1........... Introduction. 6

2........... Procedural Issues and Consultation of Interested Parties. 7

2.1........ Related EU initiatives. 7

2.2........ Consultation of interested parties. 9

2.3........ Impact Assessment Steering Group and IAB.. 10

3........... Problem Definition. 11

3.1........ Problem drivers. 11

3.1.1..... Regulatory fragmentation makes it difficult for investors to gain exposure to long-term assets. 11

3.1.2..... The diversity of long-term assets creates a potential for misplaced expectations from investors 12

3.2........ Problems. 17

3.2.1..... Inefficient market for pooled investments impedes access to finance. 17

3.2.2..... Potential investors in long-term assets are currently deprived of an appropriate investment vehicle 18

3.2.3..... Managers face barriers to activity, costs and reduced economies of scale. 20

3.3........ Consequences of the problems. 21

3.4........ How would the problem evolve without EU action? The baseline scenario. 22

3.5........ EU’s right to act and justification for acting. 23

4........... Objectives. 24

5........... Policy Options. 25

5.1........ Identification of options. 25

6........... Analysis of impacts. 27

6.1........ Analysis of options. 27

6.1.1..... Option 1: take no action at EU level 27

6.1.2..... Option 2: Use soft law to develop an LTI fund label 28

6.1.3..... Option 3: Long term assets permitted within UCITS. 29

6.1.4..... Option 4: LTI fund for institutional investors. 30

6.1.5..... Option 5: LTI fund for institutional investors and HNWI 33

6.1.6..... Option 6: LTI retail fund passport with no redemptions. 34

6.1.7..... Option 7: LTI retail fund passport with redemptions. 41

6.2........ Impact summary. 44

7........... The retained policy option and its impact 47

7.1........ The choice of instrument 47

7.2........ Estimate of likely uptake. 48

7.3........ Substitution and distributional effects. 49

7.4........ Impact on EU fund legislation. 51

7.5........ Impact on SMEs. 52

7.6........ Social impact 52

7.7........ Environmental impact 52

7.8........ Impact on Member States. 53

7.9........ Impact on third countries. 53

7.10...... Risks. 53

8........... Monitoring and Evaluation. 53

Executive Summary Sheet

Impact assessment on the Proposal for a regulation on Long Term Investment Funds (LTIFs)

A. Need for action

Why? What is the problem being addressed?

Investors are often too short term in perspective, reducing investments into longer term assets such as infrastructure projects. Tackling this will help stimulate the real economy by providing a further source of funding for businesses. It will also provide investors with fresh options for accessing long term assets which can generate good profits. Currently accessing these assets can be difficult. Investment funds are a key way of investing in them, but there are no common standards among Member States (MS) so the market is fragmented, leading to higher costs and conflicting terms and definitions are used. Investor protection standards can be too low. This has discouraged or blocked investors from targeting long-term assets, such as infrastructure projects or participations in SMEs. This proposal would create a harmonised set of product rules (for ‘Long Term Investment Funds’ or LTIFs) which would address these problems and so help stimulate growth in the real economy.

What is this initiative expected to achieve?

A LTIF brand would be created, developing a new market for these funds targeting long term assets. This would increase investment into the real economy, and provide an alternative source of capital to bank lending. Impacts would be maximised by developing harmonised product rules for LTIF. Allowing access to the widest possible range of investors will maximise the amount of capital available for firms. For this reason, the funds will be free to market cross-border to both institutional and retail investors. The new LTIF framework will offer a secure investment environment for investors seeking exposure to long-term assets. Existing national regimes are not always sufficient to offer the kind of protection retail investors need.

What is the value added of action at the EU level?

The market for long-term assets is currently highly fragmented with Member States subjecting funds targeting them to varying rules. This is a barrier for fund managers, who have to deal with a range of legal issues depending on the Member State. Costs are raised and fund sizes constrained. The experience of UCITS shows that a strongly regulated product structure can be very successful in attracting substantial amounts of capital from both institutional and retail investors, and in building a cross-border market.

B. Solutions

What legislative and non-legislative policy options have been considered? Is there a preferred choice or not? Why?

A range of options have been considered: no action; non-legislative action; and then a range of options for creating cross-border rules with each subsequent option widening the potential audience of investors able to use them. The preferred option is to create a LTIF open to all types of investors, including retail investors, with strong product rules and set up as a closed-ended fund. To tackle divergences and fragmentation between Member States, a legislative measure is needed to create a consistent regulatory framework for LTIF and to ensure better cross border marketing to all types of investors. To address possible mis-selling to retail investors, the new LTI fund would need harmonized product rules to mitigate risks. To this effect rules in the areas of diversification, derivatives, transparency, leverage, and conflict of interest are necessary. The fund would remain closed to redemptions. Strong investor protection standards create a solid basis for facilitating the marketing of LTIFs to all investors.

Who supports which option?

Stakeholders from the asset management sector are mainly supportive of this initiative. Those with experience with the UCITS market are generally more positive that a retail regime is necessary while those coming form the private equity and infrastructure background are more mixed on this issue. The few contributions received from investors suggest an appetite for investing in long-term assets but the views are however how this structure should work. Supervisors have not yet expressed strong views.

C. Impacts of the preferred option

What are the benefits of the preferred option (if any, otherwise main ones)

Permitting cross-border marketing to all investors, including retail, allows the deepest capital pools to be drawn on. Using closed-ended funds has the advantage of permitting investments in all types of long-term assets as the structure better matches the illiquidity profile of these assets. Such a solution has the merit of being transparent as to the long-term commitment that investing in such assets requires. It also is relatively simple (in that complex liquidity management is not necessary. Greatly improved and harmonized product rules may mitigate risks of mis-selling, particularly also in the context of rules already applying to distributors to act in the best interest of their clients. Institutional investors also can prefer clearly harmonised and regulated products. Fund managers would choose whether or not to take up the preferred option, though they would be bound by it if they opted to use it. This means estimating the scale of uptake is difficult ex ante; experience in the UCITS market suggests a well-defined and understood brand can evolve into a globally dominant model. Indirect social impacts could include better financing of social housing projects, of health infrastructure, and of green projects, which all fall within the scope of eligible assets.

What are the costs of the preferred option (if any, otherwise main ones)?

The fact that such funds would not allow redemptions during their lifecycle may limit the range of retail investors willing to invest in such funds, particularly where offered with ten year or longer time horizons. Risks remain that retail investors invest in such funds without fully grasping the risk and liquidity consequences, even where disclosures are transparent and clear. Should retail detriment arise that is not effectively mitigated through MiFID rules or the rules under the preferred option – through either active mis-selling and non-compliance, or investors failing to undertake sufficient due diligence – this could negatively impact the development of an LTIF market. Since setting up LTIF is optional for managers, hard costs are not relevant.

How will businesses, SMEs and micro-enterprises be affected?

The creation of an LTIF would have indirect impacts for the financing of SMEs. SMEs represent one of the core assets in which the LTI funds will be able to invest. This can be achieved either by providing loans or by acquiring (direct) equity participations in the companies. The creation of pan-European LTIFs will not address all of the challenges SMEs face in accessing financing, but it can contribute to a wider range and depth of alternative sources of financing, alongside banks.

Will there be significant impacts on national budgets and administrations?

No

Will there be other significant impacts?

No other significant impact except an indirect impact on third countries. The new LTI framework may represent an added value for potential investment targets domiciled in third countries. In addition the newly created LTI fund might represent an export label as UCITS does currently for funds invested in transferable securities.

D. Follow up

When will the policy be reviewed?

The forthcoming legislation will be subject to a complete evaluation (about 4 years after its implementation deadline) in order to assess, among other things, how effective and efficient it has been in terms of achieving the objectives presented in this report and to decide whether new measures or amendments are needed.

1. Introduction

In the aftermath of the financial crisis, academics, policymakers and industry experts highlight a tendency toward short term behaviour. Investors have tended to focus on short term investment returns, strongly reflecting market fluctuations, and on assets that are capable of being readily sold. What they have not done is to focus on the return profile of assets held over the long term.

Yet taking a long term perspective and investing in asset classes which require longer term commitments from investors can have benefits for investors and for the economy more widely. For instance, investments in energy generation and distribution or transport infrastructure can reduce costs for individual firms, raise employment opportunities and provide investors with a steady rate of return. The importance of such 'knock-on' effects means that any tendency toward short term behaviours, to the detriment of long term investments, should be addressed.

The Commission Green Paper on financing long term investment in the European economy (Green Paper) examines options that might be considered in different areas for encouraging long term investments.[1]

This impact assessment focuses specifically on asset management and options for fostering long term investments through private investment funds.

While the EU Directive on Undertakings in Collective Investment in Transferrable Securities (UCITS) creates a cross-border framework for investment into mutual funds,[2] these funds must remain able to offer redemptions on demand. This redemption profile requires a portfolio of liquid transferable securities, such as bonds and shares. This means long term investments under UCITS can only take the form of a ‘buy and hold’ investment strategy built on liquid assets. UCITS cannot execute direct investments in unlisted entities or engage in participations in projects.

