The new UK Long-Term Asset Fund
The Financial Conduct Authority has published its final rules for a new category of open-ended authorised fund designed for investing in long-term illiquid assets like venture capital, private equity, private debt, real estate and infrastructure. The FCA’s intention is to ensure that investment in long-term illiquid assets is a viable option for investors with long-term investment horizons who understand the risks.
The Long-Term Asset Fund (“LTAF”) is aimed at DC pension schemes, sophisticated investors and some high net worth individuals. The FCA will be consulting in the first half of 2022 on the potential for widening the distribution of the LTAF to a broader range of retail investors.
Plans for the LTAF were announced in the Chancellor’s statement on the UK's future approach to financial services on 9 November 2020, followed by a consultation by the FCA on its proposals in May 2021. The final rules have retained many of the features proposed in the consultation, with some notable changes following feedback, including to redemptions, valuation, and certain other changes as discussed in this note. The new rules and guidance will come into force on 15 November 2021.
Barriers to long-term investment
According to the FCA, evidence suggests that even some investors with long-term investment horizons are not investing in long-term assets due to barriers, or perceived barriers, to doing so. The FCA has been working with the Bank of England, HM Treasury and industry participants, through the Productive Finance Working Group, to break down some of those barriers. The LTAF and its operation formed part of the recommendations of the PFWG’s roadmap, published in September 2021.
The LTAF framework
The LTAF is a new, distinct category of authorised fund, and the FCA has created a new chapter 15 of the Collective Investment Schemes (“COLL”) sourcebook containing the rules for LTAFs. The LTAF regime has been based on the qualified investor scheme (“QIS”) regime in COLL 8, with additional protections. In a change to the proposals, the LTAF now has its own status in the wider FCA Handbook rather than being treated as a sub-set of the QIS. The framework is principles-based and does not set out prescriptive rules in many areas.
As is the case with a QIS, the FCA Handbook text provides that an LTAF can take the form of an authorised contractual scheme, an authorised unit trust or an ICVC (i.e., an open-ended investment company). In addition, it can be an umbrella fund with sub-funds.
An LTAF will be an alternative investment fund which must have a full-scope UK alternative investment fund manager. It will therefore be subject to the requirements of the UK’s implementation of AIFMD. UK authorised firms who do not currently manage authorised funds would need to get additional permissions to manage an LTAF, and the FCA encourages firms who want to manage LTAFs to engage with its Firm Authorisations team where they do not currently have the “managing an authorised AIF” permission.
The FCA has added additional governance around LTAFs to give investors confidence that they are being managed appropriately and in their interests. This includes a requirement that the manager of an LTAF must have demonstrated that it:
- possesses the knowledge, skills and experience necessary to understand the activities of the LTAF and, in particular, the risks involved in those activities and the assets which the LTAF holds; and
- employs sufficient personnel with the skills, knowledge and expertise necessary for discharging the responsibilities allocated to them.
The manager may not rely on a delegation or outsourcing arrangement to satisfy the above requirements.
At least one-quarter of the members of the governing body of the manager must be independent natural persons (if fewer than eight members, at least two members must be independent), with time limits on their appointment.
Investment strategy and powers
The investment strategy must be to invest mainly (i.e., at least 50% of the value of the scheme property) in assets which are long-term and illiquid in nature, or in other collective investment schemes which invest in such assets. The FCA clarifies in its policy statement that it does not intend the 50% guidance to constitute a limit to be monitored on a day-to-day basis either by the manager or the depositary, but rather the guidance applies to the investment strategy and not the holdings in the fund at any time.
The investment powers of the fund are based on the existing rules for QIS, which permit a fund to invest in certain specified investments (such as unlisted securities), as well as certain types of immovable assets and commodities. The FCA also permits LTAFs to invest in loans (including direct lending) in addition to the assets permitted for a QIS, subject to the existing relevant rules on managing conflicts of interest, but have included some limits on lending, e.g., where the loan is to a natural person. There is no requirement for LTAFs to invest only in UK assets.
