The FCA has, this week, published Discussion Paper DP17/1 on 'Illiquid assets and open-ended investment funds' which considers some of the risks created when consumers use open-ended investment funds to gain exposure to assets that may be difficult for the fund manager to buy, sell or value quickly.
What are the FCA's aims?
The FCA aims to gather evidence to decide whether more (or different) rules and guidance are needed to support market stability and protect consumers, without preventing them from having access to a diversified range of investment opportunities.
This is a tricky balancing act. On the one hand, the purpose of open-ended funds is to allow investors the opportunity quickly to liquidate their holdings if they need access to the value of their investments in cash. On the other, illiquid holdings such as land, buildings, infrastructure and unlisted securities offer investors the potential for strong investment returns in the medium to long term. Critical to the success of an investment policy that includes access to illiquid assets is how the manager will manage the liquidity mismatch between investor's rights in the ability to liquidate their holding in the fund and the manager's ability to liquidate its holdings in underlying assets of the fund in such a way as to not disadvantage the continuing investors in the fund.
What's the context?
On the morning of 24 June 2016, the people of the United Kingdom awoke to an uncertain future. While the result of the referendum on the UK's membership of the European Union was being announced, markets around the world reacted to the shock news – the pound fell against the dollar to the lowest point since the mid-1980s, the FTSE 250 fell by 14% and, shortly thereafter, both experienced a mini-revival.
The property market did not escape this volatility either with agents reporting a sharp drop in buyer interest in the face of a climate in which property prices had surged since the financial crisis but had started to slow in the months leading up to the referendum. Suddenly, property was more difficult to value and that caused issues for funds with significant property holdings, forcing a number of high profile asset managers to either suspend trading on their property funds or to apply asset valuation adjustments. This caused the FCA to enter the fray and began a period of close supervisory-based scrutiny of the affected asset managers, with some reporting at least daily discussions with the FCA to explain the rationale for suspension and to thrash out plans for lifting the suspensions.
Subsequently, the FCA published a guidance note on the use of liquidity management tools for exceptional market circumstances, which included the interesting suggestion that firms could look to lift the suspensions and give investors the opportunity to redeem at a revised valuation of the units in the fund which might reflect the price at which illiquid assets can be realised in a shorter than usual timeframe.
The latest discussion paper implies that some of the mechanisms employed in this context may not have worked as well as the FCA would have liked and so the FCA is now asking for stakeholders to provide information on:
- what problems exist where open-ended funds hold illiquid assets
- how well the current rules address those problems
- what further regulatory intervention might be needed.
However, if the rules are to be changed to make investment in illiquid assets by open-ended funds less appealing, a tension could be created with various initiatives for example:
- The government's National Infrastructure Delivery Plan, which has already identified and seeks to rectify the problems caused by a prolonged period of significant under-investment in public infrastructure.
- The government’s plans for local government pension schemes to bring their assets together into a small number of pools; these pools are apparently likely to allocate between 5% and 10% of their assets to infrastructure – an increase of around £10 billion across the schemes compared to current allocations.
- The European Long-Term Investment Fund (ELTIF), introduced at the end of 2015 and aimed at professional and certain retail investors, which can provide opportunities to gain exposure to a portfolio of fundamentally illiquid investments.
What is the FCA seeking input on?
Stakeholders are invited to tell the FCA the problems they think exist where open-ended funds hold illiquid assets, how well the current rules address those problems and what further regulatory intervention might be needed.
The discussion paper describes in detail the various pre- and post-event liquidity management tools available to fund managers including:
- portfolio diversification
- redemption charging
- investor analysis to predict behavioural patterns
- use of redemption notice periods
- anti-dilution measures
- in-specie redemption
- suspension of dealings.
The FCA also notes that fund managers are afforded a discretion in deciding which liquidity tools they might want to use and if and when to use them. So, to understand how that discretion is exercised, the FCA is looking for input from the industry on what factors affect the use of liquidity management tools.
Prior to receipt of such information, and as part of this discussion paper, the FCA has proposed certain improvements that could be made to the rules and guidance affecting the use of liquidity management tools. The FCA recognises that there are certain problems, risks and possible unintended consequences associated with some of the proposals. The FCA invites a debate on the issues. The proposals are too numerous to set out here but include:
- Guidance issued to managers to encourage different share classes to be issued to retail and professional investors in NURS products so that their respective money is not comingled and their respective interests can be balanced. This also includes a suggestion that managers will be encouraged to apply differential treatment to share classes to achieve a fair balance of the interests of investors in the fund as a whole.
- A proposal to change the rules around diversification of investors in a similar manner to the rules for property authorised investment funds (PAIFs) (which requires the AFM to prevent certain investors holding more than 10% of the fund).
- Strengthening the rules on portfolio diversification to set a cap on the proportion of the portfolio that could be held directly in illiquid assets, or a minimum amount to be held in uncommitted cash.
- Following similar rules currently being applied in the US in respect of liquidity 'buckets' so that fund portfolios are subject to either hard or soft limits on the proportion of assets that can be realised for cash within a specific timeframe.
- Imposing specific conditions where funds invest in units or shares of another fund when the underlying fund invests mainly in illiquid assets.
- Additional guidance by the FCA on when and how certain liquidity management tools might be used, or requiring managers to make provision in scheme documents for their potential use (some managers might have the power to use the tools but fail to use them; while others might not have the power provided for in scheme documents).
- Requiring other regulated persons in the value chain to change their procedures and processes to meet the fund manager’s needs (the manager might be unable to use certain liquidity management tools because other parties in the value chain cannot accommodate certain mechanisms).
- Requiring firms to take action, or not to take action (for reputational reasons, a manager might be reluctant to be the first one to implement a suspension even where they are aware of widespread problems).
- Enhanced or better-targeted investor communications to help investors understand the possible impact of fund liquidity problems on their own situation.
The FCA also asks whether stakeholders think more could or should be done to encourage market-led development of alternative redemption mechanisms (such as "matching" prospective sellers and buyers – to create a "secondary market" of sorts).
The FCA has recognised that many of the issues and suggestions set out in the discussion paper will interact with the ideas and remedies proposed in the asset management market study and to the extent that firms are proposing to respond to this discussion paper it would be helpful to bear that broader context in mind.
Responses to the paper are requested by 8 May with a response paper to be published "later in 2017".
We can advise on liquidity management and have been involved in broader industry discussions on the issues affecting property funds following the 'Brexit' referendum. If you would like to discuss your own approach to this topic please feel free to contact Tom Dunn or your usual Burges Salmon lawyer.