Asset classes excluded from UCITS are, however, key to long term financing. They directly contribute to the growth and financing of projects, companies and infrastructure across the EU. These assets typically share certain core features: they require long term commitments but also provide income over the long term. They are generally illiquid, so that selling an asset can be difficult, and the assets are rarely listed on secondary markets. Long-term investments can take the form of equity or debt investments covering equity or quasi-equity participations, debt or loans provided to fund infrastructure, small to medium-sized enterprises (SMEs) or property projects.

Such long term assets can also be attractive for many investors, but there is a clear lack of opportunity to buy these assets on the European market:

· Institutional investors such as pension fund operators, insurers or foundations with set liabilities (e.g. pay-outs to members on retirement by pension funds) which have a timeline that places them far in the future, for whom shorter-term liquidity of investments is not as important as matching these liabilities over this longer-term time horizon.

· Some investors specifically seek long term assets, e.g. foundations or businesses that commit to support sustainable investments, including those driven by innovation, or seek to include investments that achieve specific social or environmental impacts (e.g. green infrastructure investments).

Despite this demand, the development of cross-border investment funds targeting these assets face a number of problems:

· There is currently no EU-wide fund framework dedicated to long term assets – with a common definition of such assets -- and recognisable by any type of investor. A patchwork of national rules means funds offering targeted long term investment opportunities are not easily identifiable by smaller institutional investors and may be inaccessible to retail investors due to regulatory restrictions.

· Funds are required to comply with diverging national requirements incur legal, administrative and marketing costs.

· Regulations have not always served investor needs well enough: investors in funds that appear to target long term assets have not always properly understood the long term nature of the commitment and the specific risk profile of these assets and funds[3]. This undermines confidence.

This report will focuses on examining these problems and options for addressing them. It identifies options for funds capable of making investments into illiquid assets not covered by UCITS.

2. Procedural Issues and Consultation of Interested Parties

2.1. Related EU initiatives

Smart, sustainable and inclusive growth is at the heart of the Europe 2020 vision.[4] Promoting long term investment over short term investment is a clear driver for achieving these targets. Increasing levels of long term investment will contribute to all of the five targets identified in the Europe 2020 vision (employment, research and development, climate change and energy sustainability, education and fighting poverty and social exclusion).

More specifically, the Commission highlights access to a greater mix of quality finance as a key issue in the 2013 Annual Growth Survey,[5] calling on Member States to do more on alternative sources of financing. The Commission action plan to improve access to finance for SMEs has also outlined many of the wide range of measures needed.[6] In this respect, the equity financial instruments proposed under the Programme for the Competitiveness of Enterprises and SMEs (COSME),[7] as well as under Horizon 2020,[8] play a significant role as drivers of long-term financing. COSME in particular plays a key part in attracting institutional investors back to the venture capital industry by establishing cross-border, pan-European funds-of-funds.

The Commission is also committed to improve the digital infrastructure in Europe, notably with the Connecting Europe Facility (CEF).

The Single Market Act I (SMA I) underlined sustainable finance for SMEs and social entrepreneurs as key to tackling poverty and social exclusion and increasing employment. The creation of European Venture Capital Funds (EuVECA) and European Social Entrepreneurships Funds (EuSEF) illustrates the practical implementation of these measures in the area of investment funds. Raising the availability of long term investment clearly contributes directly to the pool of available patient capital.

Further steps are being taken to deepen long term financing: see for instance, the provision of financing through EU financial instruments notably under the cohesion policy, investments by the European Investment Bank, and the Europe 2020 Project Bond Initiative.[9]

Within this broader context of multi-stranded work on long term investment, the Single Market Act II (SMA II) announced under key action 6 there will be specific work on long term investment funds: “In addition, the Commission will make proposals on possible forms of long term investment funds. Investment funds can open new sources of financing to long term projects and private companies. They can constitute an attractive offer to retail investors who seek to invest long-term, diversify risk and prefer stable and steady returns with lower volatility, as long as the necessary degree of investor protection is ensured”.[10] This impact assessment assesses options for key action 6.

The options examined in this impact assessment are a sub-set of the broader possible measures announced in the Commission Green Paper on financing long term investment in the European economy (Green Paper).[11] The Green Paper explores demand and supply side issues and developmental trends across the markets for long term financing, and identifies a series of measures to be explored for tackling these issues or areas in which further work might be done. This includes investors' behaviour (appetite for and adoption of long term investment perspectives); prudential rules impacting institutional investors handling of different types of assets or behaviours of fund managers (increasing focus on long term perspective when investing in short term assets). Responses to the Green Paper will inform broader actions on long term investment, but the Green Paper does not address in detail the area covered by this impact assessment, in which consultations had already commenced in July 2012, as set out under 2.2 below.

Nevertheless, the evidence collected in the course of the asset management consultation of 26 July 2012[12] revealed that investment funds can provide a highly regulated vehicle to channel investor's assets to a variety of asset classes. The evidence reflected in this impact assessment, therefore, suggests that a new investment fund vehicle focusing on long-term asset classes could easily be developed on the basis of certain structural elements already 'tried and tested' in the context of the successful UCITS framework. This is because the essential ingredients of a pan-European framework for asset management – a precise catalogue of assets that would be eligible for the cross-border fund vehicle, its risk diversification, exposure limits and rules to limit recourse to leverage – are already in place for the UCITS framework. This set of basic rules could be easily transposed and, if necessary adapted, to create a comparable cross-border vehicle for investment funds that do not focus on transferable securities but on less liquid long-term asset classes, such as participations in unlisted infrastructure projects, unlisted SMEs or real assets that are necessary to develop the European economies.

In light of the previous wealth of experience that exists in the design and creation of EU-level investment fund vehicles, this impact assessment concludes that the time is ripe for action at an early stage, without the need to await the outcome from the much larger consultation on long-term investing that is launched by the above mentioned Green Paper.

In addition, the high level of participation and interest in the July 2012 consultation on various topics in the field of asset management reveals that stakeholder expectations with respect to a 'second passport' for long term investment vehicles are high. The level of interest displayed and the concrete nature of many of the stakeholder responses shows that considerable thinking into the possible design of a fund passport for long-term investment funds has already taken place and that awaiting the more general and conceptual responses from the Green Paper would not deepen the Commission's knowledge pool on how to structure a fund passport for a long-term investment vehicle.

Finally, as evidenced in this impact assessment, the Commission services convened a series of targeted stakeholder roundtable to discuss specific features of a future framework covering a second passport for long-term investment vehicles. Such consultations also included extensive canvassing of possible investor interest; several representatives of the 'buy side' were also in attendance at the relevant round-tables. The consultations also provided the Commission with further insight into the possible LTI investor base and the specific safeguards necessary to ensure that the LTIF framework caters to the specific needs (in terms of yield) and vulnerabilities of these investors (in terms of the selection of assets and in terms of the absence of redemptions during the lifetime of the LTIF).

In light of the above, the conclusion is taken that the evidence gathered is of such substance that the results of a much more conceptual consultation on long-term behaviour, as launched by the Green Paper, would not add any knowledge in the very specific area of asset management.

Other external factors that might further increase the effectiveness of options explored here are also being assessed in development work linked to legislative proposals which are part of Solvency II. The European Insurance and Occupational Pensions Authority (EIOPA) has been requested to take into account longer-term financing when calibrating that work, in particular risk weightings when investing in private equity and venture capital funds.

2.2. Consultation of interested parties

Since mid-2012 the Commission has been engaged in extensive consultation with representatives from a wide range of organizations. The consultation has taken the form of bilateral and multilateral meetings, a written public consultation on asset management issues including long term investments (LTI), and a follow up questionnaire which was circulated amongst interested parties. This impact assessment draws strongly on these consultations, and where possible reflections from stakeholders are included. There is broad and strong support for action in this area across all kinds of stakeholders. The written consultation noted above was part of a broader consultation on various asset management issues[13] published on 26 July 2012.[14] The Commission services received 65 responses related to the LTI section. All contributions have been thoroughly examined and relevant information contained in them has been taken into account throughout the report.[15] The follow up questionnaire led to 50 responses and further bilateral discussions with fund managers operating in the infrastructure and long term markets, fund management associations, and both retail and institutional investor representatives.

2.3. Impact Assessment Steering Group and IAB

Work on the Impact Assessment started in October 2012 with the first meeting of the Steering group on 7 November 2012, followed by 2 further meetings, the last one taking place on 18 March 2013. The following Directorates General (DGs) and Commission services participated in the meetings: Competition, Economic and Financial Affairs, Employment Social Affairs and Inclusion, Health and Consumers, Enterprise and Industry, Legal Services, Secretariat General, and Taxation Customs Union. The report and the minutes of the last steering group were sent to the Impact Assessment Board on 2 Mai 2013.

DG MARKT services met the Impact Assessment Board on 29 May 2013. The Board analysed this Impact Assessment and delivered its positive opinion on 31 May 2013. During this meeting the members of the Board provided DG MARKT services with comments to improve the content of the Impact Assessment that led to some modifications of this final draft. These are:

· The report should better explain what the real drivers of the problem are, i.e. regulatory failures or the result of LTIs particularities/investors' preferences.