An LTAF would be required to have a prudent spread of risk. The FCA Handbook does not define the term ‘prudent’, but in the FCA’s view the word should be given its ordinary natural meaning, even if it is not supported by prescriptive requirements. An LTAF should be allowed time to build up its portfolio, but it should not engage in excessive concentration of risk during this time. This is a change to the proposals, which had contemplated a 24-month exemption.
An LTAF will be open-ended. In a change to the proposals in the consultation, the FCA has imposed a mandatory notice period of at least 90 days for redemptions and a requirement that LTAFs cannot offer redemptions more frequently than monthly. These are minimum requirements and longer notice periods or less frequent dealing are likely to be appropriate for some LTAFs. Managers must set appropriate terms and redemption policies for an LTAF, ensuring they are consistent with the fund’s liquidity profile and the investment strategy they are operating. The FCA notes that it would welcome the development of guidance by industry on appropriate lengths of notice periods for different types of asset, as recommended by the PFWG.
An LTAF should not expect to use, nor rely on, suspension as a means of managing fund liquidity in the normal course of events, and instead should have tools available to manage its liquidity that are appropriate to the types of asset that it invests in.
The FCA has considered whether an LTAF may operate a commitment approach to subscriptions. It does not rule this out, but any LTAF that wanted to operate in this way would need to comply with the existing legislative framework for authorised funds, as well as with the fund rules. If a firm is considering applying for authorisation on this basis, the FCA would welcome early engagement on the proposed model.
The FCA does not plan to impose a cap or to prohibit performance fees, noting that the rules for authorised funds do not contain any caps on fees but that managers must undertake an annual assessment of value. The FCA has said it will instead allow the market to decide the appropriate structure and amount of any performance fees based on full disclosure. However, the charge cap applicable to DC pension schemes is an important factor here, and although the PFWG report has made some recommendations about how DC pension schemes might accommodate funds with performance fees within the charge cap, it remains to be seen how successful this will be in the LTAF.
The manager will have to consider an appropriate level of borrowing for the investment strategy, with the maximum level of borrowing that an LTAF may undertake set at 30% of net assets. This does not require look through to the aggregate borrowing of underlying investments of the LTAF.
Investment due diligence
Given the nature of investments that an LTAF might make, the FCA requires managers to undertake due diligence on their investments in line with good practice and to disclose in the prospectus how they do this. This is in addition to UK AIFMD requirements for due diligence. The FCA would welcome any work by the industry to set out what is good practice for investment due diligence for different asset classes.
The manager must appoint an external valuer (under UK AIFMD), unless it can demonstrate that it has the competence and experience to value assets of the type in which the LTAF invests. The FCA acknowledges concerns raised about external valuer liability, and while it is unable to change the way the AIFMD rules have been implemented in the UK at this stage, it does note that it is considering the function of external valuers together with HM Treasury. The FCA explains it is comfortable with managers using the support of valuation advisers to value individual assets, although the manager remains responsible for the valuation, and has made this clear in the LTAF rules. The FCA has also clarified that a manager may rely on valuations provided by collective investment schemes in which the LTAF invests, where those schemes are themselves subject to an independent valuation by an external valuer.
If no external valuer is appointed, the LTAF’s depositary will be required to (regularly, and at least annually) determine that the manager has the resources and procedures for carrying out a valuation of the assets. This is a change, following feedback, to the proposal that the depositary be required to assess the competence of the manager to carry out the valuations on an ongoing basis.
The FCA requires that a valuation must be carried out at least monthly, even where there is no dealing in units. The FCA does not plan to require suspension of dealing when there is material valuation uncertainty, but managers should consider in those circumstances when suspension is in the interests of unitholders.
Disclosure and Reporting
The FCA has set out disclosure requirements for the fund prospectus in new COLL 15.4.5, which are in addition to the pre-sale disclosure requirements in FUND 3.2 (i.e. those derived from Article 23 AIFMD). The rules require full disclosure of all costs and charges incurred directly or indirectly by the scheme. The FCA would welcome LTAFs disclosing consistently with the Cost Transparency Initiative (“CTI”) templates, but do not plan to require this, as not all LTAFs may have investors who use these templates.
