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.
The decision to suspend redemptions by these large property funds has triggered discussions surrounding the fate of the property market and whether this is a repeat of 2008, when funds were last similarly gated. More fundamentally, this has also brought to the forefront the key question of whether real estate is even an appropriate asset class for an open-ended fund.
What is an open-ended fund? An open-ended fund is a fund that does not have restrictions on the number of shares issued or redeemed at any time. Shares are issued by the fund and likewise sold back to the fund based on the fund’s net asset value at the time rather than to another investor, which creates liquidity for any investors looking to redeem their shares quickly. The attraction of an open-ended fund is therefore the flexibility afforded to investors and the ease with which capital can be extracted, which makes open-ended funds highly appealing to both institutional and retail investors alike.
Why have open-ended property funds suspended trading? After the Brexit vote, there was a rush of investors looking to redeem their shares in open-ended property funds. The outflows were largely attributed to investors’ concerns regarding the property market. Although most funds maintain around 10 per cent of their asset value in cash, the sheer volume of redemptions since the vote has put these funds under pressure to sell their assets at an undervalue to meet the redemption requests.
Depending on the type of property asset, the time frame for the sale of UK property assets may range from three to six months and potentially even longer depending on market demand and liquidity constraints. Furthermore, there is an inherent conflict between selling assets at a discount and so suffering losses to meet redemption demands, and safeguarding the interests of non-redeeming investors. The recent spate of suspensions therefore allows these funds time to survey the market, assess their respective portfolios and stave off the premature sale of property assets in order to protect the interests of all investors. On the other hand, investors who want their money back face delays in receiving their redemption proceeds and continue to be exposed to market risk and volatility.
These suspensions have therefore now turned the industry’s attention to the illiquidity of property assets and the mismatch with an open-ended fund structure. One of the criticisms raised was that the crisis in 2008 was brought about by the failure to acknowledge the illiquidity of property assets, and that this gating of redemptions is yet again the result of a collective reluctance to tackle this issue.
Property assets and open-ended funds – a late diagnosis? On 8 July 2016, the Financial Conduct Authority (FCA) released a short statement of guidance on fund suspensions1.
Broadly, this is a reminder to fund managers of their duties to act in the best interests of all their clients and of how this duty applies to their decisions in managing their funds in stressed market conditions. In particular:
- Fund managers must “understand the range of tools available to them” in managing their funds through periods of market disruption. This range of tools will depend on the make-up of each fund. (The clear implication, here, is that managers should not reach immediately for suspensions.)
- Fund managers must ensure that assets sold are valued accurately and fairly so that subscriptions and redemptions are made at a fair price. (In stressed market situations this may become more difficult to establish.)
- If a fund must dispose of assets to meet an unusually high volume of redemption requests, that disposal must be carried out in a way that does not disadvantage investors remaining in the fund or newly investing in it.
- Fund managers should consider whether it is in their clients’ best interests to suspend dealings. But: (a) FCA suggests this is likely to occur only “in exceptional circumstances” and (b) FCA expects the fund manager to contact it in advance of that suspension.
- Having temporarily suspended a fund, a manager must consider when to lift the suspension – that decision must be taken in the best interests of all the investors. In some cases, where assets are illiquid, it may be better to lift the suspension and give investors an opportunity to redeem at a revised price that reflects realisation of those assets in a shorter than usual time frame. In these circumstances fund managers must pay particular attention to their duties to keep investors informed, clearly communicate revised redemption prices, provide adequate time for investors to make their decision and specify details of the process for redemption or cancellation of redemption requests.
In addition, firms should ensure that they manage any conflict between their own interests and those of their clients when deciding to suspend redemptions.
Following the FCA’s guidance, on 12 July 2016, it was reported that AJ Bell had reclassified suspended property funds as a non-standard asset. This move has been met with mixed responses: some have stated that this is a positive step toward retail investor protection, while others have expressed doubt as to whether this is an appropriate measure given that the liquidity issue is, in their view, largely temporary.
Although there are no formal statistics relating to the composition of the redeeming fund investors (i.e., hedge funds with institutional investors only or retail funds with both institutional and retail investors), the regulatory guidance and general industry commentary strongly suggest that the majority of redemption requests are constituted by retail investors in open-ended retail funds. While the current lock-ups are mainly affecting open-ended retail funds (which are traditionally subject to greater regulatory scrutiny), it should be emphasised that the illiquidity in 2008 also impacted a number of unregulated hedge funds which were only open to qualified or institutional investors. At the time, there were many instances of managers gating or suspending redemptions to prolong the life of otherwise failed investment vehicles and the potential recurrence of such behaviour should be kept in view by regulators and industry participants when considering next steps.
The future On 4 July 2016, the FCA released its quarterly consultation paper with a chapter focused on non-mainstream pooled investments (NMPIs). At the moment, the consultation paper does not mention property funds as a type of NMPI. However, given the timing of publication and recent events, it remains to be seen as to whether open-ended property funds may be incorporated as a sub-category under the definition of NMPIs, though this further revision may invite a lengthier consultation. Comments from the public are welcomed and can be submitted via an online response form until 1 September 2016.
The overarching message is that investors should always carefully evaluate the return profile and asset composition of any fund they invest in and understand whether the liquidity profile of the fund meets the liquidity profile of the underlying assets.
As for future opportunities, there has been speculation that investors may now look toward closed-ended vehicles like real estate investment trusts (REITs) and property investment companies. However, in relation to REITs, any sudden influx or spike in popularity ultimately depends on their performance from this point onwards. Since the Brexit vote, share prices for REITs such as British Land and Land Securities have only declined and, despite brief fluctuations, have yet to recover to the levels seen in 2015.
Client Alert 2016-219