· The problem definition should better describe and substantiate, with quantitative elements where possible, the magnitude and cross-border dimension of the problem.

· The reasons justifying the timing of the initiative should be clarified, given the on-going Green Paper consultation on LTI.

· Regarding the assessment of the options, the analysis should be strengthened, where possible with quantitative elements, notably with respect to the impact on administrative burden of the retained option.

· The superiority of the preferred option should be better established, for instance by demonstrating its greater effectiveness in addressing all identified problems and in attracting sufficient interest from retail investors despite its lack of redemption facilities.

· The report should clearly justify why some of the choices made deviate from the preferences expressed by stakeholders.

3. Problem Definition

3.1. Problem drivers

3.1.1. Regulatory fragmentation makes it difficult for investors to gain exposure to long-term assets

There is currently no effective internal market for pooled investments targeting long term assets. In the absence of a common EU fund model, national frameworks have proliferated, fragmenting the market across the EU and preventing the emergence of a deep investor base for the long term asset class. In addition, in those Member States where no national framework exists, investors are precluded from investing in a pooled vehicle that provides access to long-term investments.

In the absence of a common framework for pooled investments targeting long term assets, national frameworks have either been absent or have developed different approaches to establishing rules for investor protection for funds targeting long term assets, leading to such funds possessing very different profiles and characteristics.

For example, some structures have diversification rules whilst others permit a fund to invest into only one asset. So it is often difficult for investors to make their own risk assessment. In addition, fees can be opaque, and given their impact on the returns, if they are not well understood they can undermine confidence in the whole sector. Indications are that price competition is not effective with variations of up to 30%. [16]

In some Member States funds make extensive use of leverage to increase exposure (and thereby their volatility and potential for gains or losses). This can change their risk and reward profile significantly, compared with funds that do not use leverage in this way. Leverage, including by means of borrowing from banks, also creates additional risks for investors.

In addition funds targeting long term assets can be particularly prone to conflicts of interest. This might occur where fund managers possess an interest or controlling influence in an investment target themselves, such that they benefit from terms that are not in the best interest of the investors in the fund. For example, a manager of a property fund may be linked to the company in charge of the entity constructing or managing the long-term asset: there is a risk that the fund pays above market price for its stake in the project.

Due to these reasons, investors in LTI funds have sometimes been misled as to expected returns and risks.

As shown in the Annexes (see Annex 2 in particular), there is a great degree of variety in national rules on pooled investment vehicles that can target long term assets, making it difficult to raise productive capital across the EU. The Alternative Investment Fund Managers Directive (AIFMD) will not remove these national frameworks in their entirety, as it focuses exclusively on managers rather than on funds. [17]

For retail investors the market is even more fragmented. There is no framework facilitating cross-border marketing to retail investors of non-UCITS funds or funds that specialise in long-term asset classes. In consequence, each host Member State is able to individually authorize marketing to such investors and may impose additional requirements to those in the AIFMD. This has prevented the development of a single market for retail investors that wish to gain exposure to long-term investment assets.[18]

While some Member States have created a national market for pooled investments in long term investments others have no market for this asset class at all. For example DE, FR, UK or NL have long histories of funds targeting investments in long-term assets. In some markets the investors are mostly institutional while in others retail investors – high net worth individuals, family offices or indeed mass retail – represent the biggest share.[19] But the majority of Member States have no frameworks in pace for long-term asset classes – a fact which deprives investors in those jurisdictions from the investment opportunities that these asset classes offer. A cross-border investment vehicle will often be the only 'access gate' that will provide investors in these jurisdictions the opportunity to diversify their investment portfolio.

3.1.2. The diversity of long-term assets creates a potential for misplaced expectations from investors

Investing in long-term assets entails substantial risks when these investments are not properly managed. The first risk is that investors do not correctly understand the nature and risks of the assets they invest in due to the lack of a harmonized approach to defining these assets. Uncertainty prevails as to (1) the precise classification of assets as 'long-term' assets; (2) their risk and return profiles and (3) recommended holding periods. The second risk is linked to the characteristics of the assets, namely that they are illiquid in nature.

Sub-driver 1: No homogenous definitions of long-term assets: Long term assets include infrastructure, participations in unlisted companies and property. Box 1 identifies investment targets (long-term assets), and Box 2 the means by which investments are made in these assets (financial instruments). The duration of commitments to the assets by means of these instruments is not essential to assessing their long-term nature. Their generally non-transferable and illiquid nature distinguishes them from the mass of highly liquid assets, such as company shares and corporate bonds, which are readily bought and sold through secondary markets on a short-term basis.

Box 1: Overview of 'long term' asset classes[20]

The definition of what constitutes a long-term asset is very broad, in general comprising all asset classes that generate steady cash returns over periods ranging from 10 to up to 50 years.

Infrastructure: This category covers different sectors such as utilities, energy generation and distribution facilities, roads, bridges, airports, telecommunications, hospitals and schools. The infrastructure category is generally characterised by public rather than purely private uses and impacts that such assets can have, reflecting the high level of positive externalities they can create. For the purpose of portfolio allocation, infrastructure projects are usually divided in two distinct categories: (1) "greenfield projects", that is new infrastructure projects and (2) "brownfield projects" which represent more mature and already operational infrastructure. To lead an infrastructure project, consortiums or special purpose entities are created for the life of the project. Investors, such as investment funds, take participations in these entities. Participation in infrastructure projects can be achieved through different ways such as acquiring a participation in the form of equity or by granting different types of loans to the project. These investments are intrinsically long term because the life cycle of an infrastructure project lasts over many years or decades. Some brownfield investments may be open-ended in duration.

Asset managers already active in this area are heavily focused on utilities and transport infrastructure. Utilities are popular on account of their government-controlled revenues and infrastructure is seen as an attractive asset when the government guarantees a certain level of income (e.g., an airport where government guarantees a minimum concession income to the operator).

Another popular asset class are PFI-PPPs where the Government promises a certain guaranteed level of return (PFI stands for public financing initiatives).

New investment commitments to infrastructure via unlisted funds, for instance, have been estimated at about $60 billion (roughly €46 billion at current exchange rates) over the period of 2004 to 2013.[21]

SMEs and larger companies: Unlisted companies do not always have the size or structure needed to gain access to public financing, such as issuing shares on a listed market or issuing bonds. These companies often rely on private financing, provided for example through debt or equity participations, via private equity or venture capital funds or via fund-of-funds. Depending on the business cycle in which the company is operating (seed stage, start-up or more mature stage) investment characteristics change. Investment horizons are often around 10 years, reflecting the time needed for due diligence prior to investing, for launching development projects and for selling the participation at the end of the investment period, for instance by listing the company through a public offering.

Managers operating private equity or venture capital funds have considerable experience as active owners that, in addition to financial backing also exert a degree of governance and oversight as well as provide skills, management expertise and network for the underlying companies. Such managers invest either directly, or via funds-of-funds that enable larger institutional and long-term investors to access small venture capital funds backing smaller companies.

Around €500 billion has been raised between 2002 and 2011 in the private equity sector, while €45.5 billion was raised in 2012. (Source: EVCA annual yearbook). This compares to net inflows of €201 billion into UCITS funds (Source: EFAMA, Quarterly Statistical Release, No 52).

Property: This category represents investment in immovable property such as land, office buildings, private housing or social housing. These assets require high investments at the beginning which are reimbursed over an extended period of time, for instance through rental income. For this reason, they need long term investments to cope with their particular life cycle as well as with their illiquid nature.

Estimates of the size of the EU property fund market range between €120 billion and €300 billion.

Other assets: Other long term assets include the financing of certain goods, such as maritime financing and airplane financing. Due to the large amounts of capital required to buy ships or airplanes, companies often use external financing to avoid placing these assets on their balance sheets.

The size of this market is difficult to estimate due to the lack of data. Ship funds that are popular in Germany can be used as an example: they represent a size of around €50 billion. (Source: VGF Branchenzahlen 2012)

Box 2: Types of financial instruments used to gain exposure to long-term assets

Equity or quasi-equity participations: Investors acquire a share of the capital of the investment target. It can represent a share in an infrastructure project (in the consortium developing the project), a share in an unlisted company or a share in a company in charge of building properties. Shareholders are entitled to receive dividends from their equity participation. These need long term commitment because the shares are not listed on a liquid market. They can take hybrid forms that include debt elements.

Debt: Investors can provide debt facilities (bonds, project bonds or loans) to the target investments identified above. Loans are generally the instrument used for providing private debt facilities. They represent an essential part in the financing mix for companies. Usually provided by banks, loans can also be provided through other sources, such as funds. In contrast to bonds that are listed and transferable securities, loans are issued in private placements and do not benefit from liquid secondary markets. Again, investing in loans of this nature requires long term commitment, usually until the loan matures. Bonds are generally the preferred financing instruments of the companies that are large enough to have a direct access to the financial markets whereas loans are the preferred instruments of the companies that are too small, such as the SMEs, to obtain direct access to the financial markets. Bonds are subscribed by multiple buyers whereas loans are normally contracted between the borrower and the lender, being a bank or a fund, bilaterally.

