On 30 March 2015 the FCA confirmed the publication of six new draft Technical Notes relating to listed closed-ended investment funds (the Investment Fund Notes). It also consulted on the amendment of the Procedural Note relating to Block Listings.
Understanding the Investment Fund Notes requires them to be read in their historical context, which arises from prior Listing Rules amendments. In particular, it must be remembered that prior to 2007, LR 15 (being the chapter of the Listing Rules that relates to closed-ended listed funds) set out eligibility requirements for investment funds that were both restrictive and prescriptive. Following representations from industry after certain high profile funds listed on Euronext, and a brief flirtation with “secondary listings” of some alternative asset funds, which sparked significant industry debate around consumer protection issues, LR 15 was significantly relaxed in order to allow a wider range of funds to benefit from what then became a “premium” listing. This deregulation was effective in attracting a range of alternative funds to the UK markets. In particular, in the last few years, we have seen listings of infrastructure funds, renewable infrastructure funds, hedge funds, debt funds and private equity funds, including master-feeder structures.
Anyone involved in the IPO of any such fund will be aware of concerns raised by the UKLA during the eligibility review in relation to risk-spreading, related party transactions and other issues. The Investment Fund Notes in part seek to summarise and consolidate the UKLA’s position on these matters. They should not affect funds that are already listed under LR 15 but may be seen as signalling a hardening of the UKLA’s approach to eligibility and other matters that should be borne in mind by anyone considering launching a listed alternative asset fund. The UKLA is consulting on the Investment Fund Notes until 11 May 2015.
UKLA/TN/408.1 – Eligibility of closed-ended investment funds
In this draft Technical Note, the UKLA notes that key concepts in LR 15 include:
- “the requirement to have a defined investment policy that can only be changed materially with the consent of shareholders
- the obligation to have a board independent from the fund manager
- the need to spread investment risk, and
- a prohibition from conducting significant trading activity”
The UKLA then notes that the last two of the bullet points noted above tend to feature most prominently in its assessment of the eligibility of a new fund for listing. In particular, the UKLA is concerned to ensure that companies listing under LR 15 are genuinely investment funds and not simply holding companies of commercial groups that should more properly be listed under LR 6 or LR 14.
The requirement to spread risk results in the requirement for an investment policy that articulates how the applicant fund will manage its assets and spread its investment risk. An investment policy must include information on asset allocation, risk diversification and gearing, including maximum exposures. As those involved in recent fund IPOs will be all too aware, the UKLA will consider the investment policy carefully and engage with the sponsor where it considers that there is a risk that genuine diversification may not be achieved. For example, if a particular investment may represent a significant part of the issuer’s portfolio, the UKLA will seek to understand why the sponsor believes the proposed policy enables a genuine spread of risk investment. The example given in the draft Technical Note refers to more than 25% of the portfolio being represented by a single asset. Promoters of real asset funds have experienced challenge from the UKLA in this area, with some promoters being unsuccessful in their arguments that the proposed issuer should be classified as an investment fund.
The UKLA is also keen to emphasise the distinction between a trading company and an investment company – a fund must not engage in trading activity that is significant in the context of the fund as a whole. Here, the UKLA distinguishes between the issuer and its investee companies. The UKLA notes that, in determining whether an applicant is “credibly described as a closed-ended investment fund”, it will take into account a number of factors, including:
- the asset class – contrasting for example a FTSE tracker and a windfarm fund
- for assets that require more operational oversight than shares and bonds (eg. real assets), how the operational aspects will be managed and by whom
- the extent to which there is a clear focus on spreading investment risk
- the rationale for follow-on investment
- how many (if any) staff are employed by the fund, and in what capacity
- the track record of the individuals behind the proposal, and
- the intended use of capital and debt facilities in the context of the specific asset class.
One may surmise that a fund investing in real assets operated by employees of the fund, that will be investing in a limited portfolio of assets and is being promoted by individuals with a background that owes more to operations/industry than to investment management, may struggle to fulfil the eligibility criteria.
The final point covered in this draft Technical Note is the UKLA’s attitude to financing arrangements. The UKLA is primarily interested in how financing structures may impact on the requirement to spread risk. The UKLA particularly highlights that “secured debt that sits at issuer level or across multiple assets may imply that, in the event of default, material parts of the portfolio may be at risk”. The UKLA accepts that there are legitimate reasons for debt being used in this manner. One assumes that once again it is not overly-focussed on those funds investing in liquid pools of securities, with a low level of debt financing. The UKLA pushes responsibility onto the sponsor to explain to the UKLA how it has satisfied itself that the applicant can spread investment risk in spite of the gearing structure.
