The FCA has launched a Consultation Paper on illiquid assets and open-ended funds. This, to some extent, picks up from a previous Discussion Paper published in February 2017 , as noted below. One of the main drivers behind both papers was the perceived need to produce a considered response to the way in which open-ended funds investing in illiquid assets, reacted to the market jolt that followed the Brexit referendum result. (The referendum result had a marked effect on illiquid property funds in particular, triggering a rush of redemptions.) Whilst funds using existing tools to deal with such events - such as suspensions- avoided serious market disruption and, in the FCA’s words, the outcome did not suggest that a major overhaul of the regulatory framework was needed, the FCA nonetheless considers that some lessons could be learnt.
The FCA has therefore issued proposals which it hopes will improve outcomes for investors in open-ended funds investing in less liquid assets, such as property and infrastructure funds, in particular for investors in non-UCITS retail schemes (NURSs). These proposals focus on the following measures to improve management of difficult market events:
- requiring NURSs that invest in immovables to suspend trading where there is material uncertainty about pricing of a significant part of the fund property;
- better contingency planning and oversight in liquidity management- the FCA will require managers to produce contingency plans which would be available in the event of a liquidity crisis and enhance Depositaries’ oversight of such plans;
- better disclosure to clients about the liquidity risk and liquidity management tools.
Background Influences to FCA approach
The Consultation Paper refers to the previous FCA Discussion Paper which sought to learn lessons from the fractured market in illiquid assets which followed the Referendum. The FCA suggested a series of responses to market disruption including:
- the use of existing liquidity management tools;
- alternative treatments for professional and retail investors;
- the requirement to hold a minimum liquidity buffer or restrictions on the level of illiquid assets;
- specific tools such as deferred redemptions, reduced redemption frequency and notice periods;
- enhanced disclosure to investors in relation to the effect of investing in illiquid assets;
- the possibility of a secondary market developing which would allow dealings in funds which had suspended redemptions.
Looking at the responses received to the Discussion Paper, the FCA noted that:
- there was no appreciable support for prescriptive limits or thresholds to be set for liquidity buffers or portfolio structures;
- there was support for daily pricing and dealing but with tools available for liquidity management, and a minority had taken the view that there was a mismatch between illiquid assets and daily dealing;
- asset valuation and anti-dilution measures were a complex area with a number of reservations expressed as to how well such measures worked; and
- there was strong support for improving transparency to investors on the risks involved in funds holding illiquid assets.
The FCA’s new proposals take into account the responses to the Discussion Paper and also (i) the conclusions of its own 2017 Supervision Project, reviewing events following the Brexit Referendum, and (ii) the recommendations of IOSCO set out in the revised version of the IOSCO Principles of Liquidity Risk, published on 1 February 2018.
The FCA has indicated that most of the new proposals will apply to “Funds investing in inherently illiquid assets” (FIIAs). The FCA has proposed that a fund will be classed as a FIIA where one of two sets of circumstances apply, namely:
- NURSs which have disclosed to their investors that they are aiming to invest at least 50% of their scheme property in inherently illiquid assets;
- NURSs which have invested at least 50% of the value of the scheme property in inherently illiquid assets for at least three consecutive months in the last twelve months.
The 50% threshold is seen by the FCA as an appropriate threshold as it would exclude funds which hold some illiquid assets but not enough to give rise to the risks that the FCA is concerned about. The three month threshold for bringing a fund within the FIIA regime has been devised to exclude funds which have illiquid assets on a temporary basis. However, where the three month period is exceeded this provision will allow investors to benefit from the same protections accorded to other funds holding illiquid assets.
The FCA’s proposed definition of an inherently illiquid asset would encompass:
- an immoveable (including property and real estate);
- an investment in an infrastructure project (including special purpose vehicles investing in infrastructure projects);
- a transferable security that is not a readily realisable security;
- any other security or asset that is not listed or traded on an eligible market and has particular features that make the process of buying or selling difficult or time consuming;
- a unit in a FIIA or another fund which has substantially similar features to a FIIA – this is perhaps an obvious addition; if a fund in turn invests in a FIIA, it is likely to face the same liquidity risks to a fund which invests in such assets directly (for example an investment in a property-authorised investment fund).
Where a NURS currently operates limited redemption arrangements under the Collective Investment Scheme Sourcebook and these limited redemption arrangements reflect the time needed to redeem or realise assets, then the FCA proposes that such funds will be exempted from the FIIA requirements.
The funds most affected by these proposals will be NURSs.
The FCA takes the view that as investors in QISs (which may have similar characteristics) are basically able to look after themselves by virtue of the entry criteria applying to such funds, they will not be covered by the new rules.