Investments in long term assets can offer different risk and return profiles, depending on how the investment is structured. For example investments in infrastructure can be done indirectly, such as buying shares of investment funds or shares of companies involved in the sector, or in a direct way by acquiring a direct participation in a new or in a mature infrastructure project. Greenfield infrastructure is generally considered more risky than brownfield infrastructure (greenfield infrastructure entails constructions risk, risk of obtaining the requisite permits and changes in the regulatory environment). In general, long term assets offer access to relatively strong yields over their lifetime, following initial development phases. The yields are also backed by real assets.[22]

The absence of a clear regulatory definition has led market participants to define various different categories for such assets, with approaches also varying across national markets. The terminology used for long term assets is complex, contradictory and fragmented[23]. This, in turn, leads to a lack of comparability between investment propositions and a lack of transparency on essential characteristics of long-term investments, undermining investor trust and comprehension, and leading to mis-allocations of resources. The tables contained in Annex 2 reveal that each of the 9 countries that are referenced have several fund frameworks for offering access to the real estate assets or the private equity and venture capital assets. For example, only for investing in real estate assets Luxembourg has 5 different funds, France 4 and Germany 3. The proliferation of different fund frameworks make difficult for the investors to select the appropriate fund in their own Member State and almost impossible to select the appropriate fund framework across borders. This choice is even more difficult for the retail investors that lack the knowledge and resources to investigate the different legal frameworks in a language that is not necessarily customary to them.

Sub-driver 2: The liquidity profiles of long term assets are idiosyncratic: Long-term assets are mostly illiquid because they are not traded on secondary markets. The value of assets reflects the cash flows and residual capital values investors anticipate for a given holding period. Unlike liquid assets, their market values do not offer a ready and transparent short-term valuation, such that asset valuation is a key challenge for investors.

Not all forms of participation in long-term assets show the same level of illiquidity, for example equity participations in infrastructure projects tend to be the less liquid than loans provided to companies (where occasionally a secondary market might exist). Liquidity can correlate with the age of assets and transparency: assets that have clearly demonstrated a good income stream are generally more liquid than new assets with no track record.

Taking infrastructure as a case study, long term assets and the funds investing in them can be classified according to their liquidity profile (higher or lower), focus (on a few or many projects) and time lines on investments (very long term, or medium term).

|| >20 years || Between 10 and 20 years ||

High liquidity risk || New transport infrastructure Motorways, tramlines, airports || New property and utility infrastructure Hospitals, social housing, medical centres, waste treatment || Focus on a limited number of projects

Some liquidity || Operational infrastructure Participations in existing infrastructure (transport or communications infrastructure) || Infrastructure technology Tunnelling technologies, waste treatment || More diversification

High liquidity risk = Projects that are complex to administer, in terms of cost, cost overruns, budgets and deadlines. Some liquidity = stable returns

Source: Ernst & Young, submission on LTI

For all of these assets, even where a secondary market exists or there is some potential liquidity, it can still be difficult or impossible for an investor to divest themselves (at a price of their choice) of their commitment prior to maturity.

The illiquidity of assets forces investors to adopt a long-term investment strategy. Therefore, ‘closed-ended’ funds are the common vehicle to provide the tool for pooling investments into such assets. These funds do not buy and sell assets as investors enter or exit the fund, but are normally closed to redemptions for their entire life; they collectively manage the investments for investors and provide them with regular cash flows. Capital commitments are only reimbursed after a normally predetermined number of years. The fact that investors do not need to be given rights to redeem during the life of the fund permits the fund manager to invest in long-term assets that are illiquid.[24]

There is a risk that investors are misinformed about the lack of redemption rights at the level of the fund, or secondary markets made available for selling investments turn out to be themselves illiquid. Spreads in the secondary market would grow very wide. There is a risk also that distributors sell investments on the basis that the distributor themselves will provide liquidity (at a price) for those wishing to leave, yet the scale of those wishing to leave (on the basis of the promises of the distributor) leaves the distributor unable to support the requests. Another problem can be that the maturity of funds might, on occasion, need to be extended without investors having the option to disinvest.

Open-ended funds, which offer regular redemption options and which normally do not have a finite life, have sometimes been used in some cases for investing into long term assets. These funds tend to be popular in the property market. But with this kind of fund, there is a risk that the liquidity of the assets will be too low to support the redemption rights offered to investors on a regular basis. An open-ended fund may therefore need to suspend redemptions.[25] Investors are then forced to remain invested even where they formed the appropriate expectation – given the fund is open-ended -- that they would be able to redeem.

3.2. Problems

3.2.1. Inefficient market for pooled investments impedes access to finance

In the EU, banks represent the biggest provider of funding to the economy, marginally complemented by financing coming from other sources such as capital markets. According to recent data published by the Economist, US bank financing (as opposed to financing via the bond markets, and so by investment funds) represents under 30% of total financing as of 2011; for the UK and the Eurozone, the figures are about 70% and almost 90% respectively.[26]

There are 21 million SMEs in Europe, which represent the backbone of the EU economy, and which rely heavily on bank financing which is still by far the most relevant source of financing for them.[27] European banks hold €8 trillion of corporate debt on their balance-sheets (by comparison only €1.3 trillion of such debt is in the bond markets, which would be a conduit for investments via funds).[28]

A variety of factors, following on from and accelerated by the crisis, have deepened the focus of private financing on shorter-term commitments. According to stakeholders, many projects have not been able to raise financing suited to their time horizons, and have instead had to resort to short term financing structures (5 to 7 years maturity), solely covering construction and initial commissioning of the projects.

For example, infrastructure operators such as Veolia underline the lack of financing instruments which take into account the construction phase and its associated operational risks. Moreover they point out that there is no financing that appears adapted to the needs of small and medium-sized projects. For such projects, for instance environmental projects that commonly fall under €100 million, project bonds are too expensive to put in place.

This is in the context of a global listed infrastructure market (e.g. shares in utilities and transport companies) estimated at about $1 trillion (approx. €770 billion), with potential to reach $5 trillion (approx. €3.8 trillion) within 5 years. Estimates of funding gaps are potentially huge; a recent UK assessment put the national ‘gap’ (for private firms) at almost £200 billion (approx. €240 billion) by 2016.[29] The UK is a market that is already less dependent on bank financing than many markets in continental Europe.

Market participants expect a shift to other sources of funding. “The direction of travel in Europe is clear: the incremental replacement of banks by the capital markets,” says an analyst at Barclays.[30]However, the problems identified threaten the capacity of investment funds (pooling capital market investments) to fulfill their potential.

Weaknesses in the EU market for pooled investment vehicles cannot be addressed by other capital sources. According to Macquarie Renaissance Infrastructure Fund, the key ‘added value’ of the fund model is that it allows investors to support projects indirectly that would be impossible for them directly.[31] Without funds performing this intermediation role, capital market funding is unlikely to fulfil its potential.

Costs and burdens for those seeking to invest in long term assets therefore rise. Such costs include preparing information and data for potential investors, search costs related to finding potential investors, and structural costs in establishing corporate forms that are capable of attracting investment. The ability to perform important activities and functions are dependent on a wider range of counterparties. The under-developed nature of the LTI fund market also reduces the effectiveness of the LTI market more widely. Expertise is more dispersed or less visible, and therefore more costly. Service providers – legal, administrative, economic – are underdeveloped. Fund markets are key drivers for the development of other ancillary services, and the under-development of these has a deeper and wider effect.

3.2.2. Potential investors in long-term assets are currently deprived of an appropriate investment vehicle

Smaller institutional investors (typically smaller pension or retirement schemes, for example as may be set up by the liberal professions, certain smaller insurance undertakings, charities, foundations or municipalities) are neither able nor willing to invest in long-term asset classes directly.

Mid-size pension schemes with assets ranging from €100 million to €1.5 billion are often administered by a trustee or very small staff that lack the specific expertise to select appropriate long-term assets, assess their future revenue potential and analyse their downside in terms of risk (risk of completion, risk of change in the regulatory or public policy environment that governs the asset). On the other hand, the overall capital requirements for many long-term projects will be too great for even the largest of individual participants to bear in isolation. For mid-sized pension schemes or other investors managing investments of comparable volume the use of investment funds to pool smaller stakes and diversify investments across different projects is a precondition to investing in long term assets.

However, the absence of a single identifiable model for LTI funds across the EU undermines the visibility of such funds. This prevents the emergence of economies of scale in the LTI funding sector, and reduces their visibility in the market. In addition, costs are raised, reducing the broad attractiveness of these funds for smaller investors. National regimes can offer access to all sorts of assets, but these may have been designed for other more specific purposes, such that there are no pooling schemes dedicated to the range of long term assets as set out in this impact assessment.

