LTAF – Coming Soon. Final rules in force from 15 November 2021

On 25 October 2021, the FCA published its keenly anticipated policy statement, PS 21/14, “A new authorised fund regime for investing in long term assets” (the PS).

The PS sets out not only the FCA’s response to feedback on its consultation paper CP21/12 (see our summary here) but also final rules which will allow the introduction of a new authorised fund vehicle, the Long Term Asset Fund (LTAF) from 15 November 2021.

What is an LTAF?

The LTAF is a new category of authorised fund, intended, in the FCA’s words, “to facilitate investment in long-term illiquid assets combined with rules to address the specific risks these assets pose”, i.e., allowing a wider range of investors better access to such assets while providing an appropriate level of investor protection.

Our view?

We consider this to be a positive move in the right direction and are pleased to see that the FCA appears to have taken a constructive response to industry comments made as part of the consultation phase.

Simmons & Simmons has long supported the development of a suitable regime which enables much broader access to long-term and productive capital vehicles.

We are represented on both the Steering Committee and Technical Expert Group of the Bank of England / HMT / FCA Productive Finance Working Group (see our summary of the PFWG’s recent Roadmap here) and have actively engaged with our clients on this topic, informing our responses earlier this year to both the HM Treasury consultation on the tax treatment of asset holding companies (see our response here) and to its wider Call for Input on the future of the UK’s funds regime (please see here).

What next?

The PS shouldn’t be seen as the last FCA’s word on LTAFs.

The aim all along has been to bring the new vehicle to market and then work on expanding the investor base to which it can be promoted, while ensuring proper levels of investor protection.

The new rules come into effect on 15 November 2021 – the FCA is encouraging firms which are considering making an authorisation application for an LTAF to engage with it prior to submitting an application.

However, the work will continue and the PS notes that the FCA is planning to consult in 2022 on:

• proposals to enable a broader range of retail consumers to invest in LTAFs in a controlled way; and
• amending the requirement for the depositary to be the legal owner of an LTAF’s non-custodial assets.

What does the PS say?

The LTAF is introduced primarily through the creation of a new chapter,
COLL 15, which sits in the FCA’s Collective Investment Schemes sourcebook (COLL).

This Note deals with the key points arising from the PS, and looks at the principal changes it makes to the original proposals on which the FCA consulted:

Liquidity management

In one of the few headline measures taken by the FCA, the final rules move away from merely requiring that an LTAF should not be daily dealing to requiring that:

• they must be open for redemption no more frequently than monthly; and
• all redemptions must apply a notice period of at least 90 days.

Whilst some investors, such as Defined Contribution (DC) default pension plans, may prefer more short-term access to invested capital - and longer notice requirements are an operational challenge for some investors - ultimately this is an important aspect of liquidity management for managers investing in these asset classes and aligning fund liquidity to the assets is key. Larger schemes will potentially be better able to manage their liquidity pipeline than smaller schemes and this is perhaps another area where consolidation in the DC market might bring benefits.

In its feedback, the FCA suggests that closed-end LTAFs would not be appropriate and we would agree that, within the current legislative framework, investors in authorised funds have to be entitled to redeem their investments on request at a price related to net assets albeit the frequency of those redemptions is not set out in the legislation (FSMA for authorised unit trusts and authorised contractual schemes and the OEIC Regulations for ICVCs).

We would, however, expect there to be some demand from investors (and managers) to develop products that operate on a much less frequent dealing cycle and/ or longer notice on redemptions than the baseline set out in the new rules. Indeed, the FCA acknowledges that notice periods are just one example of the tools available for liquidity management and that they are open to the use of a range such tools provided they are appropriate and clearly disclosed to investors.

The FCA also welcomes industry guidance as recommended by the Productive Finance Working Group on appropriate lengths of notice periods for different types of asset.

Governance

The final rules require (as trailed in the consultation) that:

• a senior manager must have responsibility for overseeing that the LTAF is managed in the best interests of investors which may require some internal reorganisation of senior personnel particularly where the LTAF is being managed by a firm that traditionally has only managed authorised funds investing in liquid assets (with illiquid strategies being managed by a separate AIFM entity, perhaps);
• as an addition to the assessment of value requirement, the AFM must carry out an assessment of how the LTAF is being managed in accordance with investors’ best interests;
• AFMs will need to be full-scope UK AIFMs with the collective knowledge, skills and experience to manage the risks involved and the regulatory permission of “managing an authorised AIF”;
• firms that currently only have “managing an unauthorised AIF” will need to seek a variation of permission (which may take up to six months to obtain); and
• such firms will need to appoint at least two independent directors to meet the requirement for all AFMs in COLL.

Disclosure

Not least because LTAFs will allow some retail investment through the NMPI rules (see below) and some of the concepts being used by LTAFs (for example, performance fees and notice periods) are not currently widely used in authorised funds, there is to be a focus on clarity of disclosure.

The prospectus will be written in clear, plain language and the intention is that this will inform the clarity of key messages in other documentation.

Investment and Borrowing Powers

• Prudent spread of risk (PSOR)
  This requirement is retained despite it having no legal definition and the FCA expects the industry (and the courts if necessary) to apply a natural meaning to the term. In what is perhaps a surprising move, the 24 month “ramp-up” period relaxation of the spread rules has been removed and the PSOR requirement will apply from launch so that the LTAF’s initial portfolio will have to be compiled on a “PSOR” basis from the beginning.
• Investment in Other Funds (Second schemes)
  The requirement for a second scheme to also operate on the principle of prudent spread of risk has been dropped (except where the second scheme is in fact the master fund to which the LTAF is dedicated). Instead reliance is placed on the standard being applied at the level of the LTAF together with the due diligence requirement.
• Feeder funds
  The rules have been amended to clarify that an LTAF is permitted to invest as a feeder fund into a “qualifying master LTAF” which does not need itself to be an LTAF (or, indeed, an authorised fund at all).
• Loans
  The original draft rules in this area were the subject of some criticism and the FCA has heard the rules against investment in loans which involve conflicts of interests have been amended and reliance is placed instead on the general principles in the FCA rules and the AIFMD Level 2 Regulation on conflict management.