The FCA is not planning to add any specific sustainability disclosures to the LTAF rules. Instead, the FCA notes the Government’s plans, announced in October 2021, to introduce a sustainability disclosure regime which the FCA anticipates would apply to LTAFs, and reminds potential managers of LTAFs of the letter it sent to Chairs of AFMs on funds with environmental, social and governance (ESG) / sustainable investment objectives.
Annual reports (due within four months of year-end), half-yearly reports (due within two months of half-year end) and quarterly reports (due within 20 business days of quarter-end) to investors will be required, with certain details to enable investors to monitor the activity of the manager. The depositary is also required to make an annual report to investors, to be included in the annual report.
Several respondents raised concerns about the proposals for depositaries to take legal ownership of all assets of the LTAF (as is required under the QIS framework), noting this is impractical for all eligible assets that an LTAF might invest in. The FCA acknowledges these concerns. As this feedback applies to other categories of fund and not just the LTAF, the FCA aims to consult on alternative registration options more broadly in the first half of 2022.
In the meantime, where a firm wishes to establish an LTAF, the FCA will consider applications to modify or waive this requirement. Among other things, waiver applications will need to satisfy the FCA that proposed alternative custody arrangements provide appropriate investor protection.
The tax status of an LTAF was largely not addressed in the consultation paper, but in the response the FCA confirms it understands the Government will ensure that pre-existing tax legislation will continue to operate effectively based on the respective types of vehicle (i.e., authorised contractual schemes, etc). The FCA had noted in its consultation paper (but does not add further detail in the policy statement) that investing in loans may cause tax issues if an LTAF’s activities would amount to a trade for tax purposes, and that they were engaging with HM Treasury and Her Majesty’s Revenue and Customs on those issues. More generally however, taxation of UK funds is being looked at by HM Treasury as part of its review of the UK fund regime, and any changes made as a result of that review would also apply to LTAFs.
The FCA had originally proposed that the LTAF be classified as a non-mainstream pooled investment (“NMPI”), which broadly means it could only be promoted to professional clients and certain types of retail client, taking the same approach as is the case for a QIS. The FCA noted in its consultation that guidance in its Conduct of Business Sourcebook (“COBS”) at chapter 4.12.13 implies that it is unlikely to be appropriate or in the client’s best interest to promote a QIS to retail investors who are not certified sophisticated investors or self-certified sophisticated investors, therefore excluding certified high net worth investors who do not qualify as sophisticated. However, the FCA queried whether and how that guidance should apply to the LTAF. Based on feedback received, the FCA confirms it intends to proceed with the introduction of the LTAF as an NMPI (noting it remains an “appropriate first step”), but it also acknowledges that the level of protections within the LTAF regime mean that certified high net worth individuals should be able to access the LTAF as part of a diversified portfolio (particularly given they can in any case access unauthorised funds). The FCA will amend COBS 4.12 to achieve this. The FCA remains open to broadening the base of eligible investors for an LTAF and intends to consult on this in the first half of 2022.
Permitted links rules
In order to make the LTAF more attractive to DC pension schemes, the FCA will change the ‘permitted links’ regime in COBS 21.3, to treat the LTAF as a permitted link in its own right. This will exempt the LTAF from the 35% cap on illiquid holdings that currently applies to unit-linked funds. The FCA has taken on board feedback received during the consultation and has made some changes to its rules to ensure its policy aims are achieved by the drafting.
The new rules and guidance will come into force on 15 November 2021. The FCA intends to consult in the first half of 2022 on the potential for widening the distribution of the LTAF to certain retail investors, and on the same timescale for alternative registration options for asset ownership for authorised funds more generally.
Future UK regulatory framework
The LTAF is one of several workstreams the government has launched to shape the future of financial services regulation in the UK, which has also included a Call for Input on the UK funds regime. Visit our dedicated future regulatory framework webpage for more information on the UK’s plans.