For instance some institutional investors have highlighted gaps in the supply of national opportunities to invest, notably in relation to infrastructure funds. The absence of clear common criteria setting out the eligibility of investments in private equity, property or infrastructure represents an additional burden for institutional investors. In the absence of cost-effective LTI funds, institutional investors will have to arrange such investments directly. This is more costly, limiting up-take. Each investor will need to obtain in-house or buy in external expertise in the area of long term assets targeted, and undertake costly due diligence and on-going monitoring and support for these investments. Economies of scale are difficult to achieve, and benefits of diversification are either not available or entail additional costs or lower overall yields. This problem is particularly acute for pension funds and insurance companies, which are major users of investment funds. Funds backed by long term assets could be particularly attractive to such investors: long-term assets have the ability to create steady income streams backed by real economy assets that are well suited to matching the long term liabilities such investors face.

Box 3: Financial intermediaries are key in channelling investments into long-term asset classes

According to the ECB Monthly Bulletin of November 2011, the Euro area pension funds invest around 41% of their €1,420 billion of assets in investment funds whereas only 2.7% is directly invested in non-financial assets, which can be assimilated to the long term asset classes described above. Insurance undertakings invest 17.7% of their €5,664.7 billion of assets in investment funds whereas 2% is directly invested in non-financial assets. These figures show the importance of investment funds for institutional investors’ attempts to gain exposure to wider asset classes; direct investment in non-financial assets represents only a tiny proportion of their portfolios in comparison. Tackling the under-representation of long term investments within the investments funds that make up investment portfolios of institutional investors is a key lever.

Mis-selling of long-term assets could further undermine take-up of this asset class. This problem is particularly acute for retail investors who can lose confidence very rapidly, triggering runs, should investment expectations not materialize. This is despite the fact that the long-term assets can represent an interesting investment opportunity for retail investors as well. The usual low correlation of the long-term asset class with the traditional assets makes this investment attractive for diversifying the portfolio. For the retail investors seeking to invest for the long-term, they have traditionally the choice to invest in funds investing in stocks and bonds but with a long-term strategy, in long-term insurance products or simply in long-term cash deposits. Only in a few Member States do retail investors have the opportunity to gain access to long-term assets. As revealed in the box in the section 6.1.6, where the retail investors have access to funds offering exposure to long-term assets, they usually represent one of the largest investor categories. The cross-border dimension is, at this stage, not very developed. Most retail version of long-term investment funds are sold domestically under the investment laws of that specific Member State. This is mainly explained by the proliferation of fund frameworks in each Member State as described in sub-driver 1.

Even if this is difficult to assess the possible cross border retail dimension ex-ante, one could however estimate the possible cross-border dimension that could be reached by making a parallel with the UCITS framework where 20% of the assets under management result from cross-border marketing. This bulk of this cross-border flow, as with the earlier UCITS model, is expected to be constituted mostly of investors from jurisdictions that have currently no long-term investment fund framework in place. But retail investors that already benefit from national regimes might also be attracted by investment propositions linked to long-term assets of other Member States. In foreign assets, the foreign fund’s managers have a higher expertise than the domestic fund’s managers; therefore the cross-border access is essential. Contrary to stocks and bonds that tend to be highly correlated between Member States, the long-term assets are often link to local characteristics that render their return and risk profile unique. This could make foreign assets and thus foreign funds particularly attractive for diversification reasons.

For all the above reasons the long-term asset class, while seen as a valuable and important asset class, remains broadly inaccessible to smaller institutional and to retail investors. This is despite the fact that LTI funds, properly regulated and construed, may provide many advantages to investors: stable income and capital returns that have the potential together to beat inflation, and which are broadly uncorrelated with listed equity and securities traded on listed markets. For example:

· From 1990-2004 annualised real estate performance of 12.71% beat the S&P 500 (equity index) at 10.94% and the typical bond index at 7.70%.[32]

· For long term (20 year) venture capital funds in the US, annualised returns were 16.5%, long term (20 year) private equity funds had returns of 13.3%, compared to the S&P 500 at 11.2%.[33] In 2011, the French private equity sector achieved an annual performance of 8.5% over the last 10 years while the reference equity index achieved an annual return of 2.7%[34].

· Long term assets have lower volatility compared to equities: for instance, the annualised standard deviation in asset values (a measure of volatility) for real estate from 1990-2004 was 12.74%, compared to 14.65% for the S&P 500.[35]

· In general, infrastructure investments provide a good means for achieving higher returns than the base interest rate. In average, an investor that invests in an infrastructure fund can expect a return of around 2.75%/3.00% above the base interest rate.[36]

The positive aspects of an investment in long-term assets should also be assessed against the risks that they carry. As traditional investments in stocks and bonds, the risk to lose the entire capital is present. This is for example the case when a venture capital investment in a SME is valued at zero because that SME went bankrupt. What distinguishes the long-term assets to the other assets is their illiquidity risk. Contrary to stocks and bonds which can normally be easily sold, long-term assets do not benefit from liquid secondary markets and it often requires months or years to be able to sell such an asset.

3.2.3. Managers face barriers to activity, costs and reduced economies of scale

Differences in national rules and definitions of long term investment funds raise costs for the funds when they are marketed cross-border. AIFMD provides for a right to market to institutional investors, which will reduce costs associated with conforming to national rules for institutional funds. However, costs related to fragmentation of national markets remain. Fund managers may find it easier to access investors in different Member States by forming different funds in each target Member States, with attendant establishment costs. Funds will be smaller, and thereby proportionately more expensive to run.

Access to retail clients situated across borders requires the fund to adapt to national rules in the host member state, as there is no right to market cross-border as such (except on a reciprocal basis where a Member State permits such marketing nationally) to retail clients under the AIFMD. As there is no retail ‘fund passport’ as such there is therefore expected to be very little cross-border activity of this kind.

Box 4: Infrastructure funds in the EU operate on a small scale

A study by Preqin[37] compares unlisted debt fundraising for infrastructure by manager location. In 2012, 22 funds raised $14.4 billion in North America while only 12 funds raised $7.7 billion in Europe. The financial crisis has amplified the gap since fundraising in Europe for long-term assets has declined to the levels last seen in 2005.[38] This difference is also present in private equity funds: of the total number of funds currently seeking capital in the world, 23% are in Europe, 44% in the US and 32% in Asia and the rest of the world[39].

3.3. Consequences of the problems

Despite all the efforts that have been undertaken to create a single market in the area of asset management, the long-term asset sector will continue to be characterised by strong differences in national approach (as elaborated further in section 3.4).

UCITS funds and UCITS managers already benefit from the single market, as their funds can be marketed throughout the EU and managers can offer their services cross-border. For non-UCITS funds (28% of the sector) the AIFMD will create the same rights for the managers as those currently enjoyed by managers of UCITS. While an AIF manager will be able to market an AIF on a cross border basis from July 2013, there is however still no retail product passport for AIFs as such, and the AIFMD does not create common definitions or labels at the level of specific fund types. This directly impacts funds targeting long term assets.

In the absence of common LTI fund definition and hence a functioning single market for these funds, the contribution of the deeper pool of potential capital made available by the above mentioned investor groups across the single market would be forfeited. This would reduce funding available to LTI targets, such as schools, hospitals, transport infrastructure, but also the SME sector more widely.[40]

Available funding is likely to remain geographically restricted or localised: bigger, more developed Member States with strong financing models will predominate; peripheral or smaller economies could suffer continued restrictions, worsened further by restrictions on bank financing as well as lack of cross-border equity either because of the small size of local markets or because asset classes are not developed or attractive enough. This also impacts on the variety and thereby the resilience of funding. Larger, more developed member states have more varied and resilient models. Problems with investments into long term investment funds mean EU-wide pools of capital are more weakly mobilised, harming growth.

3.4. How would the problem evolve without EU action? The baseline scenario

If no action is taken to create a legislative framework applicable to long term assets, it is very likely that the problems that have been identified will persist.

The application of AIFMD from July 2013 can be expected to improve the marketing of a wide range of well-known AIF categories cross-border. The AIFMD establishes a basis for a single market for AIFs directed to professional investors – by harmonising operating conditions and other measures relating to AIFMs and providing a procedure for a passport for marketing AIFs by these AIFMs. However the AIFMD does not harmonise the definition and product rules for AIFs as such, as it is focused on the rules applying to the AIFMs. As a result, the single market created by the AIFMD can be expected to benefit those AIF models that are already well understood cross-border or where detailed national regimes have not yet developed. For instance hedge funds and certain well-established private equity models (leveraged buy-out funds) might be expected to be prime beneficiaries of an AIFMD passport. Those fund models where there is already fragmentation in detailed national rules can be expected to benefit less from the AIFMD, since this fragmentation is likely to persist.

Since there is no EU-wide consistency in defining funds targeting long term investments, and no clear consistency as to the essential features of long-term asset classes, the risk and return profile that a fund vehicle specialising in such assets should be targeting, long-term fund managers encounter difficulties in practice accessing non-domestic investors. These fund managers must, as noted, determine their funds according to the variant national fund models. Domestic investors usually know and trust their own national fund regimes and it cannot be assumed that they will readily invest in fund structures regulated under foreign rules and by foreign supervisors. Given the widely differing national fund frameworks that apply across the LTI fund area, as set out in the Annex, managers may be less inclined to market such funds cross-border, and managing such funds cross-border would raise costs for managers in familiarising themselves with varying national fund rules. Fragmentation would therefore likely persist.