New Proposals- Suspensions
The new proposal on suspensions is that where the Standing Independent Valuer (SIV) has expressed material uncertainty about immoveable(s) that account for at least 20% of the value of a fund, the fund manager must temporarily suspend dealings in units of a NURS. According to the FCA, if there is material uncertainty in the valuation of a significant proportion of the fund’s assets, this can prejudice investors leaving or those remaining, as the redemption price may not reflect true value. A suspension in such circumstances, even if only temporary, should avoid the purchase and sale of units at a price which may not properly reflect the fund’s NAV. The FCA’s approach is that if only a relatively small part of the fund’s assets is affected by material uncertainty, the manager should be allowed to continue to manage the situation in discussions with the SIV and allow redemptions to continue.
The new rule will also apply to funds that hold a similar interest in other funds, which in turn have suspended dealings due to material uncertainty. The same concern about fair pricing applies but the FCA sees the danger here as being that the fund manager will not be able to sell units in the suspended underlying funds and can only sell non-suspended assets to meet redemption requests. The remaining investors could therefore be left with an increasingly illiquid portfolio.
If circumstances which require mandatory suspensions occur, there will be no need for Depositary consent to a suspension. Notification will be sufficient.
New Proposals- Contingency Planning
The FCA notes the finding in its Supervision Project on property fund suspensions that fund managers did not adequately plan, or have clear policies, for valuing their portfolios in stressed market environments. The new rules will require managers of FIIAs to draw up and maintain contingency plans for exceptional circumstances.
The contingency plans must:
- describe how the fund managers will respond to a liquidity risk crystallising;
- set out the range of liquidity tools and arrangements which they may deploy, any operational challenges associated with such tools and the consequences for investors;
- include communication arrangements for internal and external parties and explain how the fund manager will work with other interested parties, such as platforms and depositaries, to implement the contingency plan.
The FCA wants to introduce more stringent requirements where a fund manager relies on third parties to implement part of the contingency plan. This will obligate the fund manager to obtain written confirmation from any third party on which they rely to deliver the contingency plan, so that the third party can undertake the relevant matters.
There are additional provisions proposed for the COLL Sourcebook detailing the enhanced duties of the Depositary to review the liquidity management of a FIIA.
As part of this approach to FIIAs, the FCA also issues some guidance on the use of various liquidity tools by fund managers. The areas where the FCA seeks to provide some guidance include:
- rapid sales of immoveables- the FCA sees this issue occurring where there is a need for meeting redemption requests for particular fund reasons but with no major turbulence in the underlying market for illiquid assets. In such circumstances, the manager should agree with the SIV what is a fair and reasonable price for an immoveable in the event of a rapid sale. As rapid sales could affect the value attributable to investors, the ability to do this should be drawn to the attention of investors in the Prospectus;
- Anti-dilution measures- primarily these tools, such as dilution adjustments or dilution levies, are meant to ensure that additional transactional costs are met by those entering or leaving a fund. These are not really liquidity management tools. The same might be said of single swing price mechanism. The FCA believes that fund managers should ensure that the purposes of these tools are more clearly explained;
- Liquidity buffers- the FCA is concerned that the practice of holding larger proportions of cash in uncertain circumstances can act as a drag on performance and favour investors who sell in anticipation of major events (first mover advantage). The FCA intends to provide guidance to the effect that funds should not accumulate or hold cash and near cash for a significant duration in anticipation of unusually high and unpredictable volumes of redemption requests;
- Suspensions - the FCA emphasises that suspensions may be in interest of investors, over and above the provisions detailed above. The FCA wants managers of FIIAs to be comfortable in suspending where this is interests of investors. Examples are where liquidity would otherwise be severely depleted or property sold at a substantial discount.
New Proposals- Disclosure
The final proposal is that disclosure of the issues surrounding illiquid assets to investors should be improved so that investors understand the risks better. The FCA has made the following proposals for FIIAs:
- the fact that the fund invests in illiquid assets should be signposted more clearly. This will be achieved by adding the illiquid nature of the assets to the name of the fund. This does look a bit clumsy - the example used by the FCA is “the Blue Fund - a fund investing in inherently illiquid assets.” This new form of nomenclature would not need to be used every time the name of the fund was used but on occasions where it would best describe to investors the nature of the fund, including a key information document;
- better risk warnings are needed - the FCA has outlined a specific risk warning to be used in certain documentation outlining specific issues associated with FIIAs. This will apply to financial promotions issued in respect of FIIAs and intermediaries and platforms will also need to use the warning;
- the Prospectus for a FIIA should include enhanced wording explaining how liquidity issues are to be managed.
The FCA’s proposals are detailed and hopefully proportional to the risks that retail investors face with illiquid funds. They are however another measure which will no doubt have costs implications for managers, in an environment where there is also a strong regulatory focus on greater transparency as to costs.