Setting the discussion in context
Open-ended funds are an important means of investment into illiquid assets, representing an efficient way for large numbers of people, including retail investors, to access those assets via professional fund managers. The regulatory spotlight has shone brightly on asset managers since the financial crisis, with various bodies voicing concerns about systemic risks that certain aspects of the industry might present, including the use of liquidity management techniques and their effect on the market. There has been a slew of consultations and reports on the topic, which sets the context for the FCA’s latest Discussion Paper. It is also worth remembering that the paper is not limited to real estate assets, but applies to illiquid assets more widely.
This report follows the headings in Chapter 4 of the Discussion Paper, as did our roundtable debate.
Treatment of professional investors
“Behind every professional is a retail investor, at the end of the day.”
We began by asking what was meant by “professional investor” for these purposes, or perhaps, how professional and retail investors should be distinguished. John Forbes’ report, written for the Association of Real Estate Funds (AREF), showed that real estate fund sales were heavily intermediated. Accordingly, retail investors had the benefit of expert advice prior to investing and of course most professional investors (such as discretionary fund managers and pension funds) ultimately represented retail investors at the end of the investment chain. Delegates therefore felt that it was more helpful to think of investor expertise as a spectrum, rather than as a binary distinction between retail and professional. Alternatively, as one delegate put it, “there’s a bunch of people in the middle now.”
This spectrum of expertise would suggest that it is not appropriate to direct “retail” and “professional” investors into different funds or indeed share classes. Indeed, many delegates felt that distinguishing between retail and professional investors in this way could raise regulatory questions about fair treatment of customers.
We also discussed the focus on daily liquidity as a means of consumer protection. Consumers might be better served if they had a range of liquidity options to choose from, which might also enhance their appreciation of the impact that liquidity frequency has on portfolio composition and cash management.
“Liquidity disclosures need to be in neon lights on the front cover.”
Enhanced disclosure is principally relevant to retail investors. As investment in open-ended funds running illiquid strategies is largely intermediated, retail investors should be better-informed than execution-only investors. It was also agreed that fund prospectuses already provide disclosure on the availability of liquidity management tools, such as suspending dealings.
Our delegates acknowledged that these disclosures, whilst already generally comprehensive and accurate, could be more specific and in particular more prominent, rather than being “buried on page 36 of the prospectus”. For example, the prospectus could disclose the manager’s proposed approach to liquidity management. Would the manager seek to impose longer notice periods or redemption discounts in preference to a suspension? Would the manager seek to run a larger cash pool (with the associated impact on performance) in order to minimise the risk of suspension, or would it run a smaller cash pool, with increased risk of suspension or other liquidity management measure, in order to maximise investors’ exposure to the chosen investment strategy? Every investment decision made by the manager has an opportunity cost and more emphasis could be placed on explaining this to investors, with a view to increasing investor choice.
The group noted, however, that heavily prescribed disclosures would make this type of explanation difficult to give in sufficient detail. For example, it would not be possible to give a clear explanation of the various liquidity options and how they impacted investment decisions within the confines of KIDs, which were felt to be “an example of well-intentioned attempts at promoting transparency and comparability leading to disclosures that don’t ultimately help the reader.” While the disclosure would be available in the full prospectus, there was no real way to ensure investors read the full prospectus, rather than the KID or other summary information.
We also noted that fund managers' approaches to liquidity tools might, and indeed arguably should, develop in response to changes in circumstances. In practice, a fund manager could find itself boxed in, by pre-contractual disclosures made in other circumstances, to an approach that it no longer felt was optimal.
Use of specific liquidity tools
“I would challenge anyone at the moment to explain how the deferred redemption provisions [of the COLL Sourcebook] work.”
Suspension of redemptions is, of course, not the only liquidity tool available to fund managers. We discussed the other options theoretically available, including deferral and queuing of redemption requests. There was also a discussion about whether new investment was permitted in a fund that had imposed any form of liquidity suspension or deferral. Some investors are undeterred by liquidity suspensions, and the cash inflows from any additional investments could improve the cash position of the fund and lead to a quicker lifting of a suspension/deferral. The group felt that the existing rules “need complete clarification”.
We also questioned whether the move to a unified rule book had worked as hoped. It used to be clearer where specific rules applied to specific types of fund because it was easier for the rules to be adapted to suit particular products.
A focal point of this part of the discussion was the role of funds platforms, other intermediaries and outsourced providers, such as transfer agents. These all play an increasingly important role in fund distribution and their IT infrastructure puts practical limits on how liquidity management tools can be deployed. “It’s fine amending the rules, but mechanistically the Administrator wasn’t permitting us to switch on [deferred redemptions] because their systems couldn’t cope.”
Platforms do not generally support queued or deferred redemptions. Changing this would require significant IT investment and regulatory intervention would likely be needed in order to justify this investment.
Portfolio structure and liquidity buffers
“Where do you set the limits? There is no right limit. So it comes back to disclosure.”
We then turned to the question of whether additional rules or regulatory guidance on portfolio composition would be helpful. Generally, the group found it difficult to understand how proposals to require specific allocations to cash/near-cash and uncorrelated liquid securities would work in practice. The view was also given that liquidity buffers “just don’t work for illiquid products”.