Other measures that are shortly to come into force will also be unlikely to transform this picture. The EuVECA Regulation[41] will improve the functioning of the single market for Venture Capital funds. However, it is limited in scope to smaller fund managers and so is unlikely to be strong interest to those operating LTI funds that seek participations in large scale projects, such as infrastructure. In addition, the EuVECA Regulation is focused on providing risk capital (equity) to SMEs during their start-up phase, ruling out investments in other companies, real assets or projects that do not take a SME form, or support through other instruments such as loans.

Given this, even for institutional investors, current or shortly to apply rules can be expected to be insufficient to drive convergence in models and access to them. It is unlikely that the EU fund market will overcome its fragmentation in relation to LTI funds, particularly given a preference for many investors for highly-regulated (retail) funds, since non-UCITS highly-regulated funds are the most fragmented. Because of differences in national rules, costs for funds operating cross border are likely to remain significant under AIFMD.

Retail markets are likely to remain wholly national, given the discretion AIFMD provides for divergent national rules in this area, with little cross-border activity. This limits the potential for competition as LTI funds can be blocked from accessing retail investor bases in other Member States. Investors’ choice, especially retail, is also reduced with the consequence of mis-selling practices, inefficient portfolio allocations, increased risks and costs. Experience with UCITS and with the existing non-UCITS national frameworks suggests convergence between Member States to address these problems in the absence of action at the EU level would be unlikely. Given this, self-action by the industry would have little scope of success.

3.5. EU’s right to act and justification for acting

Legislative action on the policy options examined in this report is based on Article 114 of the TFEU. The legislative action to be examined would lay down uniform product rules on investment funds that are targeting long term assets. It aims at ensuring that such funds are subject to consistent rules across the EU and that they are identifiable as such by investors throughout the EU. At the same time it also aims at ensuring a level playing field between different long term investment fund managers. It aims therefore at establishing uniform conditions for the operation of such funds. This proposal therefore harmonises the operating conditions for all relevant players in the investment fund market, and for the benefit of all investors.

Different rules that vary according to the national regulation in this area create an un-level playing field, erecting additional barriers to a Single Market in financial services and products. Member States have already taken divergent and uncoordinated action to develop national fund regulation related to long term investment funds, and it is likely that this development will continue, even as the marketing and management passports contained in the AIFMD come into force. Divergences in such rules increase costs and uncertainties for fund managers, distributors, and investors, and represent an impediment to the further cross-border development of the market for long term investment funds. These divergences represent an obstacle to the establishment and smooth functioning of the Single Market. Consequently, the appropriate legal basis is Article 114 TFEU.

According to Article 4 TFEU, EU action for completing the internal market has to be appraised in the light of the subsidiarity principle set out in Article 5(3) TEU. Hence it must be assessed whether the objectives of the proposed action could not be achieved by the Member States alone in the framework of their national legal systems. The internal market for investments in long term assets by means of funds currently is fragmented due to divergent national regimes. This fragmentation raises costs, reduces economies of scale, and reduces innovation and access to investment opportunities.

Member State actions to widen funding sources and promote funds targeting long term assets have operated solely within the constraints of national markets. Different rules that vary according to the national regulation mean that funds in different national markets that target long term assets can be very divergent in their operating conditions and their permitted assets. For instance, in some national markets diversification of investments is required, while it is not in others. Or, the permitted investments can vary, between regimes designed for all kinds of assets, to those limited to certain kinds of innovative companies or infrastructure projects. These variations create an un-level playing field for fund managers depending on their location, and by fragmenting fund models along national lines erect additional barriers to a Single Market in financial services and products. Key drivers of fragmentation include the preference of investors for familiar or known investment propositions and costs associated with variations in marketing rules across different Member States.

Action by Member States alone cannot be expected to address such weaknesses in the EU market for long term assets and funds, even as the marketing and management passports contained in the AIFMD come into force. Actions by Member States alone can be expected indeed to deepen divergences, further undermining the efficiency of EU capital markets in providing long term investments.

The success of UCITS indicates the efficacy of action at the EU level in dismantling the barriers that have been erected by fragmented regulation. The launch of UCITS Directive in 1985 created a level playing field for UCITS funds and ensured effective and uniform protection for unit-holders. It shows the strongly positive impact of investor trust, rooted in the familiarity and trust that comes from uniformity of rules. The confidence that unit-holders, fund managers and investment targets derive from a single legislative framework and predictable investment conditions lay down a solid ground for a development of internal market for funds.

Consultation responses have shown a strong recognition of this factor and its possible impact by industry stakeholders. The vast majority stakeholders have endorsed the view that a market for retail investors in pan-European long term funds can be readily built on the condition that a common framework is put in place (see, e.g., Annex 6, question 1,2). By harmonizing the essential features that constitute an LTI fund the proposal aims at establishing a uniform framework in relation to the definition of such funds, clearly setting common rules on eligible investments, an area not addressed by the AIFMD which does not delimit the potential investments of AIFs.

As regards proportionality, proposals to be explored would seek to create a common product label for which there is a strong public interest and which would lay down a foundation for a common, competitive and cost efficient market for LTI funds in the EU. An appropriate combination of parameters suitable for longer horizon investments and specific investor groups can be designed by taking full account of safety and trust considerations relating to any LTI funds designation or label. Proposals would therefore not go beyond what is necessary to achieve a common legal framework for LTI funds. Action at the EU level would be more efficient than uncoordinated action at the national level. In sum, legislative action at the EU level is essential in fostering the growth of a pan-European market for the LTI funds. Definitive ptrogress cannot be achieved by the industry, nor by Member States actingalone. Therefore, it is necessary for the EU to intervene and facilitate the creation of an effective internal market for LTIFs where they can be easily marketed and accessible to all types of investors. The measures proposed to achieve that aim at complying with the principles of subsidiarity and proportionality.

4. Objectives

In light of the analysis of the risks and problems above, the general objectives are to:

(1) Improve the longer term financing of the European economy

(2) Remove the barriers in the single market

Reaching this general objective requires the attainment of the following more specific policy objectives:

(1) Enhance economies of scale for managers of LTI funds

(2) Increase the choice and protection for investors interested in LTI funds

(3) Increase investment flows into assets with long term horizons

The specific objectives listed above require the attainment of the following operational objectives:

(1) Increase the assets under management in the long-term asset sector, including cross border

(2) Reduce the number of mis-selling cases

Identified options have been selected on the basis of their capacity to address these operational objectives, and will be assessed in the light of the specific and general objectives outlined here.

5. Policy Options

5.1. Identification of options

Seven main options for addressing these objectives have been identified, from no action at EU level to the creation of a dedicated fund framework. Option 2 represents a “light touch” approach by introducing a label whereas option 3 builds on the existing framework. Options 4 to 7 entail the creation of a new European fund framework dedicated to long-term assets. Whereas options 4 and 5 consider the merits of opening the fund to professional or wealthy investors only, options 6 and 7 explore the opportunity to expand the investor base to include retail investors. The potential product rules are assessed against their general effectiveness but also against the chosen investor base, being professional only or including all investors.

Policy options || Summary of policy options

1 No action || Take no action at EU level.

2 LTI fund Label Use soft law to develop an LTI label, no passport || Achieve greater convergence in the definition and labelling of funds targeting long term assets. Soft law instruments could seek to achieve convergence in what long term assets are and a label for funds investing in such assets, subject to self-regulation, or policy guidance to be issued by ESMA. A Recommendation, for instance, could set the criteria attached to the definition of long term assets and the funds targeting them. ESMA could be mandated to compile a list of all assets that are considered to be of a long term nature. This could enhance the coherence of the LTI market by avoiding different marketing practices around these long term assets.

3 Long term assets in UCITS Allow UCITS some exposure to long term assets || Amend UCITS rules to allow investments into long term assets by allowing UCITS to invest up to a certain proportion of their portfolio into non-transferable securities that do not comply with the eligibility rules of the directive.[42] This option would entail that a proportion (e.g., 10%) of a UCITS portfolio could comprise financial instruments that are not transferable or where secondary markets are illiquid. A UCITS could gain direct exposure to long term assets, such as loans, participations in infrastructure projects, building infrastructure assets or shares of unlisted companies. A precise definition of each asset class that would be eligible would be provided together with criteria to identify and circumscribe these assets.[43]

4 LTI fund for institutional investors Establish a common framework for LTI AIFs || Under this option, a new fund, the LTI fund, would be created with a distinct set of portfolio rules relating to the classes of long term assets that are eligible for investments by the new "LTIF AIFs". Based on the model that exists in the UCITS Directive, the eligibility rules would cover non-transferable instruments such as participations in infrastructure projects, property or in non-listed companies. The key criterion for eligibility would be that the instruments finance long term projects as identified above (Box 1). Definitions will also be provided for identifying what are the eligible instruments for investing in SMEs and larger companies, in properties and in other long-term assets. The target investors would be defined through the existing framework of the AIFMD, and therefore will be institutional investors. To match the long-term nature of the assets with the commitment of the fund investors, there would be no redemption rights.

