The FCA is consulting on measures intended to reduce the risk of poor outcomes for retail investors in open-ended funds that invest predominantly in illiquid assets (such as property or infrastructure), following its 2017 discussion paper on this topic. In stressed market conditions, such investors may be unable to redeem their investments at short notice or only be able to do so at a substantial discount to the unit price.
Overall, the FCA has rejected the view of some market participants that only closed-ended funds are suitable vehicles for retail investment in illiquid assets. Rather, the FCA's approach is to encourage open-ended funds to suspend redemptions as soon as the value of a significant proportion of the assets becomes uncertain. The FCA is not in favour of funds holding large cash buffers to prevent the possibility that fund suspensions could potentially become necessary. Instead, the FCA wants investors to understand fully the liquidity risks they are taking on, and is seeking to make disclosures more comprehensive and visible. This may reduce these funds' attractiveness to certain types of retail investor, but the FCA intends that these funds will only be sold to retail investors who can withstand a delay in their money being returned if necessary.
This blog summarises the FCA's objectives and key proposals and discusses the potential impacts on fund managers and investors.
Why is the FCA consulting on these measures?
The FCA's review was triggered by the temporary suspensions in dealing in a number of property funds following the UK's referendum on EU membership in June 2016. The FCA said that these fund suspensions prevented wider market disruption but raised some questions about how to balance the interests of investors wishing to redeem their holdings and those wishing to remain invested. The FCA's primary focus is therefore on investor protection, although it also has market stability in mind.
In parallel, the EU is looking at liquidity risks in investment funds from a systemic risk perspective. The European Systemic Risk Board (ESRB) published a Recommendation on liquidity and leverage risks in investment funds in February 2018 (see our blog). ESMA is expected to publish guidance on fund liquidity stress testing in 2019, and the European Commission is expected to propose legislation on fund liquidity management by 2020. While the FCA's investor protection focus is somewhat broader than a systemic risk focus, both approaches seek to reduce the risk of a run which could substantially reduce the value of investments for those left in the fund and potentially destabilise the market more widely.
What are the FCA's proposed measures?
The FCA is consulting on a package of measures that will require:
- Non-UCITS retail schemes (NURS) to suspend dealing when the Standing Independent Valuer (SIV) expresses 'material uncertainty' about the valuation of immovables (such as property and infrastructure) that amount to at least 20% of the fund's assets.
- Managers of NURS investing mainly in illiquid assets to produce contingency plans in case of a liquidity crisis.
- Depositaries to have a specific duty to oversee liquidity management processes for NURS investing mainly in illiquid assets.
- New investor disclosures in relation to NURS
investing mainly in illiquid assets. These include:
- adding an 'identifier' to the name of any relevant fund to draw attention to the nature of the fund;
- a standard risk warning to be given in financial promotions relating to such funds to retail clients; and
- disclosure in the fund prospectus of the details of the liquidity risk management strategies and tools and the potential impact on investors.
In addition, the FCA will make further guidance clarifying:
- The circumstances in which it may be appropriate to suspend dealing. For a fund investing mainly investing in illiquid assets, the fund manager may suspend dealing before running down the liquidity in the fund, if this is in unitholders' best interests.
- How a fund manager should arrive at a fair and reasonable value for an immovable, where it needs to be sold quickly to ensure that the fund can continue to meet redemption requests as they fall due.
- That managers of NURS and UCITS1 funds should not hold large cash buffers for a long period merely to deal with the possibility of unanticipated high levels of redemption requests at some point in the future.
What are the likely impacts?
The FCA's proposed rules and guidance on fund suspensions will give fund managers additional clarity on the FCA's expectations about the circumstances in which they should suspend dealing, and reassure them that they are not expected to meet redemption demands when this may not be in the best interests of all investors.
The proposed disclosure requirements will draw attention to the liquidity risks associated with these funds, especially as the identifier in the fund's name will be very visible. Retail investors who want the option of being able to take their money out quickly may consider moving to closed-ended funds structures or investing in assets that are inherently more liquid.
The FCA's guidance that funds should not hold large cash buffers for a long period could, on the basis of past experience, improve fund performance over the long term. The FCA notes that in the run-up to the EU referendum in 2016, property funds increased their liquid holdings and continued to hold high levels of liquidity until the end of 2017. However, particularly in current conditions of negative real interest rates, large cash positions create a drag on yield and may lead to returns that disappoint investors who expected to be more fully exposed to the risks and rewards associated with a particular asset class.
The FCA's proposed rules on contingency plans follow IOSCO's updated recommendations (see our blog) and are similar to the ESRB's recommendation on this topic. Firms can expect more scrutiny on their plans for how they will act in stressed market conditions, including:
- how they will value their portfolios;
- what liquidity tools they will deploy;
- any operational challenges they may face; and
- their communications arrangements with internal and external stakeholders.
The FCA's proposed duty for depositaries to oversee fund managers' liquidity management processes should increase independent scrutiny in this area. Some depositaries may need to gain additional expertise to carry out this new task, but others are already providing a degree of oversight in this area.
The consultation remains open to responses until 25 January 2019. The FCA will publish a Policy Statement in 2019, with any new rules and guidance applying from 2020.
1 Undertakings for Collective Investment in Transferable Securities. COLL 5.2 allows UCITS funds to make limited investments in illiquid transferable securities, but not to invest directly in non financial assets like property or infrastructure. Most of the FCA's proposals do not apply to UCITS funds because there are no material risks to investors in UCITS of the type dealt with in this consultation.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.