New opportunities for fund managers

German pension fund regulations are expected to ­allow more equity risk. EU insurance regulations have recently been reformed to incentivize funds to make more long-term equity investments. Both ­initiatives are expected to support increased portfolio ­allocations involving equity risk, particularly in the asset classes private equity and infrastructure. This will create new opportunities for fund managers to position themselves with corresponding strategies and suitable pro­ducts, e.g., the recently reformed European Long Term Investment Fund (ELTIF).

German pension funds

The rules governing portfolio allocations to equity and equity-like exposures by German pension funds (inclu­ding but not limited to infrastructure) are going to change. On 27 June 2024, the draft bill of the second law to strengthen company pension funds (called the 2nd Company Pension Strengthening Act) was sent by the German Ministry of Labor and the Ministry of Finance to relevant professional associations for consultation. The overarching political goal pursued by the draft bill is to strengthen the voluntary German corporate pension system, which augments the statutory pension system (the sustainability of which is being hotly debated). The draft bill is expected to enter the parliamentary process by the end of August this year.

The draft bill provides for more flexibility for pension fund managers to take equity risk in order to generate higher returns.

• Pension funds are statutorily obliged to diversify their investments in different ways, including across asset classes. Corresponding exposure limits (quotas) apply to individual asset classes. For instance, investment in private equity is limited to 15% of a pension fund’s regulated investable assets.
• The draft bill introduces a new quota for direct and indirect investments in infrastructure projects, which can account for up to 5% of a pension fund’s regulated investable assets. Importantly, these investments will not be counted towards any other quota and will be in addition to other risk capital (i.e., equity and ­equity-like) investments. This is despite the fact that under the current quota logic they would typically qualify as private equity or private debt, i.e., as equity and equity-like risk capital investments. The net effect will be to create more capacity e.g., in the private ­equity quota, as pension funds reallocate existing ­infrastructure investments from the private equity quota to the new infrastructure quota.
• In addition, the draft bill provides that the aggregate exposure limit for risk capital investments, encompassing investments in public and private equity, as well as other investments including private debt, will be ­increased from 35% to 40%.

Combined with the new infrastructure quota, the scope for German pension funds to take equity-type risk would increase by a whopping 10% of aggregate regulated assets under management.

EU insurance undertakings

In April 2024 EU legislative bodies agreed to amend the regulatory framework for EU domiciled insurers and ­reinsurers (called the Solvency II Directive) to incentivize equity investments by European insurers, particularly long-term equity investments in infrastructure.

European insurance undertakings are a largely ­homogenous investor group, subject to a single rule book for their investment activities (the Solvency II framework) and have about 8.8 trillion euros of assets under management as of Q4 2023, according to data published by the European Insurance and Occu­pational Pensions Authority (EIOPA).

Historically and up to the present, fixed-income assets have dominated their investment portfolios, currently accounting for almost two-thirds of their aggregate ­investment portfolios, despite the low or negative yields experienced. Portfolio composition has ­remained broadly stable, according to a paper published by the EIPOA in 2023, notwithstanding the ­introduction of the Solvency II framework in 2009 and its implementation in the EU Member States on ­1 January 2016. Listed and unlisted equity investments only account for about 15% of aggregate investment portfolios. This has been identified as a “sore point” by the EU Commission, which wants to incentivize ­equity investments by insurance undertakings.

Although the introduction of the Solvency II framework liberated European insurance undertakings from national rules limiting their investment activities, ­doing away with exposure limits and other statutory prescriptions on portfolio composition, it replaced them with a complex framework of solvency capital requirements (SCR), which have their own impacts on investment activities. One such impact has been to ­deter European insurers from making equity and ­equity-like investments.

Put very simply, Solvency II requires an insurance company to treat each investment as a risk asset and to reserve a specified amount of capital on its balance sheet against it (the SCR). The largest insurance ­undertakings use sophisticated internal risk models to determine the SCR, but most use what is known as the standard formula, which prescribes SCR for different types of investments and thereby determines how much balance sheet capital an insurer is obliged to ­reserve for each such investment. Unsurprisingly, ­investments that the EU legislator considers risky have a higher SCR than investments it considers less risky.

