In recent weeks we have seen a number of UK authorised open-ended real estate funds take steps to re-price and/or suspend trading in units in their funds in response to higher than normal levels of redemption requests from investors. The ‘authorised’ funds affected are those made available to retail investors (among other categories of investor). Today’s market can be distinguished from 2008, with greater levels of cash retained in open-ended real estate funds, lower fund leverage and better capitalisation of UK banks. However, an ebbing of confidence in the wake of the Brexit vote and resulting political instability is not surprising and has contributed to retail investors taking the decision to liquidate their investments.
Despite the inherent liquidity risk in UK authorised open-ended real estate funds, the toolkit available to fund managers means that they are not necessarily being forced to sell real estate too hastily. The regulatory framework means that fund managers do have options to protect continuing investors and provide liquidity in the fund at prices reflecting changing market conditions.
In this briefing we look at (i) the different types of authorised funds available for investment in real estate; (ii) the regulatory status and various regulatory categories that apply to such funds; and (iii) the regulatory framework applicable to redemptions, suspensions and pricing adjustments.
Under UK regulation, there is a distinction between ‘authorised’ and ‘unregulated’ funds. An authorised fund is one where the fund vehicle has itself been approved by the UK Financial Conduct Authority (FCA). For other types of funds, even though the fund manager and the depositary are likely to be authorised and regulated by the FCA (or an equivalent EEA regulator) the fund itself is not subject to authorisation. This note is concerned only with authorised funds.
There are three types of open-ended fund structures that may be formed in the UK, and which may be authorised by the FCA for sale to the public:
- Incorporated funds, known as Investment Companies with Variable Capital (ICVCs) or, more commonly, Open-Ended Investment Companies (OEICs). These are formed as body corporates, governed by OEIC regulations and are usually operated by an FCA-authorised corporate director.
- Authorised Unit Trusts (AUTs). An AUT does not have separate legal personality; the scheme property is held by the trustee on trust for the investors. Both the trustee and manager are subject to FCA regulation.
- Authorised Contractual Schemes (ACSs, also known as Tax Transparent Funds). These can be in one of two forms (neither of which has legal personality). An ACS is a type of contractual scheme, based either on a co-ownership model or structured as an authorised limited partnership. This is a recently-created structure and is not yet in widespread use in the UK for real estate funds.
The majority (if not all) of the real estate funds currently affected by high level of redemption requests are OEICs or AUTs.
The operation of UK authorised funds is governed by comprehensive regulation. The fund itself and/or its operation:
- is regulated by the FCA;
- must adhere to the detailed regulatory requirements in the FCA’s Collective Investment Schemes Sourcebook (known as COLL);
- will ordinarily also be subject to the requirements of the EU Alternative Investment Fund Managers Directive 2011/61/EU (AIFMD); and
- must follow the FCA principles for business, such as an obligation on the fund manager to treat customers fairly.
In addition, the fund will be governed by a prospectus and the constitutional documents of the fund (the nature of which will depend on the form of the fund itself).
A fundamental feature of investor protection for authorised funds is the segregation of duties between the manager and the depositary; where the manager/operator and the trustee/ depositary must be both be EEA-authorised persons and be independent of each other.
The authorised status of a fund comprises one of three different regulatory types, as follows:
- Undertakings for Collective Investments in Transferable Securities (UCITS) subject to the provisions of the EU UCITS Directive. UCITS cannot invest in real estate, so this type of authorised fund is not considered further for the purposes of this note.
- Non-UCITS Retail Scheme (NURS). A NURS can invest in real estate and unregulated schemes, but subject to some limitations. For instance, no more than 15% in value of the scheme property may consist of any one property (this may increase to 25% once the property has been included in the scheme property, provided it fell within the 15% limit when obtained); and not more than 20% in value of the scheme property is to consist of mortgaged properties. A NURS also has a borrowing limit of 10%.
- Qualified Investor Scheme (QIS). A QIS can invest in a range of permitted investments, including real estate. There are provisos to investing in unregulated funds, for example, a QIS is prohibited from having more than 15% of its value invested in other funds. A QIS can only be promoted to persons in the UK who fall within the gateways in the FCA Conduct of Business Sourcebook (for example, professional clients). A QIS has a 100% borrowing limit.
The regulatory ‘category’ under which a fund operates depends on the fund’s intended strategy and investor base. Broadly, institutional investors prefer a QIS (the least regulated form) and the retail market will invest via the form of a NURS.
Redemptions, suspensions and deferrals – the regulatory framework
As the majority (if not all) of the real estate funds currently affected by high levels of redemption requests are NURSs, this section focuses on the redemption, suspension and pricing adjustment rules applicable to authorised funds established as NURSs (although the QIS provisions are similar).
When exercising these powers, the manager will still have to comply with its general obligations under AIFMD, for instance, to act honestly, with due skill, care and diligence and fairly in conducting their activities, and to treat all investors fairly.
Limited redemptions arrangements
For a NURS that invests in real estate, the prospectus and constitutional instrument may provide for limited redemption arrangements appropriate to its aims and objectives. In this case the fund must provide for redemptions at least once every six months.
Deferred redemptions may also be permitted, where the fund has at least one valuation point on each business day and the requested redemptions exceed 10%, or some other reasonable proportion disclosed in the prospectus, of the authorised fund's value.
Suspension of redemptions
In exceptional circumstances and where it is in the interests of all the unitholders, the fund manager in an authorised fund that is a NURS may (and must if the depositary so requires it) temporarily suspend the issue, cancellation, sale and redemption of units. ‘Exceptional circumstances’ may be set out in a fund’s prospectus, including for example where an accurate valuation of the fund cannot occur during a political, economic, military or other emergency. Any suspension has to be reported to the FCA and can only continue for as long as it is justified having regard to the interests of the unitholders. In any event, the fund manager must keep the unitholders informed about the suspension and its likely duration and together with the depositary must formally review the suspension at least every 28 days and inform the FCA of the results of this review and any change to the reasons for suspension. Some of the key regulatory tenets are further developed in industry guidelines and best practice recommendations, for instance AREF guidance requires funds to carry out two-way, formal communication at least quarterly and more frequently at times of high subscription and redemption activity.
As far as practicable in light of the suspension, the manager must continue to comply with FCA rules on pricing and valuation during the suspension. As long as they remain invested, investors should therefore receive all income streams from the fund’s portfolio.
‘Fair value’ adjustments, dilution levies and adjustments – the regulatory framework
The regulatory framework allow funds to use other methods applicable to redemptions, suspensions and pricing adjustments, to ensure investors are treated fairly. These are summarised below.
- Fair value adjustments. The regulations provide that where the authorised fund manager, the depositary or the standing independent valuer have reasonable grounds to believe that the most recent valuation of a real estate asset does not reflect the current value of that asset, the fund manager should consult and agree with the standing independent valuer a fair and reasonable value for the asset, which is then reflected in the unit pricing of the fund.
- Dilution levies and dilution adjustments. The regulations allow the fund manager to impose:
- a dilution levy, which is a charge of such amount or at such rate as is determined by the fund manager to be made for the purpose of reducing the effect of dilution as a result of dealings in the fund; and
- a dilution adjustment, which is an adjustment to the unit price for purpose of reducing dilution in the fund.
We have recently seen cases of funds adopting some of these corrective actions, in particular fair value and dilution adjustments, imposed to reflect the need to dispose of the fund’s real estate assets quickly in order to provide liquidity. This has been reflected in FCA guidance on fund suspensions published on 8 July which emphasises the need to treat all investors fairly.