draft RTS.

¹³ Recital 8 and Article 5(7) of the draft RTS.

¹⁴ Articles 7 and 8 of the draft RTS.

¹⁵ Namely, the ELTIF’s rules or instruments of incorporation or in the prospectus.

¹⁶ The FSB Report is available here.

¹⁷ The IOSCO Guidance is avaialbe here.

¹⁸ Commission de Surveillance du Secteur Financier, the supervisory authority of the financial sector in Luxembourg.

¹⁹ The CSSF Communiqué is available here.