The FCA has published a consultation and feedback paper (CP18/27) on illiquid assets and open-ended funds. Taking into account findings from its February 2017 discussion paper on this topic (DP 17/1), the July 2017 outcomes of its analysis of the 2016 property fund suspensions and new IOSCO Recommendations (February 2018), the FCA has concluded that a major overhaul of the regulatory framework in this area is not needed. However, it considers that improvements should be made in the use of suspensions and other liquidity management tools, contingency planning, oversight arrangements and disclosure to retail clients.
The focus of the proposed changes is on the Non-UCITS Retail Scheme (NURS), ie those authorised open-ended funds available to the retail market and that can invest substantially in illiquid assets. The proposals are framed as lessons learnt following the Brexit vote in June 2016, when several NURSs were forced to suspend redemptions to deal with the high volume of requests, as investors worried about the outlook for UK real estate and simultaneously tried to withdraw their money at short notice. However, the proposals also impact authorised funds generally (the consultation considers whether or not some of the suggested remedies should also apply to Qualified Investor Schemes (QISs)), and will also be of interest to those working in the unregulated open-ended funds space where there is a potential knock-on effect.
The consultation is open until 25 January 2019. Final rules and guidance are expected next year, to take effect one year later (ie in 2020).
The overall aim is to increase retail investors’ understanding and confidence in authorised fund managers’ (AFMs) management of liquidity risk in open‑ended funds holding illiquid assets. For instance, greater clarity around suspensions should help stabilise liquidity risk, as there should be less incentive for some investors to gain a ‘first mover advantage’ by redeeming their units quickly under stressed market conditions. The FCA is not currently taking any steps to promote the development of a secondary market.
We broadly welcome the proposals, which constitute an evolution rather than a dramatic intervention, and acknowledge that under the existing regulatory environment, AFMs, by most accounts, have done the right thing to protect all their investors, averting a possible run on the funds by using the tools at their disposal, such as gating redemptions, applying fair value adjustment mechanisms and charging redemption levies. Given the potential for a prolonged period of uncertainty and turmoil around Brexit preparations and implementation, these new rules and guidance come at an important time.
Who is caught
A new definition of funds investing in inherently illiquid assets (FIIA) will apply, being a fund structured as a NURS that intends to invest at least 50% of its scheme property in inherently illiquid assets (or those that have infact invested at least 50% of the value of their scheme property in inherently illiquid assets for at least three continuous months in the last twelve months, whether or not they have disclosed their intention to do so). Illiquid assets include real assets (eg property and infrastructure), a transferable security that is not readily realisable, units in another FIIA or in a QIS or unregulated fund with similar features. For example, a FIIA will include both an investment in a specialist real asset fund that is unregulated or holding units in a PAIF. It is up to the AFM to identify and monitor their FIIA.
However, not caught within the FIIA definition are NURSs that invest in real estate or other immovables where the prospectus and constitutional instrument provide for limited redemption arrangements appropriate to its aims and objectives. Such funds must provide for redemptions at least once every six months. FIIA will exclude these funds (along with funds being wound up) on the basis that their less frequent dealing means that they are less exposed to liquidity risk. We would note therefore that pure property funds structured as NURSs are likely to be excluded from the ambit of the FIIA regime (albeit the mandatory suspension rule summarised below will still apply).
Overview of the proposed changes
The changes being consulted on fall under three broad areas, which we have set out below, along with our comments.
1. Suspension of dealing in units in cases of material uncertainty of at least 20% of the scheme property
A new rule that an AFM of a NURS holding immovables such as property (whether or not it is a FIIA) must suspend the issue, cancellation, sale and redemption of units when there is ‘material uncertainty’ about the valuation of at least 20% of the scheme property. Material uncertainty is based on the RICS Red Book definition - where the degree of uncertainty in a valuation falls outside any parameters that might normally be expected and accepted. This is a departure from the current rules, which allow the AFM to continue to deal units having consulted and agreed with the independent valuer a fair and reasonable value for the asset.
This rule extends to NURSs that have at least 20% of the value of their scheme property invested in one or more underlying funds which have suspended trading due to ‘material uncertainty’. The FCA states that this ensures fairer treatment of investors, as otherwise the non-redeemers in the feeder fund could inadvertently end up with increased illiquid asset exposure in the underlying portfolio.
The FCA intends to keep the existing test that allows a manager to suspend redemption of units (without the above 20% test needing to apply), where due to exceptional circumstances it is in the interest of all the unitholders. However, to allow for a faster response, the depositary’s prior approval is not needed, although it must be informed of the temporary suspension and consulted on when the circumstances no longer apply and the suspension is to be lifted.
2. Improving the quality of liquidity risk management
AFMs have been criticized in recent findings for their lack of adequate plans, policies and procedures for valuing property portfolios under stressed market conditions; for not adequately considering implications of their distribution modelling in their liquidity monitoring and management; and for lack of effective communication to platform providers and therefore ultimate end-customers. The FCA seeks to redress this by requiring AFMs of FIIAs to produce contingency plans for dealing with liquidity risks. The proposed revisions to the COLL sourcebook set out the specifics, including details on how an AFM will respond to a liquidity risk crystallising; the range of liquidity tools and arrangements which it may deploy in such exceptional circumstances (along with operational challenges and consequences for investors of using such tools) and how it will work with the depositary and other third parties to implement contingency plans.
Another criticism has been levelled at depositaries not fully considering how to fulfil their responsibilities under stressed market conditions. As a result, depositaries of FIIAs will have an increased function in overseeing processes and systems to manage liquidity. This is likely to increase the depositary fees, hence fund costs, even though in some cases the depositary is likely to already be fulfilling this function.
Another proposal brings to an end the practice of using cash buffers for long periods in order to meet high levels of redemption requests: as well as often being contrary to investor expectations (causing a drag on yield and diminished performance), the FCA states that this can also risk unsuitable outcomes where well‑informed investors may be tempted to redeem their holdings early, in the event of market turbulence, before the fund manager is likely to consider suspension.
An AFM can anticipate selling assets quickly to meet demand for redemptions, provided its intentions are disclosed in the prospectus.
3. Increased disclosure for FIIAs
The consultation includes a package of measures around increased disclosure for funds investing in inherently illiquid assets. This includes a mandatory identifier/signpost in the name of the fund, a standard risk warning in financial promotions to retail clients and fuller disclosure of liquidity risk and its management in the prospectus (for instance the tools the AFM will use and the potential impact of anti‑dilution mechanisms on investors).
Given the capacity for retail investors to misunderstand the nature and scale of anti-dilution mechanisms, the FCA outlines further ways to improve disclosures, by explaining dilution mechanisms on its homepages or through platforms. The FCA considers this reflects good practice in meeting the FCA Principle of Business that firms must pay due regard to the information needs of clients and communicate in a way which is clear, fair and not misleading.