The UKLA also refers to debt structures that effectively pool a group of assets together as security for a single loan. The UKLA will assess risk-spreading based on the pools, rather than looking through to the individual underlying assets. This may have a significant effect on an applicant’s ability to demonstrate spread of investment risk.
The UKLA further notes that different investee companies should not be financed on a day to day basis using the cashflow arising from the operations of other investee companies. In the words of the UKLA, “such activity is suggestive of the applicant being run as a commercial company”.
The UKLA’s overall attitude is helpfully summed up by commenting that it would expect a fund to be able to “make an investment decision in relation to each asset on its own merit, without needing to take into account whether it will be detrimental to other parts of their portfolio to exit or increase an investment”. This will be a helpful guiding principle to those considering difficult eligibility questions.
None of the points raised above will be new to practitioners who have recent experience of seeking a listing under LR 15 for an alternative assets fund. It is useful to have guidance of which to take account when advising clients instead of having to rely on precedent and hearsay to gauge what the regulator is likely to accept or reject.
UKLA/TN/406.1 – Infrastructure funds
This draft Technical Note deals with the practice that has emerged of infrastructure and renewable infrastructure funds coming to market with a “pipeline agreement” in place that enables the listed fund to source investments from the investment manager’s group without those asset acquisitions being classified under the related party rules in LR 11. On a number of occasions in the past, the UKLA has accepted that, given the liquid nature of these asset classes, a fund’s only viable source of investments might be the manager’s group and accordingly, acquisitions from the investment manager’s group ought to be regarded as being in the ordinary course of business and therefore not classifiable under the related party rules. This was accepted if a fund had stated from the outset its intention to make such purchases and had procedures in place to manage any conflicts of interest. Such arguments have not always been accepted, particularly where the asset class comprised small-scale infrastructure assets for which there was a reasonably developed market – examples include solar PV assets.
The UKLA is articulating its policy that this argument will only be accepted where the fund can point to “structural characteristics” in the sector it invests in that mean that the fund can only provide investors with exposure to the asset class by purchasing from the related party in question. Where investments can be sourced from other parties, the UKLA will not accept that acquisitions under a pipeline arrangement ought to fall outside the related party rules. Even where a pipeline agreement is the only viable option, the fund must be able to demonstrate that it is able to effectively process such purchases and manage any conflicts of interest that may arise.
Where sponsors are advising on related party issues, they will be expected to discuss the matter with the UKLA. The UKLA also indicates that it may not be bound by precedent, particularly in light of market developments that open up a particular asset class.
Again, the content of this draft Technical Note brings no surprises based on experience over the last 18 months or so. One has the sense that the UKLA is concerned that precedent and past practice are riding roughshod over the related party rules and need to be reined in. The reference to not being bound by precedent is particularly noteworthy.
UKLA/TN/409.1 – Master–Feeder Structures
LR 15 accommodates master-feeder structures, subject to compliance with particular requirements.
The purpose of the draft Technical Note is to address quasi master–feeder structures that on the face of it look like traditional master–feeder structures but which give the (listed) feeder fund a significant stake in the master fund that should allow it to exercise some control over the master fund or under which the feeder fund proposes to invest partly in a master fund and partly through direct investment.
The draft Technical Note clarifies that in those scenarios it will not be sufficient for a feeder fund to simply describe its investment policy by reference to the master fund’s investment policy. Instead the feeder fund’s investment policy should clearly describe how investments will be made in a way which is consistent with its objective of spreading risk. In cases where a feeder fund proposes also to make direct investments, it will need to consider whether it continues to meet the criteria for a feeder fund at all.
UKLA/TN/405.1 – Investment management agreements and independence of the board
This draft Technical Note highlights the importance of the independent board to a listed investment fund. The independent board has obligations under the Listing Rules, as well as under company law. It is responsible for setting the strategy and investment policy of the fund and for supervising and, where appropriate, challenging key service providers, particularly the investment manager. The UKLA notes that to some extent, the board’s ability to challenge and supervise the investment manager is dependent on the board having the ultimate power to terminate the investment management agreement (IMA), albeit on an agreed notice period and subject to agreed compensation arrangements. The UKLA also notes that there may be limitations on a board’s ability to terminate an IMA where the underlying assets are highly specialist – in those circumstances there may be an initial period where termination is not permitted.
The independent board is a key feature of the UK investment trust landscape and the extent of board independence can take non-UK investment managers somewhat by surprise. In particular, those investment managers can be reluctant to cede control of “their fund” to the independent board. It may be these situations that have resulted in IMAs that have raised the UKLA’s eyebrows by providing that the fund agreement may only be terminated in specific circumstances, for example if the fund is wound up at the same time. The UKLA also cites agreements that purport to continue in perpetuity or for an exceptionally long period of time, with termination costs that are essentially prohibitive or where termination is only permitted following a shareholder vote.
