In the wake of the Brexit vote, several asset managers have closed their UK property funds to redemptions – commonly known as imposing a ‘gate’. This highlights why pension funds and other investors should pay careful attention to the gating provisions in fund documents, both before entering into an investment and as part of the ongoing monitoring and review process.
What is a gate?
Open-ended investment funds normally contain provisions allowing the fund manager to suspend dealing in units of the fund during exceptional circumstances. These circumstances may include a period during which markets are closed or a period when it is otherwise impossible to determine the true price of assets held by the fund, and the fund documents usually contain a ‘catch-all’ provision allowing the manager to suspend dealing whenever it determines it is necessary to protect the interests of investors.
The effect of suspending dealing is that new investors cannot purchase units in the fund and existing investors are unable to redeem their investment, i.e. withdraw their money from the fund and invest elsewhere. The power to activate a gate came to many investors’ attention during the 2007-08 financial crisis, when many hedge funds and other funds sought to use gates to stem the tide of investors seeking to exit the funds.
Are gates necessary?
The recent spate of closures of UK property funds illustrate why ‘gates’ are needed in investment funds. The future for UK property could not be more uncertain: prices have fallen since the Brexit referendum and there is, as yet, no indication of whether the UK will join the EEA or EFTA, pull out of Europe altogether or even decide not to invoke Article 50 after all. In this economic environment, not even the boldest economic forecasters are professing certainty over the future prospects for the UK property market.
Should investors in UK property funds start to withdraw their monies at the present time, the property funds are likely to be forced to sell assets at a significantly reduced value in order to pay redemption proceeds. This will affect the value of the fund and can therefore reduce the value of all other investors’ investments. It is therefore reasonable for the investment funds, to protect the interests of remaining investors, to postpone dealing in the fund.
However, the downside of this, for investors who wish to cut their losses by selling their UK property holdings now, is that they are unable to do so. An investor who expects the market to fall further in the future may wish to sell their UK property portfolio but, if they are invested in one of the closed funds, this option is not available to them. They must retain their exposure to the sector until the fund manager decides that the time is right to re-open the fund.
In addition, almost all funds now contain gating provisions regardless of how liquid their assets are. Whilst a ‘fire sale’ of assets may be undesirable in property funds, the need for gates in liquidity funds is less obvious.
Investors may not always be aware of the existence of gates, particularly in funds such as UCITS funds which are marketed as being highly liquid, with daily dealing provisions in normal circumstances. The point that in a crisis situation, there is no liquidity at all, is often missed. The Financial Conduct Authority has therefore announced that it intends to review the role of gates in illiquid funds ‘both from the point of view of conduct and from the point of view of systemic stability.’
What lessons can investors learn from this?
Firstly, investors should always understand the gating provisions in fund documents and consider the possibility of gates being activated before deciding to invest in a comingled fund. If the investor wants to be able to sell assets during a crisis at the investor’s own pace, rather than the fund manager’s, it should consider investing directly rather than through a fund. This was the reason many investors moved to managed accounts for hedge funds after the 2007-08 financial crisis.
Secondly, it is important that the fund documents contain protections against the misuse of the investment manager’s power to close a fund to redemptions. Since management fees are almost always calculated as a percentage of assets under management, the fund manager has an obvious conflict of interest when deciding whether to allow investors to withdraw monies. Academic research carried out after the 2007-08 financial crisis found that the main beneficiaries of the activation of gates were the fund managers. Review – and, if necessary, negotiation – of the fund documents at the point of investment is therefore crucial in order to protect investors’ interests.
Finally, investors should be taking the time now to understand the gate provisions in fund documents – and in particular assessing if the gates do come into operation, whether there would still be sufficient liquidity within the investment portfolio. There is a possibility that further gates will be imposed in the short- to medium-term, both on property and other investment funds.