5 LTI fund for institutional investors and HNWI Establish a common framework for LTI AIFs and introduce an entry ticket || The same as option 4, but the LTI funds would be open to an additional layer of investors, the so-called "high net worth individuals" (HNWI). Through the introduction of a minimum entry ticket set at €100,000 HNWI will have direct access to the LTI fund.

6 LTI fund retail passport with no redemptions Establish common product rules and designation for LTI, and permit marketing to retail investors with no redemption rights || The LTI funds would be open to all investors, including retail investors. This would entail stronger investor protection requirements. As compared with options 4 and 5, the retail focus would require greater use of risk mitigation techniques. To match the long-term nature of the assets, there would be no redemption rights. Transparency requirements would be enhanced to reflect the needs of retail investors, for example by introducing extensive cost disclosures..

7 LTI fund retail passport with redemptions Establish common product rules and designation for LTI, and permit marketing to retail investors with redemption rights || The same as option 6, but including regular redemption rights, after an initial lock-in, for example for three years.

Important caveat: Compliance with all product rules set out in Options 3 to 7 would be mandatory for a fund manager seeking to market a fund under the LTIF designation.

6. Analysis of impacts

This section analyses the advantages and disadvantages of the different policy options, measured against the criteria of their effectiveness in achieving the operational objectives (developing a common label, and tackling barriers to the single market) and thereby the specific objectives identified, and their efficiency in terms of achieving these objectives for a given level of resources or at lowest cost. Impacts on relevant stakeholders and their views (see the text boxes) are also considered. The policy options to be retained should score the highest for each related specific objective while at the same time should impose the lowest costs and least adverse impacts on stakeholders.

6.1. Analysis of options

6.1.1. Option 1: take no action at EU level

Under this option, investors would benefit from funds subject to UCITS and AIFMD rules, but would not be able to easily identify long term assets or diversified LTI portfolios in these funds.

Impact on investors: The requirement that UCITS invest in transferable securities does not mean that investment objectives under UCITS cannot be orientated towards the long term. However investors in UCITS would be restricted to ‘buy and hold’ strategies, developed by means of investments into transferable securities. This would exclude investments into any of the long term asset classes set out in Box 1 of this impact assessment.

Access for investors to such asset classes could potentially be achieved by means of AIFs. As set out above, fragmentation in the market for different AIFs offering access to long term assets would mean that the identification of true long-term asset AIFs would remain difficult, and the market in them would likely continue to be bounded by national rules. Many investors would thereby not have ready access to identifiable and cost-effective AIFs targeting long term assets.

In addition, with the AIFMD, retail investors would not be able to readily make such investments across borders and the retail investors that would have the possibility to make such investments domestically would continue to face inadequate levels of protection in certain cases. The situation would actually vary depending on where an investor lives

Impact on managers: Neither UCITS nor AIFs would tap the full potential of funds targeting long term assets. Because UCITS principally invest in bonds and stocks, the long term potential of non-transferable instruments is out of their scope. The AIF market would remain fragmented with no clear fund type focused on long term assets per se.

Impact on long term financing: Fragmentation along national lines would continue to act as a barrier to the emergence of a strong single market in LTI funds. A lack of a common approach on product rules for funds (relating to such areas as redemptions, transparency, and asset valuations) would undermine confidence in funds offering long term assets on a cross-border basis. This wold prevent this vehicles form operating beneath their efficient scale and, in turn, would not alleviate the present financing gap felt by many long term projects.

In short, without action at the EU level the focus of investors will likely remain on very liquid and transferable securities. The AIF market is too fragmented or limited to allow efficient access to a diversified portfolio of non-transferable instruments that require long term commitments. The sectors of the economy that rely on that source of funding will continue to have disadvantages in comparison to the entities that can issue stocks and bonds on liquid markets. The financing of large projects will remain strongly dependent on bank funding or tax payer funding.

Some stakeholders advocate this option.[44] They highlight that equities and bonds are very simple products that have a long history as ways of funding the long-term needs of the real economy. They are concerned that the creation of another kind of “packaged” investment product available for investors is not as efficient. They believe that options aimed at increasing the long-term engagement of shareholders are simpler and might well serve the same purpose.

6.1.2. Option 2: Use soft law to develop an LTI fund label

Impact on investors: This option would increase convergence in the definition of funds targeting long term assets but as with option 1, it would not be able to address limits on access to the funds in Member States where retail marketing is not permitted. For retail investors, this option would therefore be broadly equivalent to the situation under option 1. Institutional investors who can buy funds more easily on a cross border basis might however receive some benefits from a harmonized LTI definition. They would more easily recognize the different fund profile and could gain confidence in what they are buying. However, a lack of binding common rules could serve to undermine this confidence for some, while others might be overly confident, assuming binding common rules where this is not the case.

Impact long term financing: The effectiveness of soft-law instruments may be limited for the AIF market, since the fragmentation of this market reflects differences in national laws which a soft-law intervention would not be able to tackle unless Member States chose to change their national rules and align them with the emerging label. Experience in the fund sector has been that such changes are more patchy and difficult to coordinate if left solely to Member States, and the legal certainty and simplicity of implementation of a common approach is preferred by many Member States and fund managers.

In the absence of convergence by Member States it is unlikely that such an intervention would be able to address fragmentation effectively. This also reflects experience in the area of Venture Capital funds, where soft-law interventions have failed consistently to address market fragmentation.[45] Should the market fragmentation persist at current levels, it is also doubtful that economies of scale would be generated to increase the financing of long term projects. The EU will continue to operate below their efficiency levels compared to their US counterparts.

Impact on managers: In principle a soft-law intervention would be relatively low in costs for participants – mostly creating administrative costs for Member State authorities and some fund managers in considering and responding to the Recommendation. However, it would allow great flexibility on whether or how far a new convergent LTI fund label would be developed, allowing for more market led developments. A likely lack of consistency in approach could however be relatively inefficient for fund managers, leaving divergences in approach between Member States in place.

This option has not been directly tested with stakeholders. However in the responses to the consultation, there is a strong preference for the use of legislative tools rather than soft law, either in the form of amendments to the existing EU law or through a new standalone rule book governing the portfolio of LTI funds.

6.1.3. Option 3: Long term assets permitted within UCITS

Impact on long term financing: This option would allow the €6.3 trillion UCITS market to contribute to funding LTI projects. For example, allowing 10% or 15% of this market to be invested in these assets represents a potential of about €600-900 billion. Because the UCITS framework has created an accepted norm allowing cross border marketing of funds, the problem of market fragmentation would not arise. These two elements would represent a major boost for the use of LTI by investors and thus for the financing of the real economy.

Impact on investors: This option would allow retail investors who have an appetite for longer-term investments to gain exposure to this asset class by investing in regulated UCITS funds that seek exposure to this asset class. Such an approach might also be attractive for institutional investors, many of whom may have a limited capacity to undertake due diligence on LTI or indeed AIFs more widely themselves, such that a well-known and well-understood framework as UCITS would naturally be preferred over other, less clear and less harmonised frameworks. This option has also the advantage of relying on the strong investor protection standards that are contained in UCITS, which would reduce the possibilities of mis-selling practices.

Impact on managers: Illiquid long term assets would conflict with the fundamental principle that UCITS are invested in transferable securities, and the requirement that investments in UCITS can be redeemed on demand by investors.

According to article 84 of the directive, “a UCITS shall repurchase or redeem its units at the request of any unit-holder”. This provision is a core element of UCITS funds because it gives investors the certainty that their investments can be redeemed on demand. Even a holding of 10% of illiquid assets could potentially put in peril this regular redemption opportunity. LTI have life cycles that often exceed ten years and it is rarely possible to dispose of these assets before their maturity. Unlike transferable securities, there is often no secondary market for investment tools used to gain access to long term assets (cf. Box 2 of this impact assessment). It is hard to conceive of a fund guaranteeing daily redemptions assuming the risk of holding assets that cannot be sold for ten years. Even a 10% limit may drastically reduce the liquidity profile of a fund. It may impede its whole investment strategy and limit its diversification opportunities.

Example

A fund has assets under management amounting to €100 million, €10 million of which (10%) are invested in illiquid non-transferable securities. An investor representing 20% of the fund wants to redeem. The fund has to sell €20 million of liquid assets as it cannot sell any of the €10 million invested in illiquid assets. The fund then has assets worth 80 million but with €10 million still invested in non-transferable assets which would then account for 12.5% of the portfolio, thus exceeding the 10% maximum. Rebalancing to the permissible 10% ratio can only be achieved if new investors subscribe as the illiquid assets cannot be sold.

As the example shows, as the assets under management in a fund decrease, the proportion of assets that are non-transferable will increase.

Making investments into long term assets and monitoring and supporting these investments also requires a different skill base and expertise than the other investments of UCITS. This could raise costs or reduce uptake of such possibilities by UCITS funds.

In addition, the marketing of UCITS invested in non-transferable securities, and sold as such, could well confuse investors, given the broad market acceptance of UCITS. Such an option would require changing the name of UCITS since Undertakings for Collective Investments in Transferable Securities would no longer be valid. There is an important risk to irreversibly damage the UCITS brand and its acceptance by investors. The UCITS brand as an export product could also suffer from this strategic change.