While falling short of prescribing the content of IMAs and also acknowledging that the power of a board to terminate the IMA is only one aspect of a board’s ability to challenge an investment manager (who will in any case be bound by regulatory obligations), the UKLA does point out that boards should consider whether the terms of an IMA restrict their ability to act independently and provide appropriate challenge. Where an IMA contains provisions that may be regarded as unusual or onerous, the sponsor of the applicant fund can expect to have to engage in discussions with the UKLA.
UKLA/TN/410.1 – Definition of “Investment Manager”
Certain provisions in the Listing Rules make reference to a fund’s “investment manager”. This definition is deliberately drafted in broad terms. Following implementation of the AIFMD, there is an increasing tendency for a fund to have an external AIFM that delegates portfolio management to a separate entity. The UKLA has been asked to clarify who should be considered the investment manager in these circumstances. The UKLA explains, in this draft Technical Note, that its presumption is that both entities fall within the definition of “investment manager” and as such both would be treated as a related party of the listed fund for the purposes of LR 11. This appears both sensible and uncontroversial.
UKLA/TN/407.1 – Closed-ended investment funds with multiple share classes
This draft Technical Note is relevant to investment funds that have more than one share class listed. The UKLA notes the requirement for each class of shares to comply with the Listing Rules. In particular, each class of shares will need to have an investment policy that enables investors to assess the investment opportunity and identify how the objective of risk spreading is achieved in that share class.
The UKLA notes that many investment trusts issue new classes of shares that are ultimately intended to convert into an existing class – C Shares and Subscription Shares are examples of this. In those cases it is common for the investment policy to simply include a statement that post-conversion shareholders will be exposed to a broader portfolio. Whilst the UKLA is not seeking to be prescriptive, it notes that each class of shares should have a precise and clear investment policy that enables an investor to understand how risk spreading will be achieved, even in what may be a short period prior to conversion.
UKLA/TN/404.1 – Related Party Transactions by closed-ended investment funds – amendment of an existing investment management agreement to cover new money
This draft Technical Note clarifies the application of the related party rules in LR 11 to situations where an IMA is being amended to take account of a fund raising new money. The UKLA confirms that no related party transaction is taking place where the existing IMA will cover the new money on exactly the same basis as the existing funds. Where the amendment involves any changes to the terms of the agreement that are, or could be, to the benefit of the investment manager, the UKLA expects any such change to be classified as a related party transaction. The same applies where the entire IMA is replaced by one in which the management fees are calculated on a different basis.
This clarification merely articulates the UKLA’s known practice and should not be controversial.
UKLA/PN/907.2 – Block listings
While not specific to closed-ended investment funds, this amended draft Procedural Note does contain provisions that are particularly relevant to listed investment funds. In essence, it supports current UKLA practice regarding “tap issues” of shares by listed investment companies. Block listings are only available where the normal admission process is likely to be “very onerous due to the frequent or irregular nature of allotments”. The UKLA distinguishes “very onerous” from “inconvenient” or “expensive”. Block listings may be available for tap issues where issuers can provide the UKLA with supporting information including, for example:
- evidence of a price premium
- evidence of NAV management programme if such a programme is the reason for the application. This may include a board resolution, an RNS announcement or a disclosure in a recent prospectus
- where applicable, evidence of frequency of issues and evidence of where a meaningful time delay of having to make a one-off application would inhibit the ability to issue shares to investors, and
- any other relevant information.
The Procedural Note sets out examples of instances where a block listing application might be refused. The changes made to these examples are unlikely to be relevant to investment funds. Requests are likely to be refused where they are made solely for convenience, solely to avoid certain fees and to carry out a placing. Investment funds that publish placing programme prospectuses should therefore not expect to be able to take advantage of the block listing regime.
While the draft Technical Notes contain little that will surprise practitioners, they might be read as signalling a “clamp down” in response to recent perceived attempts to push the boundaries set out in LR 15. Alternative asset classes have dominated the listed fund IPO landscape in recent years. While they offer a variety of investors access to illiquid asset classes, which is to be welcomed, these funds also need to be considered against the broader regulatory backdrop. MiFID II, the PRIIPs Regulation and the ELTIF Regulation all have an impact on these highly sophisticated funds that are available, through their listing, to retail investors. In the short-term, we can expect the UKLA to adopt a conservative approach to the application of LR 15 to alternative asset funds.