Depositary issues - ownership of assets and responsibility for valuation

These were areas of significant feedback from the industry (not least the depositary community), and the FCA has moved to accommodate concerns in both areas.

• Valuation
  Instead of the depositary having to determine “without qualification” that the AFM has the knowledge skills and experience to value the assets “in-house” the final rules merely require that the depositary determines that the AFM has the resources and procedures for carrying out such a valuation
• Ownership of assets
  Depositaries have difficulty in taking legal ownership of certain asset types as is required for all authorised funds currently and although the FCA has acknowledged that difficulty it wishes to consult in the area as the point has potential implications for other categories of authorised fund such as property funds. In the meantime, those setting up LTAFs may apply for a waiver (or modification) of the relevant rules based on alternative ownership arrangements of the assets in question and the FCA will consider those applications on their merits.

Profit Allocation/ Performance Fees

A key aspect of the commercial arrangements of any new LTAF will be the extent to which a profit allocation to the manager can be accommodated as this is an important factor both in attracting the best managers and in aligning the interests of managers and investors in most long-term asset classes. There has been much commentary on the fact that the charge cap for DC schemes leaves little headroom notwithstanding recent changes to pensions rules allowing for smoothing of performance fees over multiple years. The Productive Finance Working Group identified this as a key area in which there was a need for more material reform of the rules on how performance fees are treated under the charge cap. As a result, we were pleased to note that, in its Budget on 27 October 2021, the UK Government flagged its intention to consult later this year on further changes to the charge cap for DC schemes, with a view to considering amendments to its scope to better accommodate performance fees. We will be following this consultation process closely and will report further when it is clear what changes it might lead to.

Distribution – including to retail

The distribution of the LTAF to retail was perhaps the most controversial aspect of the initial consultation with quite diverging views being aired during (and since) the consultation period.

Although there are undoubtedly dangers in opening up investment in less liquid assets to the mass retail market, many argued that with appropriate limits and safeguards and with the intervention of appropriately regulated intermediaries, distribution to some form of retail should be both feasible and desirable. On top of that the proposed route for limited access was the path less trodden that is the non-mainstream pooled investment (or “NMPI” rules) which are widely regarded as unworkable either for their complexity or for their attendant liability concerns (or both).

After acknowledging that respondents had significant concerns about the use of the NMPI rules for the LTAF, the FCA has stuck to its guns and provided for the NMPI rules as a “first step” in allowing retail access to the LTAF and it will consult “in the first half of 2022” on broader access. This was expected and, given timing constraints, a more accelerated timeframe for that consultation was never realistic. It is to be hoped that the consultation can be conducted in the round on the efficacy of the “patchwork quilt” of current rules around retail access to complex products – not just the LTAF.

Permitted Links and linked contracts of insurance

The FCA is implementing the proposed amends to the permitted links rules in COBS 21 broadly as planned to provide increased flexibility for use of illiquid assets via the LTAF.

But the final rules include two amendments which the FCA is making in response to feedback:

• The proposal to exclude investment in LTAFs from counting towards the 35% gross assets limit is being adopted as planned, but a corresponding amendment is now also being made to COBS 21.3.19R(2) exclude conditional permitted long-term asset funds from the limit. Firms should leave the gross assets invested in conditional permitted LTAFs out of account when calculating the total amount of gross assets of a linked fund to which the limit applies. Next, when firms calculate whether the limit has been exceeded, they should not aggregate the gross assets invested in conditional permitted LTAFs to the other gross assets invested in conditional permitted links.
• The FCA is amending the definition of “permitted units” to make clear that it includes conditional permitted links, including LTAFs. This is to enable life funds to invest in other life funds containing LTAF which would have been prevented by the existing drafting.

The use of LTAF as a conditional permitted link is currently limited to default funds of defined contribution pension schemes. The FCA has indicated that’ as set out in CP 21/12’ it continues to be open to potentially extending the distribution of LTAF to other linked contracts of insurance. This would be, for example, where investors have professional support on fund selection or are guided through an appropriate choice architecture.

The FCA may consult on changes of this kind in the future.

Tax considerations

The FCA statement is (perhaps understandably) light on detail concerning the tax position of LTAFs, given the ongoing wider review by HM Treasury of the tax regime for UK funds and the impending Autumn Budget on 27 October.

The FCA notes that the LTAF rules permit LTAFs to be established as property authorised investment funds (PAIFs), and that an LTAF could be structured as an authorised contractual scheme (ACS). The latter is likely to be the most attractive option for those LTAFs that are established to attract DC investment, given that the tax transparent nature of the ACS should enable tax exempt investors such as registered pension schemes to preserve their tax exemptions and access to relevant double tax treaties.

Reading between the lines, it seems that the FCA expects that the existing tax regime applicable to UK authorised funds will be extended to LTAFs, although the FCA acknowledges feedback provided to it on a number of other tax considerations, including the ISA eligibility of LTAFs and the VAT treatment of management services provided to an LTAF. These will, however, be matters for HM Treasury and HM Revenue & Customs ultimately to determine.