These concerns are strong enough that a majority of respondents – fund managers, supervisors, investor’s representatives – to the Commission consultation were against the use of UCITS as a vehicle for LTI funds.[46] Earlier consultation on social investment funds was consistent with this; with views diverging on how far UCITS could technically be adjusted invest in assets that are not transferable securities, and whether this was sensible.[47]

Regarding investments in non-eligible assets by a UCITS, respondents to the consultation were mainly opposed to UCITS funds being allowed to invest in EuSEF: 61% opposed this possibility, arguing that such investments by means of a bespoke LTI fund would be more suitable.

6.1.4. Option 4: LTI fund for institutional investors

Impact on long term financing: Eligibility rules would clarify that the LTI fund would have to acquire long term assets directly from the issuing entity or take direct participations in projects. This would significantly enhance the engagement of the asset manager with the operator of the investee project, and clearly target financing to those entities or projects that have not already gained access to capital markets. There are several positive benefits for long-term investing in stipulating direct investments:

1. Direct financing reduces costs associated with intermediaries.

2. Indirect exposure entails the risk that the LTI fund is not entirely exposed to the long term asset but to other risks, such as counterparty or market risks.

3. Direct exposure requires managers to acquire sufficient knowledge of the different assets in which they are investing. This would clearly add value for investors who themselves are not able to acquire such knowledge.

Long term financing would also stand to benefit from clarity on what constitutes a long term assets and what financial instruments are eligible to gain exposure to such assets.

1. Clarity on long term asset classes: The eligibility rules would also clearly set out the asset classes that are permitted, such as infrastructure (energy, transport, communications), and social infrastructure such as hospitals; and unlisted SMEs. Commodity investments would not be permitted.

2. Clarity on eligible instruments to gain exposure to long-term assets: A clearly defined LTI fund would be achieved by means of precise rules concerning the investment instruments to be used by LTI funds: direct equity or quasi-equity participations, bonds and loan agreements. For example an LTI fund could hold a share in a consortium building a school, a share in a Special Purpose Vehicle in charge of a concession contract covering prisons building and maintenance, another share in an entity promoting and building apartments, with the remainder of the portfolio distributed in the form of loans to companies.[48] Financing to the real economy could thus be improved.

Long-term financing is enhanced because a LTI fund manager would need to act as a knowledgeable intermediary capable of screening appropriate projects, undertaking risk/return analysis and due diligence, and effecting and monitoring investments in a cost effective way. Even the larger pension plans only have a staff of one or two dedicated to managing the investment portfolio, and so would be unable to undertake this work directly. On the other hand, diversification requirements along the lines of UCITS, which require a minimum of 16 assets, would appear too restrictive.

A uniform set of asset eligibility and product rules at EU level could enhance the awareness and trust of investors in these asset classes and thus increase money flows in this sector. This would help drive cross border marketing of such funds, ensuring investors across Europe would be able to find funds they have confidence in. Cross border marketing and cross border fundraising will create economies of scale that reduce the costs of investing in long term assets and at the same time increase the available money to invest.

Impact on managers: The creation of a cross border fund framework will facilitate the operations of fund managers across Europe. Greater consistency in requirements reduces costs for those operating cross border, while enhancing options for those looking to expand in this way. Economies of scale would develop as the funds increase in size or number.

In order to ensure LTI funds can offer a range of strategies and mitigate risks associated with their investments, fund managers would have the option – but not the obligation – to invest to a limited degree in assets that are not long term. Investments in transferable securities, such as stocks, bonds or short term money market instruments, would be permitted, as long as such investments do not exceed a pre-defined maximum threshold of, for example 30% (balancing flexibility with the requisite focus on long-term assets). Such shorter term investments could provide a 'bridge' for the fund whilst the manager identifies new investments. A 70/30 split between long-term assets and transferable securities would give greater confidence that the LTI fund manager can enhance its overall ability to pursue an effective strategy dedicated to funding long term projects. This could widen the range of investors the funds target.

The responses to the questionnaire highlight the need for some flexibility for acquiring short-term assets, as a portfolio management tool. Stakeholders propose different thresholds for this, mainly between 5% and 30%. Therefore the proposed threshold of 30% coincides with the expectations of market participants: it sets the upper limit at 30% to ensure the greatest degree of flexibility (fund managers are free to invest more than 70% in illiquid assets, should they decide to do so).

Impact on investors: With this option the target investor base is potentially very wide – notable both larger investors and the underdeveloped group of medium-sized institutional investors, such as smaller pension funds, insurance undertakings, foundations or municipalities.

Pension funds or insurers might particularly seek investments that enable them to match their long term liability profile, thereby focussing on the cash flow projections of any investment. However, other institutional/professional investors may be more focussed on long-term capital growth. Also, some investors will prefer the cash flow (and risk-return profile) of an initial construction phase ("greenfield") while others would express a preference for subsequent phases ("brownfield"). Indeed, one pension fund (the Tesco Pension Fund) argues that a pension plan might actively choose to exit certain investments after the construction phase.

The impact of having access to trusted long term investment funds with known investment targets could be positive for the planning horizon of pension plans, offering new options alongside, for instance, low-yielding Government bonds. This could be particularly the case for those operating defined benefit (DB) pension schemes who have the ability to allocate appropriate parts of their portfolios to assets such as LTI funds. While some managers might focus their marketing efforts on very large pension schemes, such as those prevalent in the Netherlands, other fund managers have indicated that they would offer their product to smaller pension schemes administering assets of €500 million to €1 billion. A pension scheme operator (Tesco) suggests that a uniform long-term investment scheme would also be attractive to pension plans administering assets of between £100-500 million (approx. €120-600 million).

Not all of the above mentioned institutional investors have sufficient knowledge and expertise to assess the risks of the products they are acquiring. Nevertheless, for institutional investors that are more familiar with the different long-term asset classes, an LTI fund could be designed that will go beyond the minimum allocation of 70% to long-term asset classes. Three aspects need however to be addressed in order to create investor confidence: the fund’s type, transparency and the costs of the investments.

On the other hand, this option would not create additional rights for LTI funds to market themselves to ‘high net worth individuals’ or family offices, or more importantly to retail investors. The marketing of the LTI funds to retail investors would remain subject to national rules, and thereby fragmented and subject to different investor protection standards. This option would therefore be unlikely to widen access for retail investors, or tackle barriers to the single market in funds for such investors. Institutional investors that only wish to invest in funds that are subject to the highest levels of regulation (as found in retail products) would also not gain from this option. But this option has the advantage to bring clarity as to what is a long-term asset and what is a LTI fund so that investors are not any longer misled in what they acquire.

Impact on fund structures: The illiquidity of long-term assets makes them better suited for closed-ended funds types. Under this option the fund would remain closed to redemptions until the investments (equity, quasi-equity, bonds or loans) come to maturity. The length of the fund would be decided by the manager depending on the asset classes in which he is investing and the maturity profile of the instruments employed to gain exposure to these asset classes. Institutional investors are used to commit money for long period of times without early redemption possibilities and they are also able to identify the risks associated with long holding periods. These rules would ensure consistency for LTI funds so that they take a common identifiable form, to increase recognition and understanding of these funds by investors. This has also the advantage of avoiding open-ended funds being forced to suspend redemptions for an indeterminate period where there is an excess of redemption requests and assets become too illiquid, undermining trust in the funds. In addition, transparency rules need to be established, in particular to ensure ‘look through’ in terms of the assets in which the fund invests. It is important that investors know precisely what the fund is buying.

The investment of institutional investors is mostly performed through private placement regimes where the investor is in direct contact with the fund manager. As such it is easier for the investor to identify and ratify the costs of the funds since there is no distributor involved. It is however important that the fund manager discloses in a transparent and precise manner all the costs that have been incurred when launching the fund and will likely be incurred in the future. These may include acquisition costs for assets, the costs of external consulting, legal costs and any other costs that may be incurred. This will give a better insight to the investor for making its investment decision.

Feedback from institutional investors has shown that transparency on the actual asset exposures created by a fund is vital in aiding these investors with applying new risk-based prudential and solvency rules. Ensuring regular valuation of assets and regular communication to investors of the main risks of their investments were cited as examples of possible transparency requirements.

6.1.5. Option 5: LTI fund for institutional investors and HNWI

Impact on long-term financing: This option is similar to option 4, but follows the approach in the EuVECA and EuSEF fund frameworks. These extend the range of investors the funds can be marketed to. It would include affluent ‘retail’ investors who are able to commit to a minimum investment of €100,000. This follows a similar allowance in the Prospectus Directive relating to access to some public offers, and is a common approach for allowing limited retail exposure. This approach was adopted for those two fund frameworks because the funding from so-called ‘high net worth individuals’ (HNWI) and family offices had traditionally been key to the evolution of the venture capital and social investment markets. In both markets, the motivation of individual investors can be particularly important, and so restricting access to such ‘qualified’ retail investors could have strong impacts on the viabili