Setting an appropriate level of liquidity for any particular portfolio depended on a number of factors, including overall portfolio composition. This made hard limits seem like a blunt tool for addressing liquidity requirements. They would also affect the overall returns to investors, who are seeking exposure to the headline illiquid strategy, not an uncorrelated set of liquid investments.
There seemed to be a working assumption in the Discussion Paper that the quality of a real estate asset determined its liquidity. However, practice has demonstrated that this was not a reliable assumption, particularly in the aftermath of the EU referendum vote, where there were reports that some of the 'most prime' assets were amongst those sold at the biggest discounts. Ultimately, “as long as pricing is realistic, it’s all liquid”. Managers have to balance the need to raise cash to fund exiting investors against realising a fair value for continuing investors. They also have to build a balanced portfolio with a spread of assets bringing different liquidity profiles.
Secondary market provision
“It’s very clear that you can’t get out of a REIT at NAV so there’s no expectation. But discounts will widen.”
REITs and other closed-ended structures are arguably better placed to hold illiquid assets. Permanent capital allows the Manager to play a long game with respect to investment and divestment decisions, whilst a listing allows investors to exit, even in a stressed scenario, albeit at a market-imposed discount. Nonetheless, REITs are not a panacea and we have to recognise that investors need a range of investment products, including open-ended ones. While it might be helpful to introduce rules that facilitate the conversion of open-ended funds to closed-ended funds, the concern would be that this would result in widespread redemptions and the need for significant portfolio realignment to accommodate that.
The International Property Securities Exchange (IPSX) is intended to be a new regulated market for trading single asset commercial real estate vehicles and to act as a proxy for direct investment in commercial real estate. The ability to trade shares in single asset vehicles could offer a new source of liquidity to open-ended real estate funds. There was certainly room for a more joined-up approach with HMRC to make it easier to wrap illiquid assets in vehicles with a view to promoting liquidity.
Managing the investor base
“It’s more about understanding the investor base and managing the portfolio accordingly than it is about managing the investor base and how it’s made up.”
The group generally did not support setting caps on the proportion of a fund that can be owned by a single investor. Most appeared comfortable, not least from a fairness perspective, with the idea that particular investors might be required to divest part of their holding in a fund. We also noted the widespread use of model portfolios, which “result in all sorts of unintended concentrations that you don’t know about.”
Delegates generally agreed on the need for dialogue with investors. This would help to understand investors’ likely investment and divestment intentions and to build up an appropriate liquidity profile in response to those discussions. By June 2016, at least one house had been increasing its allocation to cash for months simply because it felt investor sentiment was moving towards cashing in the returns achieved from several quarters’ growth.
Asset valuation and anti-dilution measures
“Who says any valuation is the right number?”
Suspension of redemptions is about allowing a period of price discovery as much as it is about funding redemptions. In periods of volatility, price discovery is extremely challenging, and suspensions provide space for markets to settle down to a point where price discovery becomes possible again. However, there may be a perception outside expert circles that suspending redemptions on a fund is akin to a run on a bank, which can trigger unwarranted knee-jerk behaviour.
Redemption discounts – as opposed to suspensions - allow managers to adjust redemption prices in order to account for the valuation uncertainty. However, in the past, imposition of redemption discounts has been criticised on the grounds that managers may be seeking to penalise exiting investors, whereas the reality is that discounts simply reflect a volatile market.
In terms of the governance process around pricing and valuation, it was felt to be the depositary’s role to engage with the manager on pricing. In turn, the depositary would acknowledge that different fund managers would have different approaches to valuation, which would be appropriate because valuations need to reflect the circumstances of particular funds.
The effectiveness of using independent property valuers was discussed, although it was recognised that giving a valuation in a period of volatility was not straightforward. One suggestion was that it should be possible to give a range of valuations reflecting different scenarios and different liquidity requirements. This would assist managers and depositaries in reaching a view on whether suspension or discounting was the better option. It was generally accepted that this approach would require industry-wide engagement, with participation from all stakeholders.
Overall, the discussions elicited three key messages:
- Enhanced disclosure, specifically on a manager’s proposed approach to liquidity management in particular circumstances, could improve the investor experience. There was an acknowledgement that the KID would become the main document reviewed by retail investors following the introduction of PRIIPs, as well as a concern that the constraints of the KID would limit the scope for clear disclosures.
There is room for rule changes in discrete areas. For example, intermediaries such as platforms and transfer agents could be required to make technology changes that facilitate the use of liquidity management tools other than suspension. On the other hand, regulatory intervention in areas such as portfolio compositions or regulator-imposed suspensions would risk taking the responsibility away from those with the expertise and experience to make the relevant decisions.
All industry participants need to work together openly to provide solutions in terms of robust governance, particularly in relation to asset valuations. The asset management review is about creating trust in the industry and the industry must be committed to change and seen to do so.
More fundamentally, perhaps the regulatory approach to liquidity needed to be considered. The daily liquidity requirement is driven by the regulator and the tax framework (for ISAs), but if investors can understand that interest income will suffer if they withdraw from a high-interest savings account, surely they can also understand that returns will suffer if they invest in a fund that has to provide daily liquidity.
“The problem the regulations give us is that we’ve tried to dovetail ourselves into an open-ended structure where giving a client their money back tomorrow is disproportionately important above all else, and then everything else is designed with that tacit assumption.”