On 4 July 2016, Standard Life Investments suspended trading as a result of investors flooding the gates for redemptions. Several other funds, such as M&G and Aviva Investments, followed suit throughout the same week. By October 2016, most of these funds had lifted their suspensions and had resumed trading normally.
The decision to suspend redemptions by these large property funds has brought to the forefront the key question of whether real estate or other illiquid assets are appropriate for open-ended funds.
This topic was initially explored in our client alert dated 8 August 2016, “Open-ended property funds: a fund-amental mismatch?”.
Following fund suspensions in July 2016, the FCA released a discussion paper in February 2017 to gather stakeholders’ views on illiquid assets and open-ended investment funds and seek to provide a basis for debate by setting out several policies for FCA intervention. Depending on the scale and nature of the issues highlighted in the responses received, this may lead to new and adapted rules to be subsequently released in an FCA consultation paper for further feedback.
The issues and questions put forward for consideration by stakeholders are as follows:
1. Existing definition of illiquid assets held by open-ended funds
Currently, there is no stipulated definition of what an ‘illiquid asset’ is. There are a number of characteristics (not traded on an organised market, a significant imbalance between supply and demand, etc.) which the FCA considers as common between financial and non-financial illiquid assets, though there is an acknowledgement that certain liquid asset classes may start to become illiquid depending on economic conditions.
There are certain asset classes which the FCA considers to be inherently illiquid and this includes real estate, and the FCA is inviting comments on the existing description of illiquid assets and suggestions as to whether other asset classes should be included.
2. Existing liquidity management tools
The existing framework for regulating open-ended funds is fairly developed and largely surrounds liquidity management. Liquidity management tools are loosely grouped as pre-emptive measures and post-event measures.
Examples of typical liquidity management tools are set out below.
- Portfolio diversification allows fund managers to manage disposals and redemption requests without compromising the overall quality and value of the portfolio. Fund managers may also limit the size of certain portfolio holdings so that they remain easily marketable.
- Maintaining cash reserves to serve as liquidity buffers against unexpected outflows reduces liquidity risk, though this results in lower investment performance than if all cash held by a fund was fully invested.
- Introducing sliding scales of redemption charges (i.e., a higher charge in the first year, then gradually diminishing) discourage short-term investment and premature redemptions by investors.
- Fund managers may tailor their investment policies to account for and anticipate investors’ behaviour, whether by controlling the investor base or analysing redemption patterns in relation to investment performance. The fund stipulates the composition of the investor base or restricts the proportion of the fund that can be held by a single investor or a group of affiliated investors (which may help to reduce the risk of the fund being unable to meet redemption requests put in by a few substantial investors).
- Fund managers may enforce notice periods for any dealing requests and also specify a fund’s dealing frequency – however, this has to be formulated taking into account the investors’ requirements (e.g., some may insist on daily dealing).
Pre-2008, many funds also employed a pre-emptive measure known as ‘side pockets’. This was the deliberate segregation of liquid and illiquid (or hard to value) assets where illiquid assets would be placed in a side pocket. If investors were to redeem their interests during the life of the fund, they would be paid with the proceeds from the sale of the liquid assets (i.e., investors were unable to realise any value from assets that had been placed into the side pocket until the specific side-pocketed investment had crystallised). As effective as this mechanism was, the side pocket was allegedly misused during the financial crisis as managers, when faced with a large amount of redemption requests, sought to place more assets into side pockets to avoid being forced to sell these assets at a distressed price. This had the effect of removing a significant proportion of fund assets beyond investors’ reach and it raised concerns as to whether sufficient disclosure was being made to investors regarding when assets may be placed into side pockets and how funds could ensure that such assets are valued appropriately. Side pockets can still be of use today provided there is an appropriate structure in place along with adequate disclosure and transparency.
- Where fund managers consider the valuation of assets to be inaccurate (particularly where these assets are not valued frequently or where the market has changed significantly), a fair value pricing discount may be applied to account for the uncertainty. Depending on the number of redemption requests, the extent of the discount could potentially be adjusted to reflect what the managers think the assets would be likely to realise if they were forced to be sold at that discounted price (this is known as a dilution adjustment) and such adjustments may discourage investors from going through with their redemptions.
- Funds may impose limits on redemptions (typically 10 per cent, sometimes lower), deferral of redemptions or other mechanisms such as queuing systems.
Managers have fairly wide discretion as to how to use any of these specific tools and currently there is no penalty presumption of poor practice where these tools are not used (whether or not it is set out in the investment policy as a manager right). It may be that redemption frequencies, queuing systems and notice periods should be considered as a minimum, though the consequences should be considered carefully. The FCA invites suggestions as to other liquidity management tools and how these could be used either singly or in combination with the existing tools set out above.
A key point for industry participants to note is that if managers plan on implementing the tools above, guidelines and policies surrounding the use of these tools and managers’ powers should be clearly set out in the fund documentation and appropriately flagged to investors. Investors and managers alike should also seek legal advice on the form of disclosure to ensure that the relevant information is sufficiently explicit and clearly worded within the fund documentation.
