One person's trash is another person's treasure: ESMA's Final Report on the UCITS Eligible Assets Directive

The Report will be directly relevant to firms involved in managing the portfolios of EU UCITS funds and ELTIFs (as UCITS core investments are also permitted investments for ELTIFs).

However, as we explain below, the Report may also be of wider interest to other market participants, including alternative asset managers and other firms pursuing retailisation strategies in the EU.

The Report does not affect the separate post-Brexit UK regime for UK UCITS funds and references in this briefing to "UCITS funds" are therefore to EU UCITS funds only.

THE "TRASH BUCKET"

The UCITS Directive currently allows a UCITS fund to invest up to 10% of its assets in transferable securities (excluding collective investment schemes) or money market instruments that do not meet the standard detailed eligibility requirements. This 10% allowance is colloquially termed the "trash bucket". 

ESMA's proposal is that the scope of the trash bucket should be widened to include derivatives and investments in units or shares of open-ended EU alternative investment funds ("AIFs"), and open-ended AIFs in other countries where equivalence has been declared. There will be no requirement to "look through" to the underlying assets of the AIF or derivative contract. However, an AIF must still offer an equivalent UCITS standard of investor protection in respect of asset segregation, borrowing, lending and uncovered sales, and a derivative would still need to meet certain conditions, such as requirements relating to reliable valuation.

If enacted, this proposal will increase the ability of EU UCITS funds to invest in EU "retailisation" strategies by avoiding some of the more stringent criteria applicable to core UCITS assets which can sometimes disqualify such investments.

CORE INVESTMENTS

Outside of the trash bucket, there is a prescribed list of assets in which a UCITS fund may invest ("core investments"). This list includes, amongst other assets, separate categories for transferable securities and collective investment undertakings (all subject to various eligibility criteria).

Under ESMA's proposals:

• Units or shares in certain closed-ended AIFs will continue to be able to qualify as "transferable securities" for the purposes of the core investments list, but ESMA proposes to clarify that this can only be the case where (among other requirements) the units or shares in the AIF meet liquidity criteria, the AIF is itself investing in core investments (i.e. "look-through" will be required) and the AIF is subject to a 10% limit on investments in other collective investment undertakings. Today, certain EU Member States may have treated units or shares in listed AIFs holding underlying alternative assets as core investments, but ESMA's proposals would make it clear that this would not be permitted in future.
  
  
• The EAD would clarify that the existing core investments category for collective investment undertakings is only available in the context of open-ended AIFs and UCITS funds, and that such funds should only invest in core investments (i.e. "look-through" will be required). Managers which are currently relying on this category to gain exposure to alternative assets would, under ESMA's proposal, need to rely on the trash bucket instead. However, this would reduce the maximum permitted exposure to 10% of the UCITS fund's assets (i.e. the trash bucket allowance), rather than the 30% limit that currently applies to investments in non-UCITS funds. ESMA recommends that the European Commission should introduce appropriate transitional provisions to allow affected UCITS funds to restructure their portfolios to comply with the updated requirements.

In practice, the above proposals mean that a UCITS fund would still be unable to invest directly in private market funds which use the traditional limited partnership structure. As closed-ended funds investing in ineligible underlying assets, investments in those funds would be neither transferable securities under the core investments list, nor permitted investments within the trash bucket.

LOOK-THROUGH APPROACH

As well as the examples listed above, ESMA is proposing that the look-through approach should apply more generally in the context of core investments such as exchange traded notes, exchange traded commodities, "delta-one" instruments (i.e. an instrument which, although it does not represent a direct holding in the underlying, has a price which moves in line with the underlying on a one-to-one basis) and non-trash bucket derivatives. In summary, a transferable security or derivative held outside the trash bucket could not be backed by or linked to the performance of an asset that would not be a core investment if it were held directly by the fund.

NO FURTHER EXPANSION OF UCITS ELIGIBLE INVESTMENT CLASSES

In consultation feedback, ESMA was requested to enlarge the existing list of eligible assets for UCITS funds expressly to permit investments in new asset classes, including commodities, cryptoassets and catastrophe bonds (i.e. high-yield debt instruments where investors will lose the premium invested if a specified catastrophic event, such as a natural disaster, occurs). In the report, ESMA is not recommending any expansion of the permitted direct investment exposures for UCITS funds but indicates that this could form a new workstream in the future.

Nonetheless, the proposal to widen the scope of the "trash bucket" may in practice allow UCITS funds to gain new indirect exposures to these asset classes through derivatives or investments in open-ended AIFs which themselves invest in such assets.

OTHER ISSUES

There are a range of other recommendations in the Report, including:

•  Asset vs portfolio level liquidity assessments: ESMA is proposing to clarify that liquidity assessments will be required at both the individual asset and overall portfolio levels. ESMA suggests that for the asset level assessment, a minimum common list of criteria should be used (but no single criterion will be determinative).
  
  
• Ancillary liquid assets: ESMA has provided some further guidance on permitted "ancillary liquid assets", although it has refused to provide an exhaustive definition of what this term covers. ESMA has also refused to impose any particular limit on the level of ancillary liquid assets that a UCITS fund can hold, but states that such assets should correspond to a clearly identified liquidity need.
  
  
• Efficient portfolio management techniques: These techniques are used to reduce risk or cost or to generate additional returns for the UCITS fund. In practice, they typically include transactions such as securities lending and reverse repos. ESMA is proposing to delete the existing requirement that any collateral received in connection with reuse of the UCITS fund's assets must be received under a title transfer arrangement (and therefore collateral could in future be received on some other basis, such as under a pledge arrangement). However, ESMA also invites the Commission to look further at rules around fee-splitting between the manager and the UCITS fund in connection with these types of transactions.

In the Report, ESMA states that it will now be cooperating closely with the European Commission as the latter reviews the EAD. In due course, the Commission will confirm whether or not it has accepted ESMA's recommendations to amend the UCITS Directive and EAD and will bring forward any legislation to that effect, although there is no clear timescale for this. As both are directives, any changes must be implemented locally in each EU Member State. In the meantime, the existing EU UCITS requirements will continue to apply.

EU UCITS managers and delegated portfolio managers with responsibility for EU UCITS funds' portfolios should consider whether, if these proposals were adopted, this would require them to make any changes to their existing operations and/or might facilitate new investment approaches. Alternative asset managers may also wish to explore whether the proposed changes might open up the possibility of new investment from EU UCITS funds in the future.

The Report also comments on several possible future workstreams, including a suggestion that the European Commission may wish to explore further work on harmonising the EU regime for marketing AIFs to retail investors and/or to consider developing a new type of AIF to facilitate retail investors gaining greater exposure to alternative assets.

If you have any questions in relation to the above or would like to discuss any of the issues raised in this briefing in further detail, please get in touch with your usual Travers Smith contact or any of the individuals named below.