The SCR for unlisted equity investments (called type 2 equities) under the standard formula is 49% (ignoring symmetric adjustment corridors and other complexities), which put simply creates a commercially ­unattractive relationship between the expected return and the capital the insurance undertaking must ­reserve on its balance sheet against such investments.

Incentives were subsequently introduced to mobilize investments by insurance undertakings in specific ­infrastructure investments (generally benefitting from an SCR between 30 and 36%) as well as what are called long-term equity investments (LTEI) which are subject to a much more attractive SCR of 22%. Yet the ­attractive capital treatment of LTEI did not materially alter investment activity. In a 2021 paper EIOPA highlighted that only 17 (i.e., less than 4%) of the regulated insurance undertakings were using LTEI. The reason, it appears, is simple: The eligibility criteria for LTEI investments were impracticable. The LTEI eligibility rules have now been changed to address this.

Under the old rules, LTEI were required to (i) consist of equities listed in the EEA or unlisted equities of companies domiciled in the EEA, (ii) be assigned to cover a specific portfolio of insurance or reinsurance obligations and over their lifetime could not be used to cover losses arising from other activities of the insurer (ring-fencing), and (iii) ensure that according to their solvency and liquidity position the insurer is able to avoid forced sales of each LTEI for at least ten years. From a practical perspective, particularly the ring-fencing requirement and the ten-year period for no forced sales were difficult for insurers to adhere to.

The new LTEI rules address these practical issues to incentivize insurers to make LTEI. Going forward, the scope of eligible equities in particular has been broadened to include equities located in the OECD, no ring-fencing will be required for LTEI and the period in which no forced sales of equities must be ensured will be reduced from ten to five years.

The new LTEI rules are expected to be formally ­adopted in fall 2024. EU member states will then have two years to transpose the amendments into national law. The changes have generally been welcomed by the industry and are expected to promote wider adoption of LTEI by European insurance undertakings.

ELTIFs – European Long Term Investment Funds

A closely related development in the investment management space is the far-reaching upgrade of the ELTIF ­regime – a harmonized pan-European investment fund rulebook for private asset investment strategies designed to complement the hugely successful UCITS rulebook for funds investing in listed securities and the more recent AIFMD rulebook for private asset investment strategies. This (unlike the ELTIF regime) is restricted to funds ­distributed to professional investors.

ELTIFs are the European regulator’s vehicle of choice to mobilize capital from all investor groups to move into private asset investment strategies, including infrastructure in particular. This means that managers using ELTIFs to raise and manage investor capital for long-term private asset investment strategies will enjoy certain beneficial treatment over other fund types. Notably, the amended Solvency II Directive allows insurance undertakings ­investing in ELTIFs to assess the LTEI qualification ­requirements and the SCR at fund level, thereby doing away with the current “look-through approach”. This ­requires insurance undertakings to obtain asset level ­reporting from fund managers in a prescribed form in order to benefit from the (usually much lower) asset-level SCR. Considering the flexibility of the upgraded ELTIF regime and the additional portfolio allocations becoming available for infrastructure and equity investments following upcoming changes to German and European regulations described above, vehicles conforming with the ­ELTIF regime may well become the new benchmark structure for infrastructure and long term equity exposure of German pension funds and European insurance ­undertakings.

Outlook

The German and European regulatory initiatives for ­German pension funds and European insurance undertakings are expected to have a noticeable effect on their portfolio allocations involving equity risk, particularly in the asset classes private equity and infrastructure. Fund managers keen to position themselves optimally in this competitive market need to understand the regulatory constraints within which their key investor groups operate in order to capitalize on the opportunities that the regulatory reforms described above are now creating. In light of these opportunities the market buzz around the new ­ELTIF regime is unlikely to subside any time soon.