3. Treatment of professional investors and applicability to retail investors
Most funds investing in real estate are available to retail investors though it is often the case that institutional or professional investors hold a significant proportion of such funds. It has been suggested that retail investors may be protected by segregating the investment of retail and institutional investors’ monies within funds. However, the FCA acknowledges that this would involve the restructuring of existing funds and also discourage firms from establishing new retail funds that invest in illiquid assets. The FCA seeks suggestions as to other possible approaches to the treatment of professional investors and whether these would be appropriate and fair to retail investors within the same fund.
4. Portfolio structure and liquidity buffer
As discussed above, imposing restrictions on portfolio composition and diversification minimises the risk of losing value in a portfolio when managers are faced with a large volume of redemptions. Additionally, setting rules on holding uncommitted cash would also reduce the risk of liquidity problems where investors move to redeem their interests. A potential consequence would be that investors who choose to redeem may have an advantage and this will have to be considered when drafting any diversification or liquidity rules.
Alternative solutions include:
- Imposing rules on the use of liquidity ‘buckets’, where the FCA would specify certain limits on the proportion of assets that can be realised within a certain timeframe.
- Requiring fund managers to manage the diversity of the relevant fund’s investor base in order to prevent a single investor or a group of connected investors from acquiring more than a certain proportion of the fund. This could be developed as an extension of the existing rules on property-related authorised investment funds and either establish a diversification threshold or implement processes that a manager must put in place to monitor investor diversity.
The FCA invites stakeholders’ views on whether these requirements should be applied and if so, whether smaller and larger funds should be or are capable of being treated differently.
5. Valuation of illiquid assets
Currently, the FCA does not have any extensive policies or guidance in relation to fair value pricing for property assets or how a manager or independent valuer may be involved in a fair value pricing process. Similarly, there is little guidance on discounting redemption prices of units or shares. The FCA invites feedback and comment from investors, advisers and other stakeholders as to whether such guidelines would benefit investors and ensure fair treatment of all parties.
6. Direct intervention by the FCA
The FCA is able to directly intervene in authorised funds’ activities and this includes a power to compel a fund to take action (or refrain from taking action). However, the FCA did not consider it “appropriate or necessary” to intervene after the various suspensions that took place in 2016. It has commented that “the fact that fund managers made these decisions individually, acting on their specific needs and circumstances, indicates an orderly market”. Blackstone, in common with certain other market players, has issued warnings to its managers in relation to client expectations on redemption frequency (Bloomberg, 20 March 2017), as their investments (which may have been described as high yield bonds) were in fact in distressed debt funds. The affected investors were then given the option to transfer their money to existing Blackstone funds, which locked up investor funds for longer periods (in a manner closer to private equity than to hedge fund investments). While these examples of market initiative and self-regulation are positive and support the FCA’s current position, the FCA also acknowledges that there may be reluctance to act as self-imposed measures by fund managers have a reputational impact, and this may lead to a preference for the regulator to make a judgement call.
There are risks in regulators taking action, the most significant being that intervention may signal to investors that they should have little confidence not only in specific funds, but also the broader asset class. The FCA invites comment as to whether the benefits of direct intervention outweigh the risks (or vice versa) and if so, how such intervention should be applied.
7. Enhanced disclosure
Existing regulatory rules mainly seek to ensure that investors are informed of the risks and nature of investment products and the accompanying restrictions on withdrawing their money prior to making an investment (e.g., the requirement for a prospectus and key investor information documents). Reporting requirements also seek to inform investors of investment performance and notify them of any changes to the manner in which the investments are managed. The FCA invites feedback as to whether these objectives are being met and if not, how these may be achieved, particularly in relation to redemption and the potential consequences of liquidity problems.
8. Secondary market for units in open-ended funds investing in illiquid assets
Where there is no platform for trading and prospective buyers are not readily available to satisfy sellers’ demands, a potential solution is to have the fund manager or an intermediary match investors in illiquid funds to buyers (though the FCA emphasises that it is not a requirement for fund managers to provide this service). It should be noted that a secondary market already exists for private equity funds (e.g., NorthStar Realty Finance’s US$390 million for a 51 per cent stake in 45 real estate funds in 2013, and AXA Private Equity’s portfolio of purchases including US$1.7 billion of private equity fund assets from Citigroup and US$740 million of fund assets from Barclays in 2011). As this secondary market is already fairly active, it may be feasible to contemplate a formal platform or exchange that facilitates the trading of fund interests on a large scale without full requirements of a public offering (e.g., Apollo Management’s private placement, which permitted it to sell some of its interests on an exchange that is only open to institutional and sophisticated investors).
The FCA would like input as to whether more should or can be done to encourage “market-led development of alternative redemption mechanisms”, and whether this could create risks that are not immediately apparent to those who would use this mechanism. Concerns already raised relate to pricing, particularly how pricing will be determined (especially where there is no simultaneous or recent fund valuation) and how this will differ from the pricing of a normal transaction. The FCA invites stakeholders’ views as to the benefits and risks of the secondary market for such funds and whether the FCA should encourage the development of these markets.
